Weighted Average Cost of Capital and Net Present Value: Pizza Franchise Case Study

Introduction

This essay is a case study of a pizza franchise that is still new in the industry. The initiator of this business is an alumni of La Trobe University who decided to create a part-time job for himself. The business is picking up and Tien is worried because he lacks the necessary experience to manage the business. He therefore, seeks for our help in the following areas: to prepare a weighted cost of capital and the net present value of the business.

Weighted average cost of capital

The cost of capital is the price a company pays for being financed. In other words, it is the reward to lenders and shareholders for sacrificing a portion of their wealth to finance the operations of a business. Therefore, the weighted average cost of capital is the expression of the market value of a source of finance with respect to its contribution to the total capital base of a business. Concerning the pizza franchise, the cost of equity is estimated to be 6.5% and the cost of debt is 6.5%. Tien has decided to have a capital structure that comprises of 30% debt and 70% equity capital. This means that 30% of the businesses’ capital is contributed by debt and the remaining 70%, by equity. Therefore, the weighted average cost of capital is estimated as follows: 6.5 (0.7) + 6.5 (0.3) = 6.5%. Consequently, the after-tax weighted average cost of capital is 6.5%.

The net present value

It is a method of evaluating whether a business is worthy of investment. It is a technique used to discount the cash flows of a business in order to estimate its value. In regards to Tien’s business, the four-year cash flows should be discounted using a factor of 6.5% because it is the cost of finance. The figures are as follows:

Present values of the cash inflows= (-51,768/1.065¹) + (-21,651/1.065²) + (8466/1.065³) + (38,584/1.065⁴) = – 30696.5.

The net present value = (- 30696.5- 620,000) = – 650,696.5

The present value accept or reject rule states that a good investment is that whose present value of cash inflows exceed the present values of cash outflows. Concerning Domino Pizza enterprise, it is not wise to make an investment into the business because it has a negative NPV. Negative NPV shows that a business would make losses in the future while a positive NPV reflects profitability. Therefore, in four year’s time, the value of Tien’s business will be negative.