The free cash flow valuation model’s implementation is based on the principle that a company’s expected future free cash flows define its worth. Capital structure can impact only the cost of capital and the tax shelter on interest expense; the other effects are irrelevant and cannot be used to revalue the business. Cost of Capital:The debt cost is less than the equity cost as the company increases its debt-to-equity ratio. Therefore, the future cash flows are applied to a lower rate of discount than is the case with the current WAC costs (Valaskova et al., 2018). Consequently, the cost of capital is reduced, and the present value of the cash flows is raised. Tax Shield:Interest on debt is tax deductible; as the company gets more debt, the after-tax debt cost diminishes thanks to the tax shield it gets. The enterprise is growing due to this tax shield.
Operating leverage and business risk:
Business risk is viewing a company’s vulnerability to any fluctuations in its EBIT (Fichtner et al., 2017). The categories include changes in market conditions, industry dynamics, competition levels, regulatory changes, technological shifts, the vulnerability of supply chains, financial structure, operational efficiency, global economic factors, and consumer behavior. Effective risk management helps to deal with uncertainties, providing firms with elasticity to adjust in a dynamic business environment and make sound choices.
Operating Leverage:
The operation expenses, which include the fixed costs, are referred to as the operating leverage of the company (Ali et al., 2023). It affects business risk through the influence that volatility has on the magnitude of the profits that a company realizes from sales. The following formula can be used to determine the operating break-even point:
The following formula can be used to determine the operational break-even point:
Operating Break-Even Point= Sales Price – Variable Costs
Fixed Costs
Using the provided values:
Operating Break-Even Point = 200
15−10
The outcome is 40 units.
Comparing Business and Financial Risk:
Business Risk: This type of risk, as it was mentioned at the beginning of the paragraph, is related to the variation of a company’s operating income, which is a result of fluctuations of both internal and external factors.
Financial Risk: By incorporating debt into its capital structure, shareholders of the company have to be prepared to shoulder an additional level of risk. This stands for owing money on interest to repay borrowed funds, even if the business is not doing well.
Recommendation
After a thorough analysis of the financial position of Pizza Palace, a diversified capital structure with the combination of debt and equity funding is suggested; in the same way as tax-advantaged debt, the proposed capital structure is interested in reducing risks of financial distress and maximizing the weighted average cost of capital (WACC). The debt inclusion strategy in the capital structure would lower the charges of capital. Debt is a financing mechanism that is at least as cheap as equity, with costs ranging between 8% and 12%. As a result, if the WACC is lower, the present value of future cash flows rises, thereby increasing the firm’s total value.
In addition, debt applications reduce the after-tax cost of debt by creating interest deductibility. This tax advantage makes the capital structure more economically efficient and lays the foundation for the choice proposed by the financial manager. It is recommended that capital budgeting methods be applied and the projects with the highest potential be funded by the company’s strategic plan. Pizza Palace may emphasize the investments that generate returns over the cost of capital through the use of discounted cash flow (DCF) and net present value (NPV) analyses. Applying this approach allows the company to achieve maximum return on investment and properly run its resources.
In summary, the suggested strategy for Pizza Palace includes the judicious application of debt, using it rather as a tool for WACC optimization, and choosing a balanced approach to using capital and performance. By fully utilizing the available financial resources and selecting the most appropriate projects using rigorous analysis, Pizza Palace is able not only to gain an advantage over the competitors in the market but also to achieve sustained growth and long-term success in the regional pizza restaurant industry.
References
Ali, H., Farooq, D. N., Khan, D. A., & Nadir, F. (2023). The Effect of Firm Size and Operating Leverage on Stock Returns: Evidence From the the Pakistan Stock Exchange. International Journal of Social Science Archives (IJSSA), 6(2), 201–210. https://ijssa.com/index.php/ijssa/article/view/153
Fichtner, J., Heemskerk, E. M., & Garcia-Bernardo, J. (2017). The hidden power of the Big Three? Passive index funds, re-concentration of corporate ownership, and new financial risk. Business and Politics, 19(2), 298–326. https://doi.org/10.1017/bap.2017.6
Valaskova, K., Kliestik, T., Svabova, L., & Adamko, P. (2018). Financial Risk Measurement and Prediction Modelling for Sustainable Development of Business Entities Using Regression Analysis. Sustainability, 10(7), 2144. https://doi.org/10.3390/su10072144
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