WHICH IS BETTERDEBT OR EQUITY FINANCING?

Background Pizza Hut Corporation has decided to enter the catering business in three states within its Southeastern U.S. Division, using the name Pizza Hut At-Your-Place. To deliver the meals and serving personnel, it is about to purchase 200 vans with custom interiors for a total of $1.5 million. Each van is expected to be used for 10 years and have a $1000 salvage value.

A feasibility study completed last year indicated that the At-Your-Place business venture could realize an estimated annual net cash fl ow of $300,000 before taxes in the three states. After-tax considerations would have to take into account the effective tax rate of 35% paid by Pizza Hut.

An engineer with Pizza Huts Distribution Division has worked with the corporate fi nance offi ce to determine how to best develop the $1.5 million capital needed for the purchase of vans. There are two viable fi nancing plans.

Information

Plan A is debt fi nancing for 50% of the capital ($750,000) with the 8% per year compound interest loan repaid over 10 years with uniform year-end payments. (A simplifying assumption that $75,000 of the principal is repaid with each annual payment can be made.)

Plan B is 100% equity capital raised from the sale of $15 per share common stock. The fi nancial manager informed the engineer that stock is paying $0.50 per share in dividends and that this dividend rate has been increasing at an average of 5% each year. This dividend pattern is expected to continue, based on the current fi nancial environment.

Case Study Exercises

1. What values of MARR should the engineer use to determine the better fi nancing plan?

2. The engineer must make a recommendation on the fi - nancing plan by the end of the day. He does not know how to consider all the tax angles for the debt fi nancing in plan A. However, he does have a handbook that gives these relations for equity and debt capital about taxes and cash fl ows: Equity capital: no income tax advantages After-tax net cash fl ow (before-tax net cash fl ow)(1 tax rate) Debt capital: income tax advantage comes from interest paid on loans After-tax net cash fl ow before-tax net cash fl ow loan principal loan interest taxes Taxes (taxable income)(tax rate) Taxable income net cash fl ow loan interest He decides to forget any other tax consequences and use this information to prepare a recommendation. Is A or B the better plan?

3. The division manager would like to know how much the WACC varies for different D-E mixes, especially about 15% to 20% on either side of the 50% debt fi nancing option in plan A. Plot the WACC curve and compare its shape with that of Figure 102 .