Finance Work

Please answer the following questions for Case #1 and Case #2 using academic writing and vocabulary. Please use 2 or more sources in APA format.

 

Case #1

Assume you have just been hired as a business manager of PizzaPalace, a regional pizza restaurant chain. The company’s EBIT was $50 million last year and is not expected to grow. The firm is currently financed with all equity, and it has 10 million shares outstanding. When you took your corporate finance course, your instructor stated that most firms’ owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm’s investment banker the following estimated costs of debts for the firm at different capital structures:

If the company were to recapitalize, then debt would be issued and the funds received would be used to repurchase stock. PizzaPalace is in the 40% state-plus-federal corporate tax bracket, its beta is 1.0, the risk-free rate is 6%, and the market risk premium is 6%.

ANSWER THE FOLLOWING QUESTIONS:

 

a. Using the free cash flow valuation model, show the only avenues by which capital structure can affect value.

b. (1) What is business risk? What factors influence a firm’s business risk?

(2) What is operating leverage, and how does it affect a firm’s business risk? Show the operating break-even point if a company has fixed costs of $200, a sales price of $15, and variable costs of $10.

 

c. Using the mini case information, write a 250-500 word recommendation of the financial decisions you propose for this company based on an analysis of its capital structure and capital budgeting techniques. Explain why you chose this recommendation.

 

Case #2

Lewis Securities Inc. has decided to acquire a new market data and quotation system its Richmond home office. The system receives current market prices and other information from several online data services and then either displays the information on a screen or stores it for later retrieval by the firm’s broker. The system also permits customers to call up current quotes on terminal in the lobby.

The equipment costs $1,000,000 and, if it were purchased, Lewis could obtain a term loan for the full purchase price at a 10% interest rate. Although the equipment has a 6-year useful life, it is classified as a special-purpose computer and therefore falls into the MACRS 3-year class. If the system were purchased, a 4-year maintenance contract could be obtained at a cost of $20,000 per year, and the best estimate of its residual value is $200,000. However, because real-time display systems technology is changing rapidly, the actual residual value is uncertain.

As an alternative to the borrow and-buy plan, the equipment manufacturer informed Lewis that Consolidated Leasing would be willing to write a 4-year guideline lease on the equipment, including maintenance, for payments of $260,000 at the beginning of each year. Lewis’s marginal federal-plus-state tax rate of 40%. You have been asked to analyze the lease-versus-purchase decision and, in the process, to answer the following questions:

a. (1) Who are the two parties to a lease transaction?

(2) What are the five primary types of leases, and what are their characteristics?

(3) How are leases classified for tax purposes?

(4) What effect does leasing have on a firm’s balance sheet?

(5) What effect does leasing have on the firm’s capital structure?

b. (1) What is the present value of owning the equipment? (Hint: Set up a timeline that shows the net cash flows over the period t=0 to t=4, and then find the PV of these net cash flows, or the PV cost of owning.”

(2) Explain the rationale for the discount rate you used to find the PV.

c. What is Lewis’s present value of leasing the equipment? (Hint: Again, construct a time line)

d. What is the net advantage of leasing (NAL)? Does your analysis indicate that Lewis should buy or lease the equipment? Explain.

e. Now assume that the equipment’s residual value could be as low as $0 or as high as $400,000, but $200,000 is the expected value. Because the residual value is riskier than the other relevant cash flows, this differential risk should be incorporated into the analysis. Describe how this could be accomplished. (No calculations are necessary, but explain how you would modify the analysis if calculations were required.) What effect would the residual value’s increased uncertainty have on Lewis’ lease-versus-purchase decision?

f. The lessee compares the present value of owning the equipment with the present value of leasing it. Now put yourself in the lessor’s shoes. In a few sentences, how should you analyze the decision to write or not to write the lease?