UV6629

Rev. Jan. 24, 2017

M&M PIZZA

Twenty-nine-year-old Moe Miller had recently been appointed managing director at

M&M Pizza, a premium pizza producer in the small country of Francostan. As a third-generation
director of M&M Pizza, Miller was anxious to make his mark on the company with which he had
grown up. The business was operating well, with full penetration of the Francostani market, but
Miller felt that the financial policies of the company were overly conservative. Despite
generating strong and steady profitability of about F$125 million per year over recent memory,
M&M Pizza’s stock price had been flat for years, at about F$25 per share.1

His new office, Miller discovered, had an unobstructed view of the nearby marble quarry.
How wonderfully irrelevant, he thought to himself as he turned to the financial analysis on his
desk. With borrowing costs running at only 4%, he felt confident that recapitalizing the balance
sheet would create sustained value for M&M owners. His plan called for issuing F$500 million
in new company debt and using the proceeds to repurchase F$500 million in company shares.
The plan would leave assets, profits, and operations of the business unchanged but allow M&M
to borrow at the relatively low prevailing market yields on debt and increase dividends per share.
Committed to raising the share price, Miller felt it was time to slice up the company’s capital
structure a little differently.

Francostan

The Mediterranean island nation of Francostan had a long tradition of political and
economic stability. The country had been under the benevolent rule of a single family for
generations. The national economy maintained few ties with neighboring countries, and trade
was almost nonexistent. The population was stable, with approximately 12 million prosperous,
well-educated inhabitants. The country was known for its exceptional IT and regulation
infrastructure; citizens had unrivaled access to business and economic information. Economic
policies in the country supported stability. Price inflation for the national currency, the Franco
1
F$ = Franco dollars.

This case was prepared by Michael J. Schill, Associate Professor of Business Administration It was written as a
basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation.
Copyright ã 2013 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved.
To order copies, send an e-mail to [email protected]. No part of this publication may be
reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—
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Foundation.
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dollar, had been near zero for some time and was expected to remain so for the foreseeable
future. Short- and long-term interest rates for government and business debt were steady at 4%.
Occasionally, the economy experienced short periods of economic expansion and contraction.

The country’s population was known for its high ethical standards. Business promises
and financial obligations were considered fully binding. To support the country’s practices, the
government maintained no bankruptcy law, and all contractual obligations were fully and
completely enforced. To encourage economic development, the government did not tax business
income. Instead, government tax revenue was levied through personal income taxes. There was a
law under consideration to alter the tax policy by introducing a 20% corporate income tax. To
maintain business investment incentives under the plan, interest payments would be tax
deductible.

The Recapitalization Decision

Miller’s proposed recapitalization involved raising F$500 million in cash by issuing new
debt at the prevailing 4% borrowing rate and using the cash to repurchase company shares.2
Miller was confident that shareholders would be better off. Not only would they receive
F$500 million in cash, but Miller expected that the share price would rise. M&M maintained a
dividend policy of returning all company profits to equity holders in the form of dividends.
Although total dividends would decline under the new plan, Miller anticipated that the reduction
in the number of shares would allow for a net increase in the dividends paid per remaining share
outstanding. With a desire to set the tone of his leadership at M&M, Miller wanted to implement
the initiative immediately. The accounting office had provided a set of pro forma M&M financial
statements for the coming year (Exhibit 1).

Based on a rudimentary knowledge of corporate finance, Miller estimated the current cost
of equity (and WACC) for M&M with the current no-debt policy at 8% based on a market risk
premium of 5% and a company beta of 0.8. Miller appreciated that, because equity holders bore
the business risk, they deserved to receive a higher return. Nonetheless, from a simple
comparison of the 8% cost of equity with the 4% cost of debt, equity appeared to be an
expensive source of funds. To Miller, substituting debt for equity was a superior financial policy
because it gave the company cheaper capital.3 With other business inputs, the company was
aggressive in sourcing quality materials and labor at the lowest available cost. Shouldn’t M&M
do the same for its capital?

2
The recapitalization would change the number of shares outstanding for M&M from 62.5 million to
42.5 million.
3
Miller’s uncle, Mert, was highly skeptical of Miller’s proposal. Uncle Mert claimed that substituting debt for
equity capital shifted more business risk of the firm to equity holders, so they required higher returns. He countered
that M&M’s beta of 0.8 must increase in the following manner: Levered beta = (Unlevered beta)
× [1 + (1 − t) × D / E], where t is the corporate tax rate, D is the debt value, and E is the equity value. With the
F$500 million share-repurchase proposal, Uncle Mert asserted that M&M’s D/E ratio would become 0.471.
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Exhibit 1
M&M PIZZA
Pro Forma Financial Statement
(in millions of Franco dollars, except per-share figures)

Income Statement
Revenue 1,500
Operating expenses 1,375
Operating profit 125
Net income 125

Dividends 125
Shares outstanding 62.5
Dividends per share 2.00

Balance Sheet
Current assets 450
Fixed assets 550
Total assets 1,000

Book debt 0
Book equity 1,000
Total capital 1,000

Source: Created by case writer.

PRA MBA QUESTIONS

1. How do the financial statements for M&M Pizza vary with the proposed repurchase
plan? Do the alternative policies improve the expected dividends per share?
2. What impact does the repurchase plan have on M&M’s weighted-average cost of capital?
The levered Beta goes from 0.8 to 1.176.
3. Which proposal is best for investors? What do you recommend that Miller do?
4. What are the key takeaway from this case?