M&m Pizza Case Study

Overview

Today we will talk about M&M Pizza’s repurchasing plan why they want to repurchase and how this plan affects company and shareholders under 2 scenarios which are with and without corporate tax law. And after that we will discuss our recommendation to this plan.

Company Background

M&M Pizza is a premium pizza, with full penetration of the Francostan Market. Although it’s generating strong and steady profit of about F$125 million per year for so long, M&M’s stock price had been flat at about F$25 per share for years.

The company  maintained a dividend policy of returning all company’s profits to shareholders or we can say that the payout ratio = 100%.

The financial policies were very conservative by using no-debt policy, with cost of equity or WACC at 8%.

Company Background

Miller, a third-generation direction of M&M Pizza, felt that recapitalizing by issuing F$500 million in debt and using this proceeds to repurchase company shares would increase share price, dividend per share and create sustained value for owners due to the low borrowing cost at only 4%.

Noted that by using this plan assets, profits and operations remained unchanged.

Macroeconomics

Francostan had a stable economy. The price inflation had been almost near zero.

Short- and long-term interest rates for government and business debt were steady at 4% so, we can conclude that there is no maturity risk premium because long-term and short-term rate are the same

The government maintained no bankruptcy law and all contractual obligations were completely enforced. >> so, we can conclude that cost of debt and risk-free rate are the same (rd = rf = 4%)

There is no corporate tax, only personal tax, but there is a law under consideration to introduce a 20% corporate income tax. And interest payment would be tax deductible.

Balance Sheet

The next one we will talk about how the financial statements changed after restructuring. Let’s start with the balance sheet.

Issuing F$500 million in debt to repurchase shares makes book value of debt increase by F$500 million and book value of equity decrease by the same amount.

Income Statement

For the income statement, after repurchasing by using debt, there will be the presence of fixed obligations or interest expense which is worth $F20 million from 4% cost of debt. As a result, the net income reduces from $F125 to $F105 million.

Dividend per Share

Since the M&M’s payout ratio is 100%, the company returned all of its net income to shareholders as dividend.

And after repurchasing by using share price of $F25 per share, number of shares outstanding decreased by 20 million shares. As a result, shareholders will receive more dividend per share.

You can see that after restructuring, total dividends reduced due to the interest payment, but dividend per share increased because of the reduction in the number of shares.

MM Proposition 1

        The next topic we will discuss the cost of capital. We will begin with the Modigliani and Miller Irrelevance propositions. MM proposition 1 says that the choice of capital structure is irrelevant for maximizing the value of the firm under the condition that there are no taxes or costs of financial distress. You can see from the graph that no matter what the percentage of debt is, the value of firm stay the same.

MM Proposition 2

        The next one is MM proposition 2 which says that the greater the percentage of debt in the capital structure, the greater the rate of return required by equity holders under the same proposition as proposition 1. Next we will show you how to calculate the cost of capital.

Financial Risk on Levered Firm

For cost of debt, we’ve known at the beginning that it is 4%. Then we will move to the cost of equity, but first we should know that for the firm using pure equity, shareholders are subjected only to basic business risk or operating risk.

But for the firm with debt in capital structure, shareholders are not only subjected to basic business risk but also financial risk. This is because of the presence of interest rate expenses that makes equity more risky, resulting in requiring higher rate of return.

CAPM

And then we will use Capital Asset Pricing Model or CAPM to calculate the cost of equity after restructuring. This model includes risk-free rate, market risk premium and beta. But the only changing variable is beta.

Beta

In this case, there is no corporate tax law so we will ignore the t variable. For the d/e ratio, equity value was calculated using share price multiplied by the number of share outstanding and then we will get the beta value of 1.1765.

As you know that Beta is a sensitivity of asset’s returns to market returns. It also reflects the business risk and financial risk of the company. You can see from the calculation that the value of levered beta is higher than unlevered beta since issuing new debt increased debt to equity ratio and levered beta increased as well.

Cost of Equity

And then we used the new beta to calculate cost of equity. You will see that cost of equity increased as well. Therefore, it corresponds to MM proposition 2 which states that the cost of equity increase as the percentage of debt increase.

WACC

And the last step we will use the inputs that we’ve calculated in the WACC equation and get the value of 8%. You can see that WACC after restructuring is equal to WACC before restructuring which is corresponded to MM proposition 1 that cost of capital is independent of its capital structure. Although debt have a low borrowing cost, the increasing in cost of equity will finally make WACC unchanged.