M&M Pizza - The Best Pizza in Town

Question 1 

M&M Pizza is a profitable company controlling a sizeable market share in Francostani. The company is operating well, and the entire profits are paid to the shareholders as dividends. However, Moe Miller feels that the company has conservative financial policies that need to be changed. The stock price has also been flat for several years. The director thinks that the company should be recapitalized to create value for the shareholders. 

The current borrowing costs are only 4%, and Moe wants to issue F$500 million in the form of debt. Moe Miller, therefore, intends to restructure the company by changing its current capital structure to include liability. Such actions will increase the per share price and the dividends since the remaining shareholders will share the entire profit. The company will have fewer shareholders who will share the gross profit which in this case will remain unchanged under the new arrangement. 

Under the new capital structure, the shareholders will benefit from the increase in the dividends per share, but such advantages can be wiped out if the tax rate is high. However, if the new tax laws are implemented, the company can benefit from tax shield which enhances its return on equity, earning per share and price to book ratio. The books of account will now have additional debts while the assets will remain the same. 

Question 2 

The purchase plan will alter the current capital structure by increasing the value of debt and reducing equity. M&M will, therefore, retain its existing assets and include more debt and less investment in its balance sheet. Current and noncurrent assets will remain the same. The books of account will now include a debt amount of 500, and a reduction in the equity will reflect the same. However, the two will be equal to the total assets. The weighted average cost of capital will also be as computed below. 

Question 3 

The debt and equity claims by Miller are based on the capital structure and the cost of capital. The cost of debt according to this case is half the cost of equity implying that the company will be better off using debt. Incorporating debt in its capital structure means that the company will reduce the number of equity holders and the remaining ones will enjoy higher dividends. 

Under the new tax laws, the company will be paying a 20% tax which is unlike the current system where the company is not taxed, but the income tax of the shareholders is imposed. Similarly, interest is, and therefore the stockholders are likely to benefit more from the new arrangement. The alternative scenarios have the same results in the long term. However, the company will benefit from the cash in the near term, and the shareholders will also record higher dividends per share. Similarly, the proposed tax shield will also positively enhance the position of the stockholders. 

Miller should not restructure the company since the benefits of the new structure will not be felt by the shareholders in the long term. However, he should focus on other measures that will increase the market share and the value of the company. From the calculations, WACC in the levered and unlevered scenario is the same at 8%. The benefits will only accrue if the corporate tax of 20% is applicable due to the tax shield. Similarly, benefits can arise if the current tax rate on personal income is low such that the benefits accrued from the additional dividends are more than the tax paid for the same. Otherwise, as long as personal income is taxed, there is no difference between the two scenarios. 

Question 4 

The implementation of the new tax law implies that the dividends paid to the current stockholders will reduce since a 20% tax will be deducted from the profits. However, the personal income of the stockholder will not be subjected to income tax deductions. The analysis in question 2 and three would change if the new tax law is implemented since the interest rates tax shield must be considered in the computation.