M&M Pizza

Abstract

This case is used in Darden's core first year finance course. The exercise introduces in a fun way the fundamentals of financial policy that are the foundation of corporate finance. It takes the textbook treatment of the Modigliani and Miller (M&M) principles and casts it in a case format. The case is accompanied by a teaching note for instructors and spreadsheets for both instructors and students. Moe Miller, the new managing director of M&M Pizza, is considering changing the company's capital structure to reduce the cost of capital. With the cost of debt at 4% and the cost of equity at 8%, adding a cheaper cost of funds through debt appears to be obvious. The case provides a simple framework for understanding the powerful intuition behind the foundational capital structure irrelevance propositions of Modigliani and Miller (1958). The case is written as an introductory experience in financial policy. Students are required to generate simple estimates of the cost of capital and estimate the value of debt and equity claims under various recapitalization scenarios. As the business is very simple and operates in a quasi-perfect market, the calculations require only that students are comfortable with the estimation of firm cost of capital. Excerpt UVA-F-1691 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. 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$ 500million in new company debt and using the proceeds to repurchase F$ 500million 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 . . .