Business and

Financial Risk
Finn A:
FirmB: ROE
8
Firm C: ROE(:
PROBA_BILITY

0.1
0.0%
(2.0)
(5.0)
0.2
5.0%
S.D-.. .
5.o.
10.0%
12.0
15.0
0.2
15.0%
19.0
25.0
a. Calculate the expected value and standard deviation for Firm C's ROE.
ROEA = 10.0%, (TA = 5.5%; ROE
8
= 1LO%, (TB = 7.7%.
0_.1
20.0%
26:0
35.0'
b. Discuss the relative riskiness of the three firms' returns. (Assume that these
distributions are expected to remain constant over time.)
c. Now suppose all three firms have the same standard deviation of basic earning
power (EBIT/Total assets), a A = a
8
= ac = 5.5%. What can we tell about the
financial risk of each firm?
(1S-) The Rivoli Company hJs no debt outstanding, and its financial position is
Capital Structure by the follo}ving data: . ..- . .. .. . . . . .. . . . . . . .
Analysis
a.
b ..
c ..
d.
. :. - . . . . . . -
$3,0bb,ooo
$500,00Q.
10%'
sell or repc<U-U<1->'-
stfllCtl1re change. . .
,irn1 paysout all earnings as dividends; hence, its stock is a zero growth
stOck. Its current cost of equity, rs, is 14 percent. If it increases levera:ge, rs will be
16 percent. If it decreases leverage, r
5
will be 13 percent. What is the firm's WACC
and total corporate value under each capital struCture? .
Beckma:n and (BEA) is considering a change in its capital
Optimal Capital Structure structure. BEA has $20 million ih debt carrying a rate of 8 percent, and
with Hamada k $ h ] 11 h.
its stoc price is 40 per s are witl 2 mi ion s ares outstanding. BEA is a zero
growth firm and pays out all ofirs earnings as dividends. EBIT is $14.933 million,
and BEA faces a 40 percent federal-plus-state tax rate. The niarket risk premium
is 4 percent, and the risk free rate is 6 percent. BEA is considering increasing its
debt level to a capital structure with 40 percent debt, based on market values, and
repurchasingshares with the extra money that it borrows. BEA willluve to retire
the old debt in order to issi1e new debt, and the rate on the new debt \vill be 9 per-
cent. BEA has a beta of 1.0 .
. . a. What :is BEl\'s unleveied bei:a? Use market value. PIS yvhen tmlevering.
. b.. W!Ia{are J?EA'sneyvbeta and cost ofequityif1thas40 percent debt?
c. BEA,:sWACC <1119 total value of the firm wlth 40 percent debt?_
its optimal ckpitalstructure,_which now
-consist qfonly dept arid con1D1o"n equity. The firm does not currently use preferred
stockinitscapital str1Jc,ture,al1d it does riot plan tQ do so in _the future. To estiniate ..
. how co_st atdiffererit debt levels, the company's treasury staff .
has bankers and, on the basis of those discussions", has
tabli_: ' - . . . . . . .
c,_ : . -: :. .
_ << . :! Market ' '

. Ratio' (wC!f R_?tio (w.) .
. Market
DebHo-Equity
Ratio (D/5)
o,oo
0;25
o:i$7
. r.sa
4;00.
Bond Rating
A
BBB'
BB
C
.D
8.0
10.0
12.0
15.0
I;lliott; uses the'GAPM t<) its cost of common equity, rs. The COJDpany
,. ;estiiil.ates,.thatdletisk-fterate isS. percent, the market risk premium is 6percent,
. and its 4o:per,q:nt. Elliott estimates that ifit had no debt, its
,beta;

.. Based,on this information, what is the finn's optimal capi-

e- resource
See FM11 Ch 16
Show.ppt and FM11
Ch 16 Mini Case.xls.
Please go to our site, academiccengage.com/finance/brigham, t6 access any
Cyberproblems:
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problems.
!'iT"!:_ '.t;;1 '1_--:I been hired ::--.
.. l:S. I i-.e CCllparns '\ ,-,...,
.-,n:1Palacc, '' piZ?.<l
''--I" . e;.:r. ;)JH.i since rhc .]: .... _H IS
! \'.:11
r'C required, PizzaPalace plans ro pav out Jil cJrnings JS dividends. The management group owns <Jhom
50 percent of the scock, and the stock is traded in the OYer-the-counter market.
The firm is currently financed with all equity; ir has lOO.OOO shares outstanding; <lnd P
0
= S25 per
>hare. \X
1
hen you rook your corporate finance course, your insrructor stated that nlC'st firms" Cl\Yllcrs
ll'<'uld be financia!h better off if the firms used some cleht. \'{Then you suggested rhis ro vour new boss,
he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm's invest-
ment banker the following estim<lted cosrs of debt for the firm at different c1pir<JI structures:
Percent Financed
with Debt, w,:
20
.10
40
50
8.5
I 0.0
12.0
lf the company 1wre ro recapitalize, debt would be issued. and the funds received would be used to
repurchilse stock. Pizze1Palace is in the 40 percent state-plus-federal corporate tax brilcket, irs bera is 1.0,
rhc risk-free rare is 6 percent, and the market risk prc:mium is 6 percent.
a. Provide a brief overview of capital structure effecrs. Be sure to identify the 1\'JYS in which capircrl srruc-
nne Ciln afiecr rhe weighted averc1ge cost of capital and free cash flows.
b. ( 1) \\'hat is busmess risk? \Vhc1t influence J firm's business nsk?
\2) \VhJr is operating leverage, and how does it afien a firm's business risk? Show rhe opera ring break-
even poinr if a company has fixed costs of 5200, a sJles price of $15, and varic1ble cosrs of $10.