Analysis of m & m pizza proposal Case Solution
Debt and equity claims under the proposal:
The market value of the debt is $500 and it does not change under the proposal. The market value is calculated by assuming the life of the bond which is 5 years. In the start, the book value and issue value are the same whereas after some time the bond issue and market value can be different.
The equity value of M &M Pizza is flat and has not changed for many years and is still fixed at $25 per share. Although the company has repurchased the shares under the new proposal but still share price is the same. The company’s share price will increase in short term due to decrease in the wacc of the company but in the long-term, the company’s share price will fall as the interest payments and redemption of bond will decrease the profits and will lead to less profit available to be distributed to ordinary shareholders of M & M Pizza. See Exhibit 4
Proposal best for miller:
According to the analysis of financial statements, the best proposal would be not to implement the new proposal as the new proposal will lead to an increased gearing and the increased gearing will lead to an increase in cost of equity of the company as the equity holders will demand an increase in their returns due to an increase in their risk levels. Whereas the new debt will also lead to an increase in interest cost and if the interest cost and the amount due is not repaid on time, it will lead to M &M Pizza going into administration and shareholders will get less or no amount in that case.
On the other hand, the market value of the share price has increased temporarily but there are chances that in future if there are lots of interest payments, then this will reduce net income and will further lead to a reduction in the dividends being received by the shareholders. This will also lead to an increase in wacc of the company and its financing cost will increase.
As an investor I will not prefer to repurchase the shares as this will give me benefit for short term but in long term it is not good for investors.
Recommendation if new tax law is implemented:
If the new tax law is implemented, then 20% of tax should be paid by the company.But as the new tax law is implemented then the viewpoint will change and now Moe miller should go with the proposal because this will lead to tax savings in debt issue. But it will lead to shareholder giving tax two times, first when dividend is announced and second when dividend is received.So from the shareholder’s point of view it is not good for them but from the viewpoint of the managing director and company, it is beneficial as it will lead to tax savings in future for the company and this will give a tax reduction benefit in the actual tax being paidby the company. This will make debt cheaper and will lead to reduction in wacc and will further lead to increase in the market value of the company as debt and wacc areinversely proportional to each otherand an increase in one will lead to a decrease in another and vice versa.
Impact of proposed repurchase plan on the company’s financial and business risk:
The proposed repurchase plan will increase the financial and business risk of the company. The risk of being insolvent or going into administration will increase and there might be periods in future where M & M Pizza might not be able to find the lenders to finance. In addition to this, the company might face liquidity issues and it might not have funds available for working capital.
The business risk refers to the company not being able to continue as a going concern in future. The business might not be able to continue as a going concern because the lenders might impose some covenants on the company for gearing ratio or current ratio or acid test ratio. If M & M Pizza cannot give interest payments on time, then their business might not able to continue in the foresee able future. These problems are only if the company carries out the proposal.
|Debt and equity after implementation of proposal|
|book debt||$ 500.00|
|book equity||$ 500.00|
|Earnings per share after implementation of proposal|
|Earnings/net income||$ 125.00|
|Dividend per share after implementation of proposal|
|interest cover after implementation of proposal|
|total interest||$ 20.00|
|Profit before interest and tax||$ 125.00|
|P/E ratio after implementation of proposal|
|Market price per share||$ 25.00|
|Earnings per share||$ 2.94|
|Effect on financial statements after implementation of the proposal|
|before proposal||After proposal|
|Gearing ratio using (debt/debt+equity formula)||0.00%||50%|
|Gearing ratio using (debt/equity)||100.00%||50%|
|Dividend per share||2||2.94|
|Dividend payout ratio||1||1|
|Before implementation of proposal||After implementation|
|cost of debt||4%||4%||4|
|Risk free rate of return||3%||3|
|cost of equity||8%||8%||8|
|equity beta of company||0.8||0.80|
|market risk premium||5%||5%|
|Market value of debt||$ 500.00||$ 0.471|
|Market value of equity||$ 1,562.50||$ 1,062.50|
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