M&M Pizza Case Solution

See table 1 below for the revised financial statements.

i. Expected Dividend Per Share

The distribution policy of the company is that they distribute 100% of the net income to shareholders. The expected net income for M&M Pizza will be F$105 million, as mentioned above. Based on the distribution policy of the company, the complete F$105 million will be distributed as dividends among the remaining shareholders. The remaining number of shares outstanding will be 42.5 million. The expected dividend per share with the current capital structure would have been F$2 while the expected dividend per share with the revised capital structure will be F$2.47. Hence, although the total dividends have decreased, the expected dividend per share for the remaining shareholders has improved.

2. Repurchase Plan and Weighted Average Cost of Capital

In order to estimate the value of the expected cash flows, weighted average cost of capital (WACC) is an essential tool when the capital structure of the firm does not change. M&M Pizza does not have any debt outstanding currently. All of its assets are being financed through equity. Using the risk free rate of 4%, company beta of 0.8 and a market risk premium of 5%, the cost of equity for M&M Pizza has been estimated as 8%. Under the same capital structure, the weighted average cost of capital (WACC) for M&M Pizza will be the same as the cost of equity as it is the only source of financing.

Under the revised capital structure, the market value debt to equity ratio is expected to be 0.471. Based on this D/E ratio, the market value weight of debt is 32%. This also reduces the weight of equity to 68%. The cost of debt is 4% where the cost of equity, according to CAPM model, will rise to 10%. Due to the increase in debt, the business risk to the equity investors also rises, causing the required return on equity to increase. With a corporate tax rate of 0%, the WACC for M&M Pizza will remain the same, i.e. 8%. Hence, an increase in debt has resulted in no change in the WACC if there are no taxes.

3. Value of Debt and Equity Claims and Recommendation

The total debt outstanding under the revised capital structure is F$500 million. At the cost of borrowing of 4%, the interest payment to the debt holders is F$20 million per year. Assuming that the debt is perpetual, the present value of the cash flows has been estimated by estimating the value of debt tax shield. Since the rate of tax is 0%, the value of debt will be zero under the revised capital structure plan. The value of debt claim under the current plan will also be zero. See table below.

The total number of shares outstanding is 62.5 million under the current capital structure. The expected dividend per share with the current capital structure is F$2. With the cost of equity at 8%, and perpetual expected dividend of F$2, the value of equity is F$1562.5 million.

After raising F$500 million in debt and repurchasing 20 million shares, the debt to equity ratio will become 0.471.