Case Scenario Overview:

Nguyen Tien has been employed part-time in a pizza franchise, near the campus, while he completed his Bachelor of Business at La Trobe University. He has been amazed at the increasing number of pizzas being ordered through the company’s iPod app. So much so that he has convinced his father to consider jointly investing in a pizza franchise which is for sale.

Not having much real world experience in preparing a financial business case, Tien has employed your team to provide him with advice on three areas:

1. Tien is provided with a copy of the financial accounts of Domino’s Pizza Enterprises Ltd. Before he can decide on the financial worth of the investment he needs to convince his father of the financial strength and sound reputation of the Domino’s brand and franchisor in Australia.  Tien requires your team to analyse and interpret these accounts for his father.
2. Tien requires your team to conduct a breakeven analysis and cash flow forecast of the franchise he is considering acquiring.
3. Based on the breakeven analysis and cash flow forecast you have prepared, Tien requires your team to calculate the NPV of the investment project.
   

Task 1:

Go to the website of Domino’s Pizza Enterprises Ltd (DMP) and download the Annual Report and Financial Accounts of the company for 2014.  This will be found under the “Domino’s Corporate” button in the top right hand corner of the home page: www.dominos.com.au

1. Based on the data in Table 1 below, calculate the annual growth in Revenue and the EBITDA margin for DMP for each year between 2010 and 2014. Describe the financial performance of DMP over this period based on your interpretation of this analysis.

2. Based on the information set out on pages 28 and 29 of the Financial Statements, calculate the annual rate of depreciation for DMP for 2013 and 2014. This is the rate at which DMP depreciates its fixed assets or Property Plant and Equipment. As DMP does not separate out the depreciation from its amortization in the Income Statement, refer to the appropriate note to identify the exact amount of depreciation excluding amortization.  As DMP does not show the gross amount of PPE in its Balance Sheet on page 29, you will need to go to the appropriate note referred to in the balance sheet to identify the gross amount of PPE, which DMP refers to as “Cost”.
3. Based on the information set out on page 28 of the Financial Statements, calculate the annual effective tax rate at which DMP is providing for tax in its Income Statement in 2013 and 2014.
4. Based on the information set out on pages 28 and 29 of the Financial Statements, calculate the average interest DMP is earning on its cash and equivalents. Actually interest income is included in Other Revenue, so you will need to refer to the relevant note to the accounts.  Also calculate the average interest DMP is paying on its borrowings.  Again you may need to refer to the note relevant to Finance Costs for more detail.
5. Based on the information set out on page 28 of the Financial Statements, calculate the Net Profit Margin for 2013 and 2014.
6. Based on the information set out on pages 28 – 29 of the Financial Statements, calculate the Asset Turnover Ratio for 2013 and 2014. Total Assets in 2012 was $175.319 million.
7. Based on the information set out on page 29 of the Financial Statements, calculate the Leverage Ratio for 2013 and 2014. Shareholders Equity in 2012 was $117.041 million.  Briefly interpret your results.
8. Based on the information set out on pages 28 – 29 of the Financial Statements, calculate the Return on Equity Ratio at the end of 2013 and 2014. Show how the Du Pont ratios derive the Return on Equity Ratio.  Briefly interpret your results.
9. After reviewing the information on the Domino’s Pizza Enterprises website, the Annual Report and any other information source you feel relevant, briefly explain whether you think Domino’s Pizza Enterprises Ltd is a financially sound, ethically sound and reputable brand in which to invest.

Task 2:

1. Pizza Recipe (adapted from Gordon Ramsay):

Ingredients for a single pizza:

• 125g strong bread flower or Italian “00” flour
• 4g dried yeast
• 10ml of extra virgin olive oil
• 35ml of passata
• 30g crushed garlic
• 100g cherry tomatoes
• 125g mozzarella cheese
• 50g Danielle ham

Sieve the four onto a clean work surface and make a well in the middle.  Mix the yeast, sugar and oil into 80ml of lukewarm water and leave for a few minutes.  Pour into the well.  Using a fork, bring the flour in gradually from the sides and whirl it into the liquid.  Keep mixing, drawing larger amounts of flour in.  When it starts to come together, work the rest of the four in with clean, four-dusted hands.  Knead until you have a smooth, springy dough.  Put the ball of dough in a large four-dusted bowl, sprinkle with flour and cover with a damp cloth.  Place in a warm room for an hour until doubled in size.

Tip the dough onto a four-dusted surface and knead it around a bit to push the air out with your hands.  You can either use it immediately, or keep it, wrapped in clingfilm, in the fridge (or freezer) until required.  Timing-wise, it’s a good idea to roll the pizzas out about 15 to 20 minutes before you want to cook them.  Don’t roll them out and leave them hanging around for a few hours, though – if your working in advance like this its better to leave your dough, covered with clingfilm in the fridge.

Put a large oven=proof frying pan on the heat and roll out the pizza dough on a floured work surface, until it’s the same size as your pan.  Add a little olive oil to the pan and add the pizza base, pressing it into the pan.  Cook over a medium heat until the base crisps and the dough starts to cook through and bubble up, about 5-8 minutes.  Top the pizza with the passata, the sliced ham, the halved cherry tomatoes and the sliced or grated mozzarella.  Put under a pre-heated grill until the toppings bubble.  Drizzle with more olive oil to serve.

Wholesale prices for the pizza ingredients:

Based on the pizza recipe above and the wholesale prices quoted for the ingredients, estimate the unit cost of food and paper for a single pizza.

1. Under the Domino’s Franchise Agreement the franchisee must pay to the franchisor a 7% royalty and a 6% contribution to marketing expenses. Calculate the per unit royalty and marketing contribution based on an Average Sales Price of $10.00 per unit.

2. On average there are three full-time staff employed at a DMP franchise store, including a store manager. Looking at the Award a reasonable average wage for the three full-time staff including the manager would be around $37,000.  The number of casuals is harder to estimate. Assume that on Sunday, Monday, Tuesday and Wednesday two casuals are employed for 3 hours per day.  On Thursday, Friday and Saturday assume that four casuals are employed for four hours per day.  This of course is assumed for all 52 weeks of the year.  Assume an average casual rate of $22 per hour.

Estimate the total salaries required to staff the franchise including say 30% for on-costs to cover superannuation etc.  While staffing costs, particularly casuals are a semi fixed cost, assume that for the range of pizzas sold by the average franchise they are fixed as you have calculated them.

3. You will have determined from looking at both the DMP website and the prospectus that the average franchise store is about 100sqm in size with a 6 meter frontage. While the lease costs will vary by location, lets assume a monthly rental of $4,000 and outgoings of a further $1,500 per month.  You will need to annualise these costs.

Calculate the annual rentals costs and annual outgoings.

4. The dominos.coma.au website, under the Domino’s Franchise button, shows the cost of setting up a franchise store as being between $350,000 and $450,000. Take the average of this range and assume that constitutes your gross Plant and Equipment.  Based on your analysis of the average depreciation rate you calculated in Part 1 of the assignment, estimate the annual depreciation expense.  Consider this a fixed cost as it will not vary with output in the range of units produced we are considering.
5. Assuming total interest-bearing debt is $150,000, via the internet find out what the major banks charge as interest on longer term small business loans. For example, Westpac’s fixed four-year Business Loan rate is shown currently as 6.50% at westpac.com.au/business-banking/.

Shop around you might find a better rate.  Use this information to calculate the annual interest expense on the loan.   Consider this a fixed cost.

6. Based on the annual costs calculated above, calculate the total Fixed Costs (including semi-fixed costs). Calculate the Variable Cost per unit and the Contribution per unit, from the costs estimated above and an average price per pizza of $10.00.
7. Based on your estimates of Fixed Cost, Variable Cost per unit and Contribution per unit, estimate the number of pizzas, which need to be sold to break even. In order to earn a return on capital invested ($400,000 in plant and equipment) equal to 30% ($120,000 in profit before interest, tax and depreciation (EBITDA)), how many pizzas would need to be sold?
8. Assume that in the first year of opening, the store sells 70% of the per week pizza sales of the average Dominos store, which is around 2,100 pizzas, at an average price of $10.00. Calculate the Revenue and deduct the cost of sales, royalty, marketing contribution, employee costs, occupancy costs and property outgoings to calculate EBITDA.  Deduct Interest Expense and Depreciation as estimated above to estimate Profit Before Tax.  Estimate Tax assuming a 30% tax rate.  Estimate Net Income after deducting tax.
9. To Net Income add back Net Depreciation, which is Depreciation as you have estimated it, multiplied by one minus the tax rate, or 70%, and also add back Net Interest Expense, which is Interest Expense as you have estimated it, multiplied by one minus the tax rate, or 70%, to get an estimate of Free Cash Flow.
10. Repeat these calculations in order to estimate Free Cash Flow for three more years, assuming that in year 2 the output is equal to 80% of the average weekly output per store, in the third year it is equal to 90% and in the fourth year it is equal to 100% or 2,100 pizzas per week. Check how close the EBITDA in the fourth year is to the 33% of the investment required to establish a store.

Task 3:

1. Go on-line to http://www.reuters.com/finance/stocks/ and type in “DMP.AX” into the Search Stocks field and click on the magnifying glass button.

What is the beta for DMP?

Repeat for “RFG.AX”, which is another company listed on the Australian Stock Exchange, which owns the franchise for Pizza Capers, a competitor of DMP, along with a number of other franchises.

What is the simple average beta of the two stocks?

Explain whether and why you think DMP and RFG are more sensitive to the risks the market is exposed to than average stock top 200 stock listed on the Australian Stock Exchange.

2. Go on-line to http://www.bloomberg.com/markets/rates-bonds/government-bonds/australia/

What is the Yield  (Interest Rate) on a 15-year Australian Government Bond?

3. Assuming an Equity Market Risk Premium of 6.5%; a beta equal to the average beta of DMP and RFG calculated above; and a risk-free rate equal to the yield on a 15-year Australian Government bond, estimate the required return using CAPM.

As the required return you have calculated is appropriate for a large franchisee and as we are wanting to estimate the required return on a single small franchisor, add an additional risk premium to the CAPM-based required return to provide some compensation for the additional risks of a small company.  If you assumed that 5% was a reasonable small company risk premium what would be the required return you estimate for valuing the pizza franchise you are considering buying?

4. Franchisees are allowed to fund up to 30% of the cost of the franchise with debt capital. Assuming Tien will fund the acquisition with 30% debt capital and 70% equity capital, and assuming the cost of equity you have calculated above and a cost of debt equal to a rate of interest equal to that of the Business Loan you identified in Task 2 of the Case Study, estimate the after-tax Weighted Average Cost of Capital for the franchise.
5. Assume that you can purchase a Domino’s franchise for around $560,000, plus an initial franchise fee, and assume that Tien is planning to build up the franchise over the next four years before selling the franchise at the end of the fourth year. You estimate he can sell the franchise for approximately $1 million at the end of the fourth year.

Calculate the NPV of the investment, incorporating your estimate of the total initial investment required; the free cash flows as you estimated for the first four years in Task 2; and your estimate of the terminal value of the investment at the end of the fourth year (the selling price in four years time).

6. Advise Tien as to the financial worth of the proposed investment in a Domino’s Pizza Enterprise franchise, including in your advice an explanation as to the significance of a positive showing a positive or a negative NPV.
7. Provide 5 key points to support your investment advice to Tien.
8. Provide 5 key points summarizing the major risks, which Tien would face in making this investment.

Note that this example oversimplifies a more realistic budget forecast.  For instance, it does not allow for the effect of inflation on revenues and costs.  It also does not include the significant contribution of products other than pizza, such as drinks and desert.

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