Case 30: M&M Pizza

References

Bruner, R., Eades, K., & Schill, M. (2013). Case studies in finance: Managing for corporate value

creation. McGraw-Hill Education.

1. At M&M Pizza Company, the stock of the company has remained dormant in terms of price for a very long period of time. This means that the shares traded at the stock exchange for this company are very small. Thus, the demand for the shares or stock is very low. Shares increase in prices when the demand is high making the supply relatively low thus the prices shot upwards (Bruner et al., 2013). The reverse is true and that’s what is happening in M&M Pizza Company. The effect of demand and supply of stock otherwise known as market impact determines the stock prices in the stock market. To improve the stock price for M&M Pizza, the director found it expedient to repurchase the company’s share to create some sort of shortage (low supply) thus increasing the shares price.

The current financial statements for M&M Pizza reflect no debt capital but this is expected to change when the proposed purchase of shares is carried out. We expect to see a debt capital of F$500M this will change the current operating expenses in the financial statement as it will add the 4% debt interest as an expense. Repurchasing of the shares will increase the demand for the shares in the capital market, which will result in rise in the share prices (Bruner et al., 2013). This will reduce the shareholders ownership thus the owners’ equity in the balance sheet will reduce by F$500M.

The policy will increase the earning per share because the outstanding shares will be reduced by F$500m. To calculate EPS, we take the net income and divide it by the outstanding shares (Bruner et al., 2013). This means since the operating profits for M&M will be constant, even after the outstanding stock reduces the earning per share will increase.

1. At M&M Pizza Company, the stock of the company has remained dormant in terms of price for a

very long period of time. This means that the shares traded at the stock exchange for this company are very

small. Thus, the demand for the shares or stock is very low. Shares increase in prices when the demand is

high making the supply relatively low thus the prices shot upwards (Bruner et al., 2013). The reverse is true

and that’s what is happening in M&M Pizza Company. The effect of demand and supply of stock otherwise

known as market impact determines the stock prices in the stock market. To improve the stock price for

M&M Pizza, the director found it expedient to repurchase the company’s share to create some sort of

shortage (low supply) thus increasing the shares price.

The current financial statements for M&M Pizza reflect no debt capital but this is expected to

change when the proposed purchase of shares is carried out. We expect to see a debt capital of F$500M this

will change the current operating expenses in the financial statement as it will add the 4% debt interest as an

expense. Repurchasing of the shares will increase the demand for the shares in the capital market, which

will result in rise in the share prices (Bruner et al., 2013). This will reduce the shareholders ownership thus

the owners’ equity in the balance sheet will reduce by F$500M.

The policy will increase the earning per share because the outstanding shares will be reduced by

F$500m. To calculate EPS, we take the net income and divide it by the outstanding shares (Bruner et al.,

2013). This means since the operating profits for M&M will be constant, even after the outstanding stock

reduces the earning per share will increase.

2. The WACC describes as the weight of the capital represented by each form of capital. In our case the equity capital and debt capital are at 50% each (Bruner et al., 2013,).

WACC = [E/V x Re] + [D/V x Rd (1-Tc)

Where:

E = 500,000,000

D = 500,000,000

V= 500,000,000 + 500,000,000

Re= 8%

Rd = 4%

Tc = 20%

The capital structure will be 50%debt and 50% equity (figures in Millions)

Thus, WACC = (500/1000 x 0.08) + 500/1000 x 0.04) x (1-0.20)

WACC =(0.04+0.02)0.8)= 4.8%

Thus, the WACC of M&M is 4.8% (Bruner et al., 2013). This means that the M&M Pizza’s shareholders and the creditors expect 4.8% return on their investments.

The equity capital reduces the company’s burden on loan payment. If the company does not make very good cash inflows the company may not be in a position to service its loan thus raising its financial risks (Bruner et al., 2013). The equity capital does not put the company into risks as when the company is not profitable the dividends are overlooked (Common stock). The preference stock’s dividend can be paid later without interest as compared to loan where interest accumulates after every defaulted payment.

2. The WACC describes as the weight of the capital represented by each form of capital. In our case

the equity capital and debt capital are at 50% each (Bruner et al., 2013,).

WACC = [E/V x Re] + [D/V x Rd (1-Tc)

Where:

E = 500,000,000

D = 500,000,000

V= 500,000,000 + 500,000,000

Re= 8%

Rd = 4%

Tc = 20%

The capital structure will be 50%debt and 50% equity (figures in Millions)

Thus, WACC = (500/1000 x 0.08) + 500/1000 x 0.04) x (1-0.20)

WACC =(0.04+0.02)0.8)= 4.8%

Thus, the WACC of M&M is 4.8% (Bruner et al., 2013). This means that the M&M Pizza’s shareholders

and the creditors expect 4.8% return on their investments.

The equity capital reduces the company’s burden on loan payment. If the company does not make

very good cash inflows the company may not be in a position to service its loan thus raising its financial

risks (Bruner et al., 2013). The equity capital does not put the company into risks as when the company is

not profitable the dividends are overlooked (Common stock). The preference stock’s dividend can be paid

later without interest as compared to loan where interest accumulates after every defaulted payment.

3. The buyback plan will restructure the company’s capital structure where the debt and the equity capital will be 50% each of the total capital. The return on equity before the buyback was higher thus the shareholders received more money as divided (Bruner et al., 2013). However after the purchase plan the WACC reduced to 4.8% reducing the amount of dividends the shareholder could have earned.

I would recommend that Miller implements his plan for buyback as this will save more money for the company (Bruner et al., 2013). This is because the amount of dividend paid will reduce by almost a half. This money can be used to finance the debt and retain the company’s liquidity.

The debt claim before taxes will be F&20M (Bruner et al., 2013). This is because the financier will require the company to pay 4% of interest to F&500M borrowed. The equity capital will attract 8% cost of capital which will be F&40M for shares worth F&500M.

The best proposal for the investors is where the company remains equity funded because they will receive more dividends than in the new proposal (Bruner et al., 2013). The dividends received will not be subjected to corporate tax thus the investors will receive the whole amount of dividends. When the company buys back the shares, the EPS will increase but the shares owned will be few thus it will not benefit the investors much.

4. When the debt to equity ratio is 0.588 it means that the company is approximately 40% financed through debt capital (Bruner et al., 2013). This means that incase of liquidation the company can be able to meet its obligation. I would advise Miller to continue with the plan as the company will enjoy a 20% tax shield on its revenues.

3. The buyback plan will restructure the company’s capital structure where the debt and the equity

capital will be 50% each of the total capital. The return on equity before the buyback was higher thus the

shareholders received more money as divided (Bruner et al., 2013). However after the purchase plan the

WACC reduced to 4.8% reducing the amount of dividends the shareholder could have earned.

I would recommend that Miller implements his plan for buyback as this will save more money for

the company (Bruner et al., 2013). This is because the amount of dividend paid will reduce by almost a half.

This money can be used to finance the debt and retain the company’s liquidity.

The debt claim before taxes will be F&20M (Bruner et al., 2013). This is because the financier will

require the company to pay 4% of interest to F&500M borrowed. The equity capital will attract 8% cost of

capital which will be F&40M for shares worth F&500M.

The best proposal for the investors is where the company remains equity funded because they will

receive more dividends than in the new proposal (Bruner et al., 2013). The dividends received will not be

subjected to corporate tax thus the investors will receive the whole amount of dividends. When the

company buys back the shares, the EPS will increase but the shares owned will be few thus it will not

benefit the investors much.

4. When the debt to equity ratio is 0.588 it means that the company is approximately 40% financed

through debt capital (Bruner et al., 2013). This means that incase of liquidation the company can be able to

meet its obligation. I would advise Miller to continue with the plan as the company will enjoy a 20% tax

shield on its revenues.

References

Bruner, R., Eades, K., & Schill, M. (2013). Case studies in finance: Managing for corporate value creation. McGraw-Hill Education.