Question

Pompeii Pizza Club owns three identical restaurants popular for their specialty pizzas. Each restaurant has a debt-equity ratio of 35 percent and makes interest payments of $57,000 at the end of each year. The cost of the firm’s levered equity is 18 percent. Each store estimates that annual sales will be $1.5 million; annual cost of goods sold will be $820,000; and annual general and administrative costs will be $480,000. These cash flows are expected to remain the same forever. The corporate tax rate is 25 percent. a. Use the flow to equity approach to determine the value of the company’s equity. (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89) b. What is the total value of the company? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89)

Answer 1

a). . Remembering that the company has three stores, we find:

Net Income = [(Sales - COGS - G&A Expenses - Interest) x (1 - t)] x 3

= [($1,500,000 - $820,000 - $480,000 - $57,000) x (1 - 0.25)] x 3

= [$143,000 x 0.75] x 3 = $107,250 x 3 = $321,750

Value of Equity = Net Income / kE = $321,750 / 0.18 = $1,787,500

b). D/E = 0.35

D/$1,787,500 = 0.35

D = 0.35 x $1,787,500 = $625,625

Value of Firm = Value of Debt + Value of Equity

  = $625,625 + $1,787,500 = $2,413,125