M and M Pizza: The Best Pizza in town

What is going on at M&M Pizza? 

M&M Pizza produces pizza in a small country of Francostan. The company has been continually making profits that amount to F$125 million per year. However, the company’s stock has been relatively flat for some time and has been at F$25 per share for the past few years. There has been a recent appointment of the managing director of the company Moe Miller who hopes to make changes to the conservative financial policies of the company which has been the cause for the company’s stagnant share price. In the given case study M&M Pizza is considering substituting its debt for equity so as to reduce its cost of capital. The proposal that has been placed is that the company should have a recapitalization of F$500 million (Franco dollars) through new company debt and thus repurchase F$500 million in company shares. One of the reasons for this is that the cost of debt is at 4% while the cost of equity is at 8%. The recapitalization is set to create value for M&M Pizza owners and it would create the growth perception (Jackson & Victor, 2015). Additionally, it would leave the profits, operations, and assets of the businesses unchanged. 

How do the financial statements for M&M Pizza…? 

The two situations that are evident in the company involve having the unlevered vs the levered option. The unlevered option involves the firm being funded by equity only while the levered option involves the firm being funded by both debt and equity ( Lei & Zhang, 2016 ). From the analysis of the two scenarios, the unlevered situation involves the firm having a high equity claim that is as high as the market value of the firm. There is an interest on debt of 4% of F$500 million which amounts to F$20 million leading the net income to reduce to F$105 million. It is observed that the changes in the dividends per share vary from 2.00 to 2.47 which translates to approximately 24.5% growth. These changes are as shown in the financial statement that is provided in table 1. 

Table 1.
M&M PIZZA Financial Statement
(in millions of Franco dollars, except per-share figures)
Income Statement
	Unlevered	Levered	Calculation
Revenue	1,500	1,500	Remains Constant
Operating expenses	1,375	1,375	Remains constant
Operating profit	125	125	Remains Constant
Interest payment	0	20	Debt * cost of debt = 4% * 500
Taxes	0	0
Net profit	125	105	operating profit - interest
Dividends	125	105
Shares outstanding	62.5	42.5	Provided in footnote 1
Dividends per share	2.00	2.47	Dividends/Shares outstanding
Balance Sheet
	Unlevered	Levered	Calculation
Current assets	450	450	Remains constant
Fixed assets	550	550	Remains constant
Total assets	1,000	1,000	Remains constant
Book debt	0	500	New debt of 500
Book equity	1,000	500	Equity decreases to 500
Total capital	1,000	1000
Value of equity	1562.5	1062..5	Dividends*cost per share
Value of debt	0	500
Value of firm	1562.5	1562.5

What impact does the repurchase plan have on M&M’s…? 

The Weighted Average Cost of Capital is a term that is used to indicated the expected rate which a company is expected to pay on average to the security holders so as to finance its assets ( Frank & Shen, 2016 ). The WACC has a direct relationship with the cost of capital. A high WACC indicates that there is a higher risk which is associated with the operation of a company ( Frank & Shen, 2016 ). Table 2 shows the calculations of cost of capital, cost of equity, and weighted-average cost of capital (WACC). The WACC does not change between the unlevered and the levered scenario. This shows that the use of additional debt does not impact the Weighted Average Cost of Capital. This could be used to prove the proposition that the value of a firm’s equity only increases with its debt-equity ratio ( Jackson & Victor, 2015 ). The impact on the WACC does not exist. However, the situation may appear to be somewhat different in case taxes were introduced. 

Table 2. Cost of Capital and Effects of Recapitalization (No Tax)
(in millions of Franco dollars, except per-share figures)
Tax = 0, Interest rate =4%, D/E=0.471, New shares = 42.5m
	Unlevered	Levered	Calculation
Debt	0	500
Cost of capital
Cost of debt	4%	4%	Remains unchanged
Beta	0.8	1.177	0.8 * (1+(1-0%)*0.471
Cost of equity	8%	9.885%	4%+1.177*5%
WACC	8%	8%	E/(E+V) * Re + D / (E+D) * Rd * (1 - t)

The calculations for WACC were undertaken as shown below. 

Where- E = Market Value of Equity, D = Market Value of Debt, Re = Cost of Equity, Rd = Cost of Debt, T = Corporate Tax Rate. 

What are the debt and equity claims worth … 

The debt and equity claims vary based on the given scenarios as shown in Table 3. In the unlevered scenario, the debt is zero and the equity of the firms accounts for the total cost of the firm. However, with the addition of F$500 debt, the company’s equity is reduced to F$1062.5. The value of the firm does not change in both scenarios. This indicates that the use of additional debt did not increase the value of the firm and this was attributed to the decrease in shares. However, this could be used to trigger the company’s value when the debt is used in the long run for the benefit of the company such as generating additional profits and improving the company’s cash flow. 

Table 3. Value of Equity and Debt (No Tax)
(in millions of Franco dollars, except per-share figures)
Tax = 0, Interest rate =4%, D/E=0.471, New shares = 42.5m
	Unlevered	Levered	Calculation
Debt	0	500
Value
Debt	0	500.00	Interest on payment / Rd
Equity	1562.5	1062.500	Dividend payment /Re
Total	1562.5	1562.5	D+E or WACC
Value of firm
D/E	0	0.471
D/(E+D)	0	0.32

Which proposal is best for investors? … 

The aim of the company was to increase the wealth of shareholders through dividends and capital gain. With all the given calculation provided, the best decision for the company is to focus on the leverage with debt. From the given analysis, the dividends per share increased by F$0.47 per share. This could be used show a strong signal of performance to the shareholders (Ansar et al., 2015). However, the cost of equity increased but the WACC remained almost constant. This showed that the advantage to the shareholders was not going to be significant. For the given scenario, the company was striving to increase the dividends paid to shareholders and using additional debt would be an easier approach to strategize its capital structure. 

The use of additional debt financing by the company could also be used to attract more investors as it indicates that the company is embarking on a new strategy that could be good for investors. Such a perception by the investors can thus be used to attract new investors into the company. However, the use of additional debt financing could place the company at a risky position as they would assume all risks with regard to the new investment. This was an indicator that while the current strategy was good, the company may have to focus on other strategies that would be used for the long-term growth of the company. The company may need to consider other factors such as avoiding excessive debt which could impact the company’s capital structure negatively. 

How would your analysis in questions 2 and 3…? 

The changes in the financial statement were as observed in table 4. From the given analysis, it is shown that the introduction in corporate tax of 20% would impact the net profit, dividends, and the dividends per share. This is because the corporate tax would first be added as an expense in the given scenario (Lee et al., 2015). 

Table 4. Cost of Capital and Effects of Recapitalization (With Tax)
(in millions of Franco dollars, except per-share figures)
Tax = 0, Interest rate =4%, D/E=0.471, New shares = 42.5m
	Unlevered	Levered	Calculation
Revenue	1,500	1,500	Remains Constant
Operating expenses	1,375	1,375	Remains constant
Operating profit	125	125	Remains Constant
Interest payment	0	20	Debt * cost of debt = 4% * 500
Taxes	0	21	20% of (op.profit - interest
Net profit	125	84	operating profit - interest
Dividends	125	84	Equals net profit
Shares outstanding	62.5	39.4	Provided in footnote 1
Dividends per share	2.00	2.13	Dividends/Shares outstanding
Balance Sheet
	Unlevered	Levered	Calculation
Current assets	450	450	Remains constant
Fixed assets	550	550	Remains constant
Total assets	1,000	1,000	Remains constant
Book debt	0	500
Book equity	1,000	500
Total capital	1,000	1000

The analysis of the WACC showed that there were changes to 7.54% putting into consideration that there were taxes that were introduced. The reason for the decrease in the WACC after the introduction of debt is that the increase in debt acts as a tax shield and the WACC formula considers the corporate taxes which results in a decrease in WACC (Baker & Wurgler, 2015). This shows that in the scenario where the company wants to go for additional debt and corporate taxes is introduced, it would come with the additional advantage of introducing the benefit of a tax shield. It would thus be more recommended for the company to go for the levered option when corporate taxes have been introduced as there are more advantages with the decrease in WACC and an introduction of tax shield. 

Table 5. Cost of Capital and Effects of Recapitalization (With Tax)
(in millions of Franco dollars, except per-share figures)
Tax = 0, Interest rate =4%, D/E=0.471, New shares = 42.5m
	Unlevered	Levered	Calculation
Debt	0	500
Cost of capital
Cost of debt (Rd)	4%	4%	Remains unchanged
Beta	0.8	1.176	0.8 * (1+(1-0%)*0.471
Cost of equity (Re)	8%	9.588%	4%+1.177*5%
WACC	8%	7.54%	E/(E+V) * Re + D / (E+D) * Rd * (1 - t)

References  

Ansar, I., Butt, A. A., & Shah, S. B. H. (2015). Impact of dividend policy on shareholder's wealth.  International Review of Management and Business Research ,  4 (1), 89. 

Baker, M., & Wurgler, J. (2015). Do strict capital requirements raise the cost of capital? Bank regulation, capital structure, and the low-risk anomaly.  American Economic Review ,  105 (5), 315-20. 

Frank, M. Z., & Shen, T. (2016). Investment and the weighted average cost of capital.  Journal of Financial Economics ,  119 (2), 300-315. 

Jackson, T., & Victor, P. A. (2015). Does credit create a ‘growth imperative’? A quasi-stationary economy with interest-bearing debt.  Ecological Economics ,  120 , 32-48. 

Lee, B. B., Dobiyanski, A., & Minton, S. (2015). Theories and Empirical Proxies for Corporate Tax Avoidance.  Journal of Applied Business & Economics ,  17 (3). 

Lei, Z., & Zhang, C. (2016). Leveraged buybacks.  Journal of Corporate Finance ,  39 , 242-262. 

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