The unique concept of designer pizzas with an unconventional menu flourished, and by 2007 there were 213 stores worldwide in seven countries. COP had various sources of revenue, including company owned restaurants, franchising and a partnership with Kraft foods to sell COP frozen pizzas in grocery stores. During 2007 the industry was experiencing high labor and food costs which put pressure on consumer spending.
Despite this, COP still managed to show earnings growth and impressive financial results. Their quarterly profits were estimated at over $ 6 million. During June 2007, Cap’s share price declined by 10% to $22. 10. This caused the management team to consider repurchasing company shares, which required debt financing. COP avoided debt financing thus far; however, it had an available line of credit of $ 75 million at 6. 16% interest rate. The company was thus considering using leverage to grow its business.
Success of COP can be facilitated by continuing with its differentiated products, menu development, managing its food and labor cost fluctuations, developing its franchise equines, developing its partnership with Kraft Foods, expanding to more locations and considering using debt as a means of financing. Leverage increases the ROE of a company, which is shown by the Du Pont analysis. Leverage affects cost of capital by reducing the weighted average cost of capital (“WAC”). This is further analyses using the Modeling and Miller (1958) (“MM) theory.
An analysis of share price and number of shares that could be bought are examined by using three possible debt scenarios. By increasing debt, a higher share price and larger amount of shares to be repurchased is found. We discuss the how tax deductibility of interest can provide the levered firm with a tax shield or tax saving. We recommend a 20% debt to capital structure as well as share buy-back policy. We evaluate this recommendation under various capital structure theories. We evaluate a capital structure required to complete the expansion policy.
PORTERS FIVE FORCES Threat of New Entry It is relatively easy opening up a restaurant. Initial capital is high but they could make use of leasing. Food and restaurant service is a simple concept that could easily be implemented. Threat of Entry is high. The Power of Suppliers There are a large variety of suppliers in the industry from where ingredients can be bought. The power of suppliers is low. The Power of Buyers As customers are mainly high net worth individuals, their sensitivity to price and macroeconomic conditions are low.
Low income earners have been affected by increasing prices; therefore COP is dependent on their high income earning customers who are able to demand quality of product and service for the price they are willing to pay. The power of buyers is high. Threat of Substitutes As market conditions have declined, consumer spending has decreased. People have thus reduced their eating out expense and substituted it with home-cooked meals. Cap’s frozen pizzas by Kraft foods could be used as a substitute; however, that is only one line of product.
The threat of substitutes is high. Rivalry among Existing Competitors The other competitors in the industry do not have the unique menu offerings that COP offers. There is thus no direct substitute for the specific menu options found at COP. Customers are thus more likely to go COP for a unique craved item at a lower average price than its upscale dining peers. Rivalry among existing competitors is owe. Based on the Porters Five Forces model above, we conclude that COP operates in an environment with relatively strong competitive forces.
SOOT ANALYSIS Weaknesses Strengths Various sources of revenue Customers are largely high income earners affected as much by macroeconomic pressures Average menu prices lower than competitors Continuously developing menu Unique menu offerings-won’t be found at ASAP Restaurant concept-at airports, therefore creates awareness amongst foreigners Kraft Partnership-when consumers can’t afford eating out, they can still purchase COP products in grocery stores
Industry is highly affected by inflation-eating out is first place consumers cut down on spending Does not appeal to low income earners Does not appeal to less adventurous consumers- do not sell any ‘normal ‘menu items Lack of geographic diversification-40% of company operated stores are located within California Opportunities 0 Opportunity to gain market share-lowest average price of all upscale dining peers 0 Expansion- currently financial performance unaffected by rising costs.
Use this opportunity to expand whilst competitors are experiencing weakened performance and earnings Franchised Restaurants and frozen pizzas through Kraft Foods have the possibility of improving overall margins in the long run 0 Could market other products through Kraft foods Threats Less market competitors-targets broader range of customers 0 Industry challenges- rising costs of commodities could continue and start reducing spending of higher income earners as well QUESTION 1 In what ways can Susan Collins facilitate the success of COP?
COP has maintained its competitive advantage and market share through sufficient differentiation. It has ensured cost leadership by competing on price and market differentiation by uniqueness of its product. In order to grow its market share and ensure success of the business, the following should be considered by Susan Collins: 1. Menu Development COP spends 50% of its marketing costs on menu development. Slow selling items are replaced with new items bi-annually. As their menu is the main attraction of customers, it is essential that they maintain a unique menu of items that are in demand.
They should continue to do research and spend money on its development. Fortunately for COP, they are very reliant on word of mouth marketing and can thus save on marketing costs. 2. Maintenance of Unique Concept As economic conditions worsen and input costs rise, COP should continue to service its niche market with high quality ingredients and unconventional food offerings. This authenticity is what has made them successful and this will continue to separate them from its competitors. 3. Cost Control The firm is highly exposed to rising input costs I. E. Food and labor.
It is essential that they develop good supplier and customer relationships to maintain profit margins and competitive advantage. Food prices are very volatile due to inflation. Between 2003 to 2006, food, beverage ND paper supplies have increased by 54%. COP has managed to keep these costs to 24% of its total revenue. They should endeavourer to maintain competitive advantage through arrangements with suppliers. By large volume orders and timely payments of debt, they could aim to receive favorable discounts. Labor costs have also increased by 54% since 2003.
Labor costs in 2006 have been 36% of total revenue. There has been an introduction of a new minimum wage, effective July 2007. This represents a 40% increase in the wage rate per hour. Cap’s labor costs will increase which will put pressure on its margins. As the employees have low skills and are easily able to switch Jobs, COP should attempt to motivate staff and create incentive programmer to ensure staff retention. They should also train staff to provide excellent service which will add to their competitive advantage. 4.
Development of Franchise Business From 2003 to 2006, COP has maintained an approximate 1% of franchise sales to total sales. There is an opportunity to grow the franchise business. By growing its franchise, it will receive upfront income of between $50,000 and $65,000 per store opened. It will also receive royalty fees of 5% of gross sales. . Expansion to be more Geographically Diversified With its expansion plans, it should aim to spread out to a wider geographic location. Based on each locations success, it could open additional stores in that location in future. . Additional Product offerings through Kraft Foods Royalties from Kraft Foods also represent 1% of COP revenues. Currently, they only sell COP branded frozen pizzas in grocery stores. As COP has other products besides pizzas, the partnership with Kraft Foods should be extended to include other items on the menu. This could help alleviate cost increases when restaurant sales decrease s more consumers demand home cooked alternatives to save money. 7. Financing Up until 2006, COP has avoided debt financing.
It does have an available line of credit of $ 75 million at a low interest rate of 6. 16%. The low interest rate environment and tangible assets available to secure any borrowing would indicate that it could be feasible to take on some debt to fund its expansion plans. The feasibility of taking on debt will be discussed in the next sections. 8. Stakeholder Theory An alternative series of actions that Susan may consider to facilitate the success of COP is to consider what is broadly titled: Stakeholder Theory.
Stakeholder Theory postulates that firms should aim to maximize not only the wealth of the shareholders (shareholder view), but to consider all stakeholders associated with the firm. The definitions for stakeholders are broad and varied, but generally constitute those directly or indirectly affected by the operations of the firm, including but not limited to customers, suppliers, society, its owners, its management, and its employees. It has been recently argued that due consideration should be given to stakeholders, and not Just direct shareholder value.
Under this theory it could be argued that by giving uh regard to its stakeholders, COP would be achieving greater success than it would if it pursued purely optimal financial performance as a goal. QUESTION 2 Using the scenarios in case Exhibit 9, what role does leverage play in affecting the return on equity (“ROE”) for COP? Leverage increases the ROE of COP (“the Company’). As shown in chart 1 below, scenarios with successive increases in the debt to equity ratio (“DIE”) from zero to 10. 0 percent, 20 percent and 30 percent increases the ROE respectively from 9. 0 percent to 9. Percent, 10. 2 percent and 11. 1 percent. Given that no operational hangers were assumed, total capital remained unchanged and the debt capital was merely used to repurchase equity, we can deduce that the sole explanation for the elevation in ROE was the injection of debt capital. The logic for this occurrence is explained via the DuPont decomposition of ROE as a product of financial leverage (“FL”), total asset turnover (“TAT”) and net profit margin (“NP): (1) Thus a company’s ROE with leverage (FL >1 implies leverage) will be greater than if it were not using any leverage.
Considering the capital of a company as pizza, each slice represents how much of total investment is financed by a particular type of capital debt or equity); they postulate that the present value of future cash flows (total value) remains unchanged irrespective of the composition of total capital. Thus the capital structure is irrelevant because under these assumptions, investors will force equivalence between the values of levered and unleavened companies by exploiting price differentials to earn arbitrage profit.
Adding leverage increases equity risk and return to equity holders but this increase in equity return is, in equilibrium, exactly offset by increases in associated equity discount rate; so that there is no change in total company value. Although this framework serves as a reasonable starting point for a discussion of capital structure, many of the assumptions are unrealistic and thus cannot be applied to the COP case under discussion. As a first practical modification, taxes are considered.
MM demonstrate that in the presence of corporate taxes, the value of a levered company (FL) exceeds that of an unleavened company (IV) by an amount equal to the product of the tax rate and the value of debt (the tax shield). Since interest paid is tax deductible, leverage provides a tax shield (ad) that offers savings, to augment the value of the levered company: By implication, taxing authorities subsidies companies’ use of debt by making interest on debt tax deductible.
This tax-modified proposition applies to COP. As shown in Tables 3, consistent increases in leverage increases the MBA by an amount equal to the debt tax shield. By implication, using 100% leverage can add up to $73 million to Cap’s value; whilst using up all the $75 million line of credit can add a tax shield of over $24 million to Cap’s value. Tax Shield 417885 7,332 14,664 439,881 21,996 Table 3: Tax Shield MM also propose that the cost of equity ( is a linear function of the company’s debt/equity ratio ( : (
Where = WAC; = Cost of Debt Thus with leverage and corporate taxes, the cost of equity exceeds WAC, and the value of a levered company discounted with WAC will be larger than an unleavened company; also explaining the rise in the value of COP as measured by price per share and PIE ratio under varying scenarios, as shown in Table 1. However, this ignores the financial risk leverage introduced into the company by increasing the probability of an occurrence of financial distress and bankruptcy, agency costs, transaction costs and information asymmetry.
These factors influence abase the tax shield such that he use of leverage becomes, in practice, a balancing act between these factors on one hand, and tax savings from the use of debt. Indeed, whilst leverage increases value, it can also reduce what Rick Responded described as “staying power”. Other capital structure theories are discussed under question 4. Thus leverage positively impacts Cap’s value and reduces cost of capital as explained within DuPont and MM frameworks. QUESTION 3 Based on the analysis in case Exhibit 9, what is the anticipated share price under each scenario? How many shares will COP be likely to repurchase under each