Question

Two ambitious business graduates, Boris and Isabelle, are considering purchasing Premier Pizza, a frozen pizza manufacturer. Forecasted annual sales for the coming year are $11 million, with operating costs equal to 73% of sales, depreciation is 6% of sales and required annual investment in equipment is 6% of sales. Sales, costs, and investments are expected to grow 5% in perpetuity. On the basis of their analysis of the industry, Boris and Isabelle anticipate financing their company with 20% debt. The required rate of return on the debt will be 6% and the required rate of return on the equity will be 15%. Premier Pizza’s corporate tax rate is 35%. The risk-free interest rate is 2% and the market risk premium is 8%.

a.	What is the maximum price Boris and Isabelle should be willing to pay for Premier Pizza?

b.	A national grocery chain, Fresh Foods, is also considering making an offer for Premier Pizza. The levered equity beta of the grocery chain is 0.9, its cost of debt is 5%, it is 36% debt-financed, and it has a 35% tax rate. What is the maximum price that Fresh Foods should be willing to pay for Premier Pizza? Assume that Fresh Foods’s forecast for Premier’s cash flows is the same as Boris and Isabelle’s.
	Maximum price

Answer 1

Calculation of annual cash flow from operations: Formula Sales 1,10,00,000 Operating costs ($11m*73%) Depreciation ($11m * 6%) Operating income (Sales operating costs depreciation) Taxes (operating profit* 35%) cash flow from operations (operating income taxes + depreciation) 11000000 73% 80,30,000 11000000*6% 6,60,000 11000000-8030000-660000 23,10,000 2310000*35% 8,08,500 2310000-808500+660000 21,61,500 Annual capex (Sales $11m*6%) Free cash flow (cash flow from operations capex) 11000000 6% 6,60,000 2161500-660000 15,01,500 Solution-(a) Calculation of maximum price Boris and Isabelle can pay Cost of debt 6% Cost of equity 15 % WACC= Cost of debt*weight of debt + Cost of equity Weight of equity WACC= 6%*0.2+15%*0.8 WACC 13.2% growth rate (given)- 5 % Expected free cash flow (as calculated above)- $15,01,500 Using gordon growth model, the price (P) is calculated as follows: P- Expected cash flow/(WACC-growth rate) P- 15,01,500/(13.2%-5%) P- $18,310,975.6 Therefore, the maximum price that boris and isabelle should pay is $18,310,975.6

Solution- (b) Calculation of maximum price Fresh foods can pay Cost of debt= 5% Cost of equity (CAPM)= Risk free rate Beta*(Market risk premium) Cost of equity (CAPM) 2% 0.9*8% Cost of equity (CAPM) 9.2% WACC= Cost of debt*weight of debt Cost of equity*Weight of equity WACC= 5%*0.36+9.2% *0.64 WACC 7.69% growth rate (given) 5 % Expected free cash flow (as calculated above) $15,01,500 Using gordon growth model, the price (P) is calculated as follows: P Expected cash flow/(WACC-growth rate) P- 15,01,500/(7.69%-5%) P= $55,817,843.9 Therefore, the maximum price that Fresh foods should pay is $55,817,843.9