PizzaFood is one of those foods with which Americans have an abiding love affair. It is also one that lends itself to all sorts of variations.

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Question 1

PizzaFood is one of those foods with which Americans have an abiding love affair. It is also one that lends itself to all sorts of variations. It was started in the 1990s by Crank Frankly in Kansas. PizzaFood, due to its brand recognition has been offered to invest in ABC Limited Inc., one of the world’s largest restaurant companies which is operating in Europe. This investment requires PizzaFood to make an upfront investment of $240,000. It will be expecting to generate a cash flows of $345,000 every end of the year after covering all operating expenses. This return may seem like a good deal for PizzaFood, however in reality, the cash flows are uncertain (depends on business’s demand) and will have an impact on the security returns. The uncertainty is shown in Table 1.1 below;

 

Table 1.1 The uncertainty of free cash flows

                                                                       Security cash flows                                             Security return

Demand

Free cash flows

Unlevered equity

Debt

Levered equity

Unlevered equity

Debt

Levered equity

Weak

$270 000

 

 

 

 

 

 

Expected

$345 000

$345 000

$157 000

$187500

15%

5%

25%

Strong

$420 000

 

 

 

 

 

 

 

The current risk-free interest rate is expected to be 5%. PizzaFood believe, however, that their profits will be somewhat risky and sensitive to the overall market (which will affect the level of activity in the building and demand for your business), so that a 10% risk premium is appropriate, for a total discount rate of 15% (5% + 10%). As an alternative, PizzaFood may also consider borrowing some of the money it needs to invest. Suppose the business’s cash flow is certain to be at least $160,000. Then PizzaFood can borrow $150,000 at the current risk-free rate of 5%.

 

Please answer the questions:

(a) Calculate the NPV of the investment on ABC Limited. (1 mark)

(b) If PizzaFood has two options (equity and levered) in raising money for this investment, discuss how these options may affect the total amount raised by PizzaFood. (4 marks)

(c) Based on (b) answer, discuss how leverage will affect risk and return of PizzaFood’s equity and raise its equity cost of capital. (4 marks)

(d) Consider the different levels of demand and free cash flows in Table 1.1 and compute the security cash flows and returns for unlevered equity, debt and levered equity (compute figure in empty area of the table). Discuss and illustrate the effect of leverage on returns in Table 1.1 (includes your computation) with graph. (7 marks)

(e) The effect of leverage on the firm’s cost of equity is illustrated by the insight of Modigliani and Miller. Describe how it is that the firm’s weighted average cost of capital stays the same even after adding leverage? (refer to Table 1.1 for WACC computation). Discuss why this WACC remains constant. (9 marks)

(f) If PizzaFood decides to pay cash to shareholders, it can do so through either dividend payments or share repurchases. Assume, PizzaFood has cash of $400,000 cash in excess and no debt with 100,000 of outstanding shares. Discuss three possible options that may be considered by the board and determine the impact of each decision on market value of PizzaFood. Assume including the cash in excess, PizzaFood’s total market value is $1,000,000 and future free cash flows of $345,000 per year. (12 marks)

(g) If PizzaFood agrees to invest in ABC Limited Inc., which is operating in Europe, PizzaFood knows it will have to pay the upfront investment in euros within 3 months with exchange rate of 1.4500 dollars per euro, discuss how forward and options contracts can be used by the company to hedge its exposure. (3 marks)

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