Financial Analysis Of Pizza Store Investment

Calculating Required Unit Sales

1.In order to arrive at the number of units required to be sold to achieve a desired level of income, it is essential to find out the fixed cost incurred and work out the return required before tax. Then, sum up these two and divide by the contribution margin per unit (Cafferky, 2010).

In the current case, the contribution margin per unit for Pizza is $3.77. Total fixed cost has been worked out to be $367,260 and the return on capital is $80,000 ($400,000*20%). The total of fixed cost and desired return is $447,260. Thus, the number of Pizzas required to be sold per year will be 118,637 ($447,260/3.77) or we can say 2,281 per week (118,637/52).

2.The estimated net income after deducting taxes is presented in the statement shown below:

3.The free cash flows from operations have been computed for the first year shown in the statement given below. The free cash flows computation has been done applying indirect method which involves starting with net income and then making add back adjustments (Jury, 2012)

In order to arrive at the free cash flows from the operations, the depreciation and interest have been added back to the profit after tax. Depreciation is added because it’s a non cash item and interest has been added because it’s a non operating expenditure (Jury, 2012).

4.

Due to 3% increase in the number of Pizzas, the sale revenues and variable cost both will increase. However, the fixed will remain constant. The net increase on the due to increase in number of Pizzas by 3% has been shown in the table above. Further, while arriving at free cash flows, the depreciation and interest charge would remain same for all years.

The EBIDTA in year-2, 3, and 4 has been shown in the table given above. It could be observed that EBIDTA is not less than 33% of $400,000 in any year.

5.The beta of Domino’s Pizza is found to be 1.31. The Beta of Retail Food Group Limited is 1.45(Reuters, 2018). The simple average of these two betas is worked out to be 1.38 times.

Beta is the measure of relative volatility of the stock to the market overall. The beta value of more than 1 signifies that the stock is more risky and if beta value is less than 1, it means that the stock is less risky. The Domino’s as well as Retail Food Group has beta values higher than 1 which means that these stocks are riskier as compared to the market (Baker and English, 2011).

Estimating Net Income

6.The yield on 15 years government bond of Australia is 2.99% (Bloomberg, 2018). This yield can be used as the proxy for risk free rate of return.

7.The capital asset pricing model (CAPM) is used to compute the required rate of return for the equity investors. In order to apply the CAPM, the data in relation to risk free rate, beta, and market risk premium is required to be collected (Baker and English, 2011). In the current case, the risk free rate of return taking yield on 15 years government bond is 2.99%, the proxy beta is 1.38, and market risk premium is assumed to be 6.50%. Using this data, the CAPM has been computed as shown below:

CAPM =          Rf + Beta * Risk Premium

            =          2.99% + 1.38 * 6.50%

            =          11.96%

Thus, the CAPM return for the store is 11.96%. This is the return that the store should generate for the investors to keep them motivated for investment.

8.The weighted average cost of capital (WACC) signifies the cost incurred by the business in financing its assets and activities. It is computed with reference to cost of different sources of capital used such as equity, debt, and preferred capital. The cost of different sources is averaged applying the weights of different sources in the total capital employed (Brigham and Houston, 2015). In current case, it has been assumed that debt will be 27% and equity will be 73% in the total capital. The cost of equity will be 11.96% as calculated applying CAPM and that of debt it will be 6.50%. However, the cost of debt will be taken after tax which is worked out to be 4.55% [6.50 %*( 1-30%)]. Using these figures, the calculation of WACC is shown below:

WACC            =          K_e*W_e + K_d*W_d

                         ₌                11.96*73% + 4.55*27%

                     =          9.96%

Thus, the weighted average cost of capital is 9.96%.

9.In order to evaluate the viability of the project, net present value technique is used as one of the prominent measures. For the purpose of computation of net present value, four factors such as initial outlay, annual cash flows, discount rate, and terminal value are required (Brigham and Houston, 2015). The calculation of net present value in the current case is shown in the table given below:

10.The NPV of the project is -$38,426.83 which signifies that the project is not financial viability. A project is accepted and considered for implementation if it has positive NPV else the project is rejected. In the current case, the NPV of the project is negative and based on this it could be advised to Tien (owner) to reject the project implementation. The positive NPV shows profitability of the project, on the other hand, a negative NPV indicates that the project will be incurring losses (Brigham and Houston, 2015).

11.Tien (owner) has been advised to reject the project. The major argument in support of this advice is the negative NPV of the project. Further, the profitability of the project over the period of four years is attractive. The project is expected to generate net profit after tax of $58,542.40 in the first year itself and then it will grow to $87,809.30 at the end of 4^th year. But due to negative NPV it is not recommended for implementation.

12.The consideration of risks is of primary importance in deicide as to whether a project should be accepted or not. In the current project of Pizza franchise, it has been observed that the project is financial beneficial but it has certain risks attached to it. First of all, there is intense competition in the market of fast food, so, the Pizza franchise will have to face threat from the competitors which may lead to price cut or decrease in the demand. Further, in computing the revenues, it has been assumed that there will 3% increase in the number of pizzas sold each year. However, if the conditions do not favor the franchise, the achievement of this growth in the number of pizzas could be difficult (Brigham and Houston, 2015).       

Apart from the above, there is always the risk of political and regulatory environment. This means that the franchise is subject to the risk of change in government regulations relating to franchises. There may be changes in the laws and regulations affecting the franchise adversely. For instance, the government may revoke license to carry out the business operations. Further, it may also impose certain taxes or enhance the existing tax rates on the income earned by the franchise (Brigham and Houston, 2015). 

References

Baker, H.K. and English, P. 2011. Capital Budgeting Valuation: Financial Analysis for Today’s Investment Projects. John Wiley & Sons.

Bloomberg. 2018. Government Bond Yield. [Online]. Available at: https://www.bloomberg.com/markets/rates-bonds/government-bonds/Australia [Accessed on: May 16, 2018].

Brigham, E.F. and Houston, J.F. 2015. Fundamentals of Financial Management. Cengage Learning.

Cafferky, M. 2010. Breakeven Analysis: The Definitive Guide to Cost-Volume-Profit Analysis. Business Expert Press.

Jury, T. 2012. Cash Flow Analysis and Forecasting: The Definitive Guide to Understanding and Using Published Cash Flow Data. John Wiley & Sons.

Reuters. 2018. Domino’s Pizza Enterprises Ltd (DMP.AX). [Online]. Available at: https://www.reuters.com/finance/stocks/overview/DMP.AX [Accessed on: May 16, 2018].

Reuters. 2018. Domino’s Pizza Enterprises Ltd (DMP.AX). [Online]. Available at: https://www.reuters.com/finance/stocks/overview/RFG.AX [Accessed on: May 16, 2018].

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