Pizza Hut Corporation has decided to enter the catering business in three states within its Southeastern U.S.

Question:

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 flow 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 Hut's Distribution Division has worked with the corporate finance office to determine how to best develop the $1.5 million capital needed for the purchase of vans. There are two viable financing plans. Plan A is debt financing 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 financial 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 financial environment.

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

2. The engineer must make a recommendation on the financing plan by the end of the day. He does not know how to consider all the tax angles for the debt financing in plan A. However, he does have a handbook that gives these relations for equity and debt capital about taxes and cash flows:

Equity capital: no income tax advantages

After-tax net cash flow = (before-tax net cash flow)(1 – tax rate)

Debt capital: income tax advantage comes from interest paid on loans

After-tax net cash flow = before-tax net cash flow

– loan principal

– loan interest – taxes

Taxes = (taxable income)(tax rate)

Taxable income = net cash flow

– 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 financing option in plan A. Plot the WACC curve and compare its shape with that of Figure.

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