Assume you have just been hired as a business manager of PizzaPalace, a regional pizza
restaurant chain. The company’s EBIT was $120 million last year and is not expected to

grow. PizzaPalace is in the 25% state-plus-federal tax bracket, the risk-free rate is 6 per-
cent, and the market risk premium is 6 percent. 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. If the company
were to recapitalize, then debt would be issued, and the funds received would be used to
repurchase stock. As a first step, assume that you obtained from the firm’s investment
banker the following estimated costs of debt for the firm at different capital structures:

Percent Financed with Debt,

wd rd
0% —
20 8.0%
30 8.5
40 10.0
50 12.0

Explain the difference between financial risk and business risk