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M&m Pizza Case Study

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Advanced Corporate Finance

Assignment 1

M&M Pizza


  1. How do the financial statements for M&M Pizza vary with the proposed repurchase plan? Do the alternative policies improve the expected dividends per share?

Unlevered situation (in millions)

Levered situation (in 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

Dividends per Share

2

2.47

Balance Sheet

Current Assets

450

450

Fixed Asset

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 this financial statement we are able to see that the total outstanding shares decreased to 42.5 million as result of debt funded share buyback worth 500 million. This resulted in a 47 cents increase of dividends per share to compensate for the higher risk that the equity investor is bearing. Additionally, 20 million interest is paid to the debtholders.

The market value of the firm in the unlevered situation is equal to the value of equity. The equity value is calculated by the share price (25) multiplied with the amount of shares outstanding. In the situation of the levered firm, there is a value of debt of 500 million. Since a firm’s total market value is independent of its capital structure (Miller, 1988), the value of equity is the residual of the firm’s value minus the debt value, namely 1062.50 million. According to the second proposition of Modigliana-Miller, the firm’s cost of equity is increased by becoming a levered firm (higher debt/equity ratio).

Concerning the dividends, initially the levered situation seems beneficial to shareholders, as the dividend per share increases. However, since Francostan taxes people personally, rather than via corporate taxes, the benefits of the increased dividends could be diluted by the personal income tax, as dividends are considered income. If the personal income tax was known, a definite best scenario for the shareholders could be chosen. In conclusion, the alternative policy improves the dividends per share with $.47, although the exact benefits for the shareholders cannot be calculated.

  1. What impact does the repurchase plan have on M&M’s weighted average cost of capital?

First, we need to calculate the weighted cost of capital in the first situation, which considers unlevered firm. Because the company is debt-free, the WACC is equal to the cost of equity as it is the firm’s only financing source.

Unlevered situation:

[pic 1]

[pic 2]

The second step towards answering the question, is calculating the expected return on equity levered. This can be done using the following formula:

.[pic 3]

[pic 4]

The unlevered cost of equity was 0.08, this means that there is an increase of cost of equity of 0.0188.

From this, we can compute the WACC of M&M in the levered situation. The following formula is used to calculate the WACC:

Levered situation:

[pic 5]

From this computation, we can conclude that the WACC remains equal (both 0.08). This indicates that repurchasing shares with debt does not affect the Weighted Average Cost of Capital. With this, we have proven MM proposition II (“A firm’s cost of equity increases with its debt-equity ratio” Miller, 1988) to be right. The impact of the repurchase plan on M&M’s WACC is nonexistent.
Important to note, is that if the after tax WACC formula considers corporate taxes and therefore the WACC generally decreases when debt increases as a result of the benefits of the tax shield. However, since there are only personal taxes in this particular situation the WACC remains constant (Myers, 2001).

  1. What are the debt and equity claims worth under the alternative scenarios? (You may note that the present value of a perpetual cash flow stream is equal to the expected payment divided by the associated required return.

Unlevered situation:

The scenarios are as follows: 1) The firm is unlevered which means that it is funded by equity only, 2) The firm is levered which means that the specific firm in financed with both equity and debt. Important to note is that debt has a senior claim over equity. This results in a higher risk for shareholders when the firm’s leverage increases.

In the unlevered situation, the equity claim is as high as the firm’s market value, which is:

.[pic 6]

Since there is no debt in this situation, the debt claim is equal to zero.

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