Executive Summary
The case is regarding the recapitalization plan of Moe Miller, the new managing director at M&M Pizza. Miller is concerned about the stagnant share price of his company at around F$25 per share. Miller plans to issue F$500 million debt to repurchase shares.
He thinks that by repurchasing shares and changing the capital structure of his company would be beneficial to both the company as well as the shareholders. A higher proportion of capital to debt would result in lower cost of capital while share repurchase would result in higher share price due to higher dividend per share.
However, his uncle Mert claims that change in capital structure would result in change in Beta, thus resulting in higher cost of equity. So the plan needs to be analysed using the target capital structure and whether it will result in higher share price, as claimed by Miller.
Financial Analysis
The financial analysis has three parts. The first part involves calculating the new cost of equity and capital based on the expected change in Beta as well as taking into account new capital structure and proposed business tax rate.
The second part is regarding projection of new income statement for the coming year taking into account the interest payments for the debt and the taxes under the proposed business tax rate. The final part of the analysis is to calculate the new share price based on the new cost of equity as well as the new dividend per share, derived from the projected income statement and the number of shares outstanding after the repurchase plan.
Part 1: New cost of equity and capital – As per uncle Mert, the new capital structure would change to a debt to equity ratio of 0.471 against the existing capital structure of complete equity and no debt.
So the new Beta is calculated as per the levered Beta formula given below:
Levered Beta = Unlevered Beta * (1 + (1 – tax rate) * debt to equity ratio)
The debt to equity ratio is 0.471, tax rate is 20% and the unlevered Beta is 0.8. Using this, the new Beta comes out to 1.10. Now the new cost of equity is calculated using the standard CAPM equitation:
Cost of equity = risk free rate + Beta * risk premium
Here the risk free rate is 4% and the risk premium is 5%. So the new cost of equity comes out to 9.51%. This is then used to calculate the new cost of capital as per the weighted average of the cost of debt and cost of equity.
The new cost of capital comes out to 6.54%, as against the old cost of capital at 8%. The reason for this decline in cost of capital is (i) some proportion of capital structure is debt, which has much lower cost as compared to equity and (ii) business tax rate provides tax shield for cost of debt, thus lowering it further.
So although the cost of equity has increased from 8% to 9.51%, the cost of capital gets reduced to 6.54%.
Part 2: New income statement projection – The new income statement is projected by taking into account the interest payments for the debt as well as the proposed business tax rate.
The operating income remains the same at F$125 million. After that interest costs at 4% of the F$500 million debt is subtracted. So the profit before taxes comes out to F$105 million. After applying tax rate of 20%, the net income comes out to F$84 million. This whole amount is paid out as dividends.
So we see that the total dividend amount has got reduced from F$125 million to F$84 million.
Part 3: New share price calculation – Based on the above projection of total dividend amount, the dividend per share is calculated by dividing it by the number of shares outstanding. Number of shares have comes down from 62.5 million to 42.5 million.
So the new dividend per share would be F$1.98. Thus we see that the dividend per share has actually reduced from F$2.00 despite the number of shares coming down.
Now we calculate the new share price by dividing the dividend per share by the new cost of equity. This comes out to F$20.79. So the new share price would be lower than the current share price of F$25.
Recommendation
We see from the above calculation that although the cost of capital for the company would reduce under the recapitalisation plan due to lower cost of debt, the cost of equity would increase as a result as shareholders would demand higher returns for the additional risk transferred to them.
The net income and thus the total dividend amount would get reduced substantially as the company would have to pay interest on the debt as well as the new business tax which is proposed. Based on all of this, the dividend per share would reduce, which coupled with higher required rate for equity, would cause the share price to comes down from existing F$25 to F$20.79.
Thus it is recommended that the company does not implement the proposed recapitalisation plan as the share price of the company would actually go down.
