M and M Pizza Case Study

M and M Pizza Case

Introduction

There seems to be a financial dilemma at M and M Pizza given the existence of a law that changes the tax policy which requires the adoption of 20% corporate income tax. Due to this scenario, the feasibility of the repurchase plan proposed by the company may vary given various situations. Thus, any changes or amendments on the tax and financial policy will likely have a significant effect on market share, net income, market share, and cost of equity and dividends of M & M Pizza. Given this scenario, it is plausible to analyze the different situations through the calculation of financial data of the company to determine the viability of its financial position.

Question 1

Income Statement

Unlevered Situation (millions)

Levered situation (millions)

Revenue

1500

1500

Operating expenses

1375

1375

Operating profit

125

125

Interest (4%)

-------

(500*.04 =) 20

Net income

125

105

Dividends

125

105

Shares outstanding

62.5

42.5

Balance Sheet

Current assets

450

450

Fixed Assets

550

550

Total Assets

1000

1000

Book Debt

0

500

Book Equity

1000

500

Total Capital

1000

1000

Value of Equity

1562.5

1062.5

Value of Debt

0

500

Value of the firm

1562.5

1562.5

From the analysis above, it is noticeable that there was a decrease of 42.5 million in total shares as a result of share buyback from the paid debts amounting to 500 million. The higher equity risk met by the investor is compensated from an increase in dividends by 47 cents per share, with an additional 20 million being paid to debt holders. The value of equity and market value are the same in the unlevered situation. Equity value is reached by multiplying outstanding shares with the price of shares (25). In the levered case, the debt amounts to 500 million. According to Miller (1988), since the total market value is independent of its related capital structure, a firm’s equity is the product of debt value subtracted from firm’s value, which is in this case 1062.50 million. According to his second proposition, Miller suggests that the cost of equity of a firm increases when a company is levered. Due to the increase in cost per share in dividends, the shareholders greatly benefited. However, on personal tax policy by Francostan, personal tax income diluted the increased

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