CALCULATING THE OPTIMUM DEBT-TO-EQUITY RATIO
Your task is to determine which of the seven scenarios, above, is the best (optimal) debtto-equity ratio for Napoli Pizza. You will want to use the information and formulas which Eva Perez has accumulated for you. When you work through the following steps, you will see that this is a relatively straight-forward process. Now, sit down with your favorite pizza (anchovies and onions) and set out to determine the capital structure that will maximize Napoli’s stock value.
121176 – Journal of Business Cases and Applications Napoli Pizza wants to, page 1 Napoli Pizza wants to determine its optimal capital structure Brad Stevenson Bellarmine University Daniel Bauer Bellarmine University David Collins Bellarmine University Keith Richardson Bellarmine University ABSTRACT This case is based on an actual business decision that was made by a small, closely-held company. Napoli Pizza is a popular pizza restaurant and bar located in a mid-sized, Mid-Western city. It has been very successful serving outstanding food and beverages in a trendy atmosphere and location. Napoli successfully caters to a working-professional lunch crowd, a family-oriented dinner crowd, and a young night-life bar crowd. The business has been entirely financed with equity since inception and the owners are investigating obtaining debt financing to improve return on equity and allow the owners to take some cash out of the business. The case is designed to give undergraduate and MBA students exposure to the determination of an optimal capital structure in a small business setting. The case will also introduce students to the concept of levered betas. The capital asset pricing model (CAPM), the weighted average cost of capital model (WACC), and levered beta estimates are used to estimate per share stock values at a variety of debt levels. The borrowed funds are used to pay a one-time, special cash dividend to current stockholders. It is recommended that the case be assigned as an advanced topic, following a discussion of the development and use of beta, CAPM, and WACC. Keywords: CAPM, WACC, Beta, Levered Beta, Equity Valuation, Capital Structure, Debt-to- Equity Ratio Copyright statement: Authors retain the copyright to the manuscripts published in AABRI journals. Please see the AABRI Copyright Policy at http://www.aabri.com/copyright.html. http://www.aabri.com/copyright.html 121176 – Journal of Business Cases and Applications Napoli Pizza wants to, page 2 EVA IS INDIRECTLY ASKED TO FIND AN OPTIMAL CAPITAL STRUCTURE Eva Perez was recently hired as Business Manager of Napoli Pizza and she is anxious to show off her MBA skills to her new employers. Once settled into her job, Eva realized that this very successful, family-owned business was financed entirely with equity. While there can be appropriate reasons for this type of capital structure, Eva knew from her finance course that most equity holders would be financially better off if the capital structure included some level of debt. The interesting question is: how much debt relative to equity? Being new, and not being part of the ownership family, Eva was not sure whether to raise this question with her employers. Unknown to Eva, Joseph Romano, patriarch and principal owner of Napoli Pizza, had been approached by several family members. While Napoli Pizza’s earnings (and cash flows) provide the family with supplemental income, most of its value is in the common equity shares held by the family. The family wondered if there was a way to enjoy the financial benefits of that equity. Joseph didn’t know, but he wondered if Eva’s MBA education could help them find an answer. Eva smiled when Joseph Romano spoke with her the next day. He was asking the question that she wanted to ask. Eva exclaimed, “Mr. Romano! That is the very thing I had been wondering about.” Remembering her finance training, Eva explained that there is an optimal relationship between debt and equity; a point at which the market value of equity will be maximized. Eva was certain she could perform the necessary calculations and the amount of debt raised would provide the financial benefit that the family desired. If Napoli recapitalized with debt, the borrowed funds would be used to pay a one-time, special cash dividend to its current stockholders. The family members would receive a cash payout and the company would attain an optimal capital structure. “The best of all worlds!” NAPOLI PIZZA Napoli Pizza is a popular pizza restaurant and bar located in a mid-sized, Midwestern city. It has been very successful serving outstanding food and beverages in a trendy atmosphere and location. Napoli caters to a working-professional lunch crowd, a family-oriented dinner crowd, and a young night-life bar crowd. Due to its success, the company’s earnings before interest and taxes (EBIT) was $500,000 last year and, because the business has settled into a comfortable market position and no expansion is planned, earnings are expected to remain constant (in real terms) over time. Joseph Romano started Napoli Pizza ten years ago with his family members as the initial employees (his children and his siblings and their children). As the business prospered, allowing Joseph to hire non-family employees, many of the original family group left for college and other pursuits. However, over the years, Joseph has given stock to each member of the family, and he has regularly paid out all earnings as cash dividends. Joseph owns 30% of the outstanding shares, and his three sons each own 10% (although Joseph holds the voting rights on those shares). Paul Romano and his two sons each own 5%, as does Carlo Romano, Carlo’s two daughters, Lorraine Romano and Lorraine’s son. Eva’s review of the company’s financial records showed that Napoli is currently financed with all equity and has 100,000 shares outstanding. Napoli is in a 40% federal plus state tax 121176 – Journal of Business Cases and Applications Napoli Pizza wants to, page 3 bracket. The company leases all of its equipment and its building. Therefore, Napoli has no depreciation expense. One problem Eva has is that Napoli Pizza is not publicly traded and, therefore it has no market price. Eva knew from her finance training that she can use estimated cash flows, weighted average cost of capital (WACC), and the capital asset pricing model (CAPM) to estimate the current value of the stock. She can use the same approach to estimate the debt and equity relationship that would maximize equity value. This is the optimum debt to equity ratio. A second problem Eva has is that because Napoli Pizza is not publicly traded, and therefore it has no market price, she cannot directly calculate the company’s beta. She does recall her finance professor saying that a firm that is not publicly traded, like Napoli, may estimate its beta using betas from similar firms in the same industry that are publicly traded. ESTIMATING CURRENT UNLEVERED BETA Searching through her old MBA notes, Eva found the following: 1 Levered Beta = Unlevered Beta*[1 + (Debt/Equity)*(1 – Tax Rate)] Eva saw that unlevered beta reflects the firm’s operational (business) risk and would be used to compute cost of equity if the firm had no debt. Levered beta combines the firm’s operational risk and its financial risk (the risk due to leverage). Eva had to ponder this for a while. It slowly became clear, if a firm that is not publicly traded wants to calculate its cost of equity and examine the impact of a change in capital structure on its firm value, it can use this formula to estimate its own beta. First, she could unlever betas for firms like Napoli to find a beta for Napoli that would reflect its operational risk. She could then relever the beta to see the effect of leverage on the value of Napoli. Eva estimated Napoli’s current unlevered beta, as follows: Using Yahoo! Finance, Eva found the betas, tax rates and debt-to-equity values for two publicly traded firms in the same industry, the first with .86, 40% and 0%, respectively, and the second with 1.73, 40%, and 36%, respectively. Using the levered beta formula, Eva un-levered and averaged their betas to estimate an all equity beta for Napoli Pizza. Eva rearranged the formula as follows: Unlevered Beta = Levered Beta / [1 + (Debt/Equity)*(1 – Tax Rate)] Firm A Unlevered = 0.86/[1+0*(1-.4)] = 0.86 Firm B Unlevered = 1.73/[1+.36*(1-.4)] = 1.42 Un-levered, all equity beta = (.86 + 1.42)/2 = 1.14 A large publicly traded firm with similar operational risk (the risk of being in the casual dining business) to the two firms Eva identified with no debt might be expected to have a beta of 1.14. However, Eva knew that Napoli may have greater operational risk than these firms because: 1) it is a small, regional firm more susceptible to swings in the local market, and 2) it 1 While there are other theoretical models, this model and Levered Beta = Unlevered Beta*1 + (Debt/Equity) are the most commonly used in practice. See working paper no. 488 “Levered and Unlevered Beta” from the IESE Business School by Pablo Fernandez (2006) for a more detailed discussion of the theoretical models. 121176 – Journal of Business Cases and Applications Napoli Pizza wants to, page 4 lacks the economies of scale that these larger national firms have. Based on this, Eva subjectively revised the estimate of the unlevered beta upward (more risk, higher beta) to 1.5. ESTIMATING CURRENT MARKET VALUE With this estimated beta, Eva was able to estimate the market value of the stock using estimated cash flows, weighted average cost of capital (WACC), and the capital asset pricing model (CAPM). Eva used www.bondsonline.com to find a proxy for the current risk-free rate of 4.50% (the 30-year Treasury bond rate). Also, based on the differences in historical returns between the S&P 500 and the 30-year Treasury bond rate (Market Return – Risk-free Rate), she estimated the market risk premium to be 7%. Her calculations were as follows: Risk-free Rate + Beta (Market Risk Premium) = CAPM (Cost of Equity) 4.5% + 1.5 (7%) = 15% (Weight of Debt * Cost of Debt) + (Weight of Equity * Cost of Equity) = WACC Because there is no debt, WACC