Question

Tonys Pizza Club owns three identical restaurants popular for their specialty pizzas. Each restaurant has a debt-equity ratio of 40 percent and makes interest payments of $54,000 at the end of each year. The cost of the firm’s levered equity is 19 percent. Each store estimates that annual sales will be $1.455 million; annual cost of goods sold will be $805,000; and annual general and administrative costs will be $465,000. These cash flows are expected to remain the same forever. The corporate tax rate is 22 percent.

  

a.	Use the flow to equity approach to determine the value of the company’s equity.
b.	What is the total value of the company

Answer 1

a. The value of the company is computed as shown below:

Earnings before tax is computed as follows:

= Sales - Cost of goods sold - General and administrative cost - Interest expense

= $ 1,455,000 - $ 805,000 - $ 465,000 - $ 54,000

= $ 131,000

So profit after tax will be:

= $ 131,000 - 22%

= $ 102,180

So the value of the company's equity will be:

= $ 102,180 / 0.19

= $ 537,789.4737

b. The total value of the company is computed as shown below:

Debt-equity ratio = 0.40

Debt / Equity = 0.40

Debt / $ 537,789.4737 = 0.40

Debt = $ 215,115.7895

Company's value

= Debt+ Equity

= $ 537,789.4737 + $ 215,115.7895

= $ 752,905.2632

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