Question 4 (Total 40 marks)

FIN 222 US Pizza 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. FIN 222 US Pizza, due to its brand recognition has been offered to invest in Yummy Brands Inc., one of the world's largest restaurant companies which is operating in Europe. This investment requires FIN 222 US Pizza to make an upfront investment of $240,000. FIN 222 will be expecting to generate a cash flows of $345,000at theend of oneyear after covering all operating expenses. This return may seem like a good deal for FIN 222 Ltd US Pizza, 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 4.1 below;

Table 4.1: The uncertainty of free cash flows

Security cash flows Security return

Demand Free cash Unlevered Debt Levered Unlevered Debt Levered

flows equity Equity Equity Equity

Weak $270,000

Expected $345,000 $345,000 $157,500 $187,500 15% 5% 25%

Strong $420,000

The current risk-free interest rate is expected to be 5%. FIN 222 US Pizza 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, FIN 222 US Pizza 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 FIN 222 US Pizza can borrow $150,000 at the current risk-free rate of 5%.

Required:

(a) Calculate the NPV of the investment on Yummy Brand. (1 mark)

(b) If FIN 222 US Pizza has two options (equity and levered) in raising money for this investment, discuss how these options may affect the total amount raised by FIN 222 US Pizza. (4 marks)

(c) Based on (b) answer, discuss how leverage will affect risk and return of FIN 222 US Pizza's equity and raise its equity cost of capital. (4 marks)

(d) Consider the different levels of demand and free cash flows in Table 4.1 and compute the security cash flows and returns for =levered equity, debt and levered equity (compute figure in empty area of the table). Discuss and illustrate the effect of leverage on returns in Table 4.1 (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 4.1 for WACC computation). Discuss why this WACC remains constant. (9 marks)

(f) If FIN 222 Ltd US Pizza decides to pay cash to shareholders, it can do so through either dividend payments or share repurchases. Assume, FIN 222 Ltd US Pizza 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 FIN 222 Ltd. US Pizza. Assume including the cash in excess, FIN 222 Ltd US Pizza's total market value is $1,000,000 and future free cash flows of $345,000 per year. (12 marks)

(g) If FIN222 Ltd US Pizza agrees to invest in Yummy Brands Inc., which is operating in Europe, FIN 222 Ltd US Pizza 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)