M&m Pizza Case Study

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Levered situation:

In the levered situation there is an interest on debt equal to €20.000 (0.04*500,000) which leaves the net income at €105,000 (operating profit- interest). The net income is fully paid to the investors as dividends. From this, we can see that the equity claim is as follows:

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The debt claim is known to be a fixed amount of €500,000.

When we sum up the equity claim and the debt claim for the second scenario, where the firm is levered, the total investor claim is: 1062,500+ 500,000= 1562,500. We can conclude that “a firm’s total market value is independent of its capital structure” (Miller, 1988).

This also proves that the WACC is equal in both scenario’s, as already shown in the previous question. Therefore the effect of debt on both WACC and Firm Value is negligible in the levered situation compared to the unlevered situation.

4. Which proposal is best for investors? What do you recommend that Miller do?

In the levered and the unlevered situation MM3 & MM4 are still valid. Therefore the investors should be indifferent to the proposals and the market value stays the same. The NPV of the shares remain the same, as can be seen in the following calculation of the share price:

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Therefore, the dividend policy does not affect the market value of the company.

Another factor that does not affect the choice of proposal, is investor indifference, as raised by Stiglitz (1969). If the investor would be unhappy with the new dividend amount of 2.47, he can create homemade dividends. The excess in cash, the amount of shares held by a single investor respectively, can be invested in new shares. In this case, $.47 per share can be reinvested. This is possible because under the assumptions of MM, the stock price will fall by the amount of the dividend on the ex-dividend date. Therefore, we can argue that the investors can compensate any decisions that the firm makes regarding its capital structure.

The propositions discussed previously, assume that there are no taxes. However, this case does include personal taxes that should be taken into consideration when deciding upon the best proposal for investors. An important note is that in general when there are personal income taxes, a firm should not pay dividends, as the taxes payable outweigh the benefits from the dividends (Eije & Megginson, 2007). However, firms do pay dividends due to several reasons that will be discussed further.

The Clienteles Theory explains how firms do not necessarily have to abide the theoretical no-dividends preference of investors. Individual investors in reality have different preferences. Where some might prefer high payouts, for instance because they are in a low tax bracket and are in need of a constant cash flow, such as a pension fund, others might prefer low payouts because they are in higher tax brackets. If investors want to convert shares into money, share repurchases are more profitable because they are not treated as income but as capital gains, which rely on another tax policy in most countries. Therefore, a firm can payout dividends despite the personal income tax, as the investors will adjust to the firm’s policy.

Objectively, the unlevered situation is better, as the tax over the dividends would be lower. However, since we do not have the investor profiles, a decision cannot be made based on the previous explained factors.

The one factor that does indicate a best proposal for the investors is the beta of the company. This beta indicates how risky investing in a certain firm is. The more debt a firm has, the more volatile and thus risky it is. Both levered and unlevered beta measure this volatility. As can be seen in the table below, the beta of M&M increases by 47.5%, whereas the dividends and cost of equity only increase by 23.5%. Thus, the dividends do not rise proportionally to the risk, therefore the investors are not fully compensated for the high risk. This results in the conclusion that the unlevered situation is best for the investors.

Table 1: Comparison of unlevered and levered scenarios.

Variables

unlevered scenario (1)

levered scenario (2)

% of change

Cost of Equity

8%

9.88%

23.5%

Cost of Debt

4%

4%

0.0%

Beta

0.8

1.18

47.5%

Dividend/share

€ 2.00

€ 2.47

23.5%

D/E Ratio

NN/A

47.06%

NN/A

The calculations for the table are as follows:

To answer this question, we first need the cost of equity levered:

This cost of equity is given in the case and equals 8% (0.08).

The unlevered beta can then be calculated as follows:

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As Miller’s objectives are to create more value for his shareholders and to increase his firm’s value, we recommend him to keep the firm unlevered. The firm value does not differ in the two scenarios, but the shareholders gain more from the unlevered situation, as is explained above. Therefore, keeping the firm unlevered would satisfy his objectives most.

5. How would your analysis in questions 2 and 3 and the recommendation in question 4 change if the new tax law is implemented?

The initial tax law in Francostan did not tax business income but through personal income