Chipotle: Capital Structure Decision

For simplicity, we will analyze three scenarioskeep the current debt level of zero, or raise $1,150M or $2,300M in debt. (We will ignore the scenario of $3,450M in debt; same logic will apply.) You can assume that they will hold this debt in perpetuity. The excel file with tables provided on Canvas contains the ProForma (Exhibit 14) tax shield effects for these transactions. Your goal is to make a recommendation on the optimal capital structure for the firm. 1) How would you characterize the business risk of Chipotle? You may want to start by reviewing its financial performance to date, and describing the main business issues that have confronted the firm. 2) What are the benefits of debt for Chipotle? That is, if Chipotle decides to finance itself with more debt relative to equity, will this create tax shield for the firm? You can provide a qualitative answer here. You will estimate the value of these benefits below. 3) Now let's think qualitatively about the costs of debt for Chipotle. What do you think are the main direct and indirect costs of financial distress for Chipotle? When describing the costs of financial distress, be specific, and think about what kind of company Chipotle is. Is this the kind of company that has high expected costs of financial distress and thus should have little debt in its capital structure? Numerically estimating the costs of financial distress is quite difficult. I am more interested in your description of the type and size of financial distress costs than your actual numerical estimate. 4) Chipotle is current financed only with equity. That means that Value levered = Value unlevered (all equity). Exhibit 14 estimates the unlevered market value of the assets to be $11,998.1 The firm is considering changing its capital structure through a leveraged recapitalization. Specifically, it would raise debt and use the proceeds to buy back shares. Chipotle is considering three options: i) Not issue any debt but repurchase $300 million worth of share using funds from its "investment in marketable securities." How does this affect the balance sheet of a firm like Chipotle that is all-equity financed? a. To answer this question, you may want to consider whether buybacks always lead to an overall increase in value. Start by reading the note below "Mechanics of a Leverage Increasing Transaction." When shares are repurchased at fair price, buying the firm's shares will be zero NPV. The price per share will not change. Some shareholders will tender their shares and receive cash. Those who do not tender, will hold shares valued at the same price. The wealth of shareholders will not change. For buybacks to increase firm 1 See Notes to table #4 for calculation. Chipotle- Case Questions 1 Carola Frydman value we need to consider why. In this case, we will focus on the tax shield and the cost of financial distress in parts 4.ii and 4.iii. ii) Raise $1,150 million is debt and use this amount to repurchase its shares. iii) Raise $2,300 million is debt and use this amount to repurchase its shares. Analyze each of these three scenarios. Which of these three options would you recommend, and why?