M&M Pizza is considering taking on $500 in debt to repurchase shares rather than maintaining an all-equity structure. The document analyzes how this decision would impact M&M's capital structure and weighted average cost of capital (WACC) with and without corporate taxes. It finds that in all scenarios, taking on debt lowers the WACC by providing a tax shield that outweighs the increased risk from higher debt. The analysis recommends that M&M incorporate debt into its capital structure to increase dividends per share and stock price.
M&M Pizza is considering taking on $500 in debt to repurchase shares rather than maintaining an all-equity structure. The document analyzes how this decision would impact M&M's capital structure and weighted average cost of capital (WACC) with and without corporate taxes. It finds that in all scenarios, taking on debt lowers the WACC by providing a tax shield that outweighs the increased risk from higher debt. The analysis recommends that M&M incorporate debt into its capital structure to increase dividends per share and stock price.
M&M Pizza is considering taking on $500 in debt to repurchase shares rather than maintaining an all-equity structure. The document analyzes how this decision would impact M&M's capital structure and weighted average cost of capital (WACC) with and without corporate taxes. It finds that in all scenarios, taking on debt lowers the WACC by providing a tax shield that outweighs the increased risk from higher debt. The analysis recommends that M&M incorporate debt into its capital structure to increase dividends per share and stock price.
M&M Pizza is considering taking on $500 in debt to repurchase shares rather than maintaining an all-equity structure. The document analyzes how this decision would impact M&M's capital structure and weighted average cost of capital (WACC) with and without corporate taxes. It finds that in all scenarios, taking on debt lowers the WACC by providing a tax shield that outweighs the increased risk from higher debt. The analysis recommends that M&M incorporate debt into its capital structure to increase dividends per share and stock price.
Austin Torres, Cole Chase, & Sebastian Quintana-Paredes
FIN512
October 25, 2023
2
Introduction M&M Pizza's decision to take on $500 in debt will have a positive impact on its capital structure, irrespective of Francostan's corporate tax policies. In all scenarios, M&M Pizza is better off leveraging debt to repurchase shares rather than maintaining an all-equity capital structure. The new capital structure will generate greater dividends per share as well as higher stock prices.
Impact WACC First, we need to analyze the scenarios where there are no corporate taxes. Figure 1 illustrates M&M's financial breakdown in the first two scenarios: Scenario 1 with 100% equity and no debt, and Scenario 2 with $500 in debt. As the company assumes more debt, the overall risk of the firm increases. This heightened risk is expected to manifest in the firm's weighted average cost of capital (WACC). In Scenario 2, the capital structure changes from 100% equity-based with a debt-to-equity (D/E) ratio of 0 to 68% equity and 32% debt with a D/E ratio of 0.471. This shift in capital structure is reflected in the firm's beta, which increases from 0.80 to 1.18, signaling greater risk in relation to the market. Furthermore, the higher beta affects M&M's cost of equity, which increases from 0.08 to 0.10. Despite the increase in the cost of equity, the change in the firm's capital structure offsets the higher beta, resulting in an unchanged WACC from Scenario 1 to Scenario 2.
In a world where Francostan implements a 20% tax rate, M&M enjoys the added benefit of a tax shield. Interest payments are expensed and deducted from M&M's taxable income. Therefore, by borrowing funds and servicing the debt, interest expenses reduce M&M's taxable income. In Scenario 3 and 4, we assess whether it is advantageous for the firm to remain 100% equity-funded or to take on $500 in new debt for share repurchases. In Figure 2, we immediately observe that, due to taxes, M&M's stock price is $20 compared to $25 in Scenarios 3 versus 1, noted in Figure 1. This decrease is expected, as a portion of earnings is paid to the government. Similar to the comparison between Scenario 1 and Scenario 2, taking on additional debt results in an increase in M&M's beta from 0.80 to 1.18. M&M's cost of equity, calculated using the Capital Asset Pricing Model (CAPM) and beta, also rises from 0.8 to 0.10. Another noteworthy change is the enterprise value of M&M in Scenario 4, which increases by $100 due to the tax shield from the $500 in debt. The 20% tax rate, coupled with the $500 in total debt, provides M&M with a $100 tax shield. The total enterprise value of the firm is the sum of the enterprise value of a firm with 100% equity (which is $1,250 in this case) and the tax shield, resulting in $1,350 for M&M in Scenario 4. From this total enterprise value, we can determine the market value of equity, as we already know the market value of debt ($500). We then calculate the weights of equity and debt (0.63 and 0.37, respectively) and factor the tax shield into the WACC calculation: Cost of Equity x Weight of Equity + 3
Cost of Debt x Weight of Debt x (1 - Tax Rate). In Scenario 4, we observe a decrease in
M&M's WACC compared to Scenario 3, 0.074 versus 0.80, respectively.
More Debt = More Risk
In both worlds, taking on additional debt increases M&M's risk. This is due to the change in the D/E ratio when we add $500 in debt, causing a chain reaction with the beta and the cost of equity rising. Figure 8 presents a sensitivity analysis, demonstrating that as debt increases, both beta and the cost of equity rise. This supports the statement that "Increased debt amplifies the risk faced by shareholders."
Debt and Taxes
In our scenario analysis, shown in Figure 9, when the tax rate increases, the value of the tax shield (Rd*Tc) also increases, reducing the after-tax cost of debt and making debt even more cost-effective, further lowering the WACC. Taxes significantly impact the cost of capital because of the tax shield provided by interest on debt. The tax shield arises because interest payments on debt are tax-deductible, reducing the company's taxable income. Higher taxes enhance the value of the tax shield, representing the amount of tax a company can save by taking on debt. Figures 6 and Figure 7 illustrate how the company's earnings are divided up amongst shareholders, bondholders, and the government. As we can, we are paying less taxes in Figure 7 and giving back more to our bond and shareholders when we take advantage of the tax shield.
Our recommendation: After analyzing M&M's WACC in all four scenarios, it is evident that, with or without taxes, M&M should incorporate debt into its capital structure. In both tax and non-tax situations, M&M witnesses an increase in dividends per share. Figure 10 illustrates the rise in dividends from Scenario 1 to Scenario 2 and from Scenario 3 to Scenario 4. The chart also shows changes in share prices in each scenario. While Scenario 1 and 2 see no change in share price, and while Scenario 3 starts with a lower share price due to taxes, we see that with the introduction of debt in Scenario 4, M&M's stock price increased. 4
