Harvard Case - Domino's Pizza Enterprises (Australia): Weighted Average Cost of Capital
"Domino's Pizza Enterprises (Australia): Weighted Average Cost of Capital" Harvard business case study is written by Colette Southam, Paul Beamish, Matthew Winkler. It deals with the challenges in the field of Finance. The case study is 10 page(s) long and it was first published on : Sep 28, 2021
At Fern Fort University, we recommend Domino's Pizza Enterprises (DPE) undertake a comprehensive review of its capital structure, focusing on optimizing its weighted average cost of capital (WACC) to fuel future growth initiatives. This involves a thorough analysis of its current debt-to-equity ratio, exploring alternative financing options, and implementing a robust risk management framework.
2. Background
Domino's Pizza Enterprises (DPE) is a leading franchisee of Domino's Pizza, operating in Australia, New Zealand, France, Belgium, Luxembourg, Japan, Germany, and Denmark. DPE faces a critical decision regarding its capital structure, specifically its WACC, as it seeks to expand its global footprint and navigate a dynamic market environment. The case study highlights DPE's impressive growth trajectory, driven by strategic acquisitions and organic expansion. However, the company is also grappling with increasing competition, volatile currency fluctuations, and the need to optimize its financial resources for future growth.
The main protagonists of the case study are the DPE management team, led by Don Meij, the CEO, who are tasked with making crucial decisions about the company's capital structure and financing strategy.
3. Analysis of the Case Study
To analyze DPE's capital structure, we employ a framework that considers both financial and strategic aspects:
Financial Analysis:
- Cost of Debt: DPE's current debt financing is primarily through bank loans and bonds. We need to assess the cost of debt, considering interest rates, risk premiums, and potential changes in credit ratings.
- Cost of Equity: DPE's cost of equity can be calculated using the Capital Asset Pricing Model (CAPM), factoring in its beta, the risk-free rate, and the market risk premium.
- Debt-to-Equity Ratio: DPE's current debt-to-equity ratio is relatively low, indicating a conservative approach. However, we need to assess if this ratio is optimal for maximizing shareholder value and supporting future growth.
- WACC Calculation: We need to calculate DPE's WACC using the appropriate weights for debt and equity, considering the company's tax rate.
- Sensitivity Analysis: Performing sensitivity analysis on key variables like interest rates, risk premiums, and beta will help DPE understand the potential impact of changes on its WACC.
Strategic Analysis:
- Growth Strategy: DPE's aggressive growth strategy through acquisitions and organic expansion requires significant capital investment. Understanding the optimal capital structure to support this growth is crucial.
- Risk Management: DPE operates in a volatile environment with currency fluctuations and competitive pressures. A robust risk management framework, including hedging strategies, is essential to mitigate these risks.
- Financial Flexibility: A well-structured capital structure provides DPE with the financial flexibility to seize opportunities, such as acquisitions or market expansion, while ensuring financial stability.
- Corporate Governance: DPE needs to ensure its capital structure decisions align with its corporate governance principles, transparency, and shareholder value creation.
4. Recommendations
- Optimize Capital Structure: DPE should conduct a comprehensive review of its capital structure, aiming to achieve an optimal debt-to-equity ratio that balances risk and return. This might involve:
- Increasing Leverage: Exploring opportunities to increase debt financing, potentially through bonds or private equity, to lower the cost of capital and fund growth initiatives.
- Debt Management: Implementing a robust debt management strategy, including regular monitoring of debt covenants, maturity profiles, and interest rate risk.
- Evaluate Alternative Financing: DPE should explore alternative financing options, such as:
- Equity Financing: Considering an IPO or private equity investment to raise additional capital and potentially lower the cost of equity.
- Hybrid Financing: Examining hybrid financing instruments like convertible bonds to combine the benefits of debt and equity financing.
- Implement Risk Management: DPE should strengthen its risk management framework by:
- Hedging Strategies: Utilizing hedging strategies to mitigate currency fluctuations and other market risks.
- Scenario Planning: Developing scenario planning models to assess the impact of potential economic and market changes on DPE's financial performance.
5. Basis of Recommendations
These recommendations are based on the following considerations:
- Core Competencies and Consistency with Mission: Optimizing the capital structure aligns with DPE's mission of driving profitable growth while maintaining financial stability.
- External Customers and Internal Clients: A well-structured capital structure supports DPE's ability to meet the needs of both external customers (through product innovation and expansion) and internal clients (employees and franchisees).
- Competitors: DPE needs to maintain a competitive advantage in a dynamic market. An optimized capital structure provides the financial resources to compete effectively.
- Attractiveness ' Quantitative Measures: The recommendations are expected to lead to a lower WACC, potentially increasing shareholder value and enhancing profitability.
- Assumptions: These recommendations assume that DPE's management team is committed to maximizing shareholder value and that the company will continue to grow its business.
6. Conclusion
By undertaking a comprehensive review of its capital structure, DPE can optimize its WACC, providing the financial resources to fuel its growth strategy, manage risks effectively, and ultimately create long-term value for its shareholders.
7. Discussion
Alternatives:
- Maintaining Current Capital Structure: DPE could choose to maintain its current capital structure, but this might limit its ability to fund growth initiatives and potentially lead to a higher cost of capital.
- Aggressive Debt Financing: DPE could pursue a more aggressive debt financing strategy, but this could increase its financial risk and potentially lead to a higher cost of debt.
Risks and Key Assumptions:
- Interest Rate Risk: An increase in interest rates could raise DPE's cost of debt and negatively impact its WACC.
- Market Volatility: Fluctuations in the market could impact DPE's cost of equity and its ability to raise capital.
- Growth Strategy: DPE's ambitious growth strategy might not materialize as expected, potentially leading to a lower return on investment.
8. Next Steps
- Capital Structure Review: DPE should immediately initiate a comprehensive review of its capital structure, involving internal finance professionals and external consultants.
- Financial Modeling: Develop detailed financial models to assess the impact of different capital structure scenarios on DPE's WACC, profitability, and risk profile.
- Investment Banking Engagement: Engage with investment banks to explore potential debt and equity financing options, including an IPO or private equity investment.
- Risk Management Framework: Implement a robust risk management framework, including hedging strategies and scenario planning, to mitigate potential risks.
- Regular Monitoring and Adjustment: Continuously monitor DPE's capital structure and make adjustments as needed to ensure it remains optimal for achieving its long-term goals.
By taking these steps, DPE can ensure its capital structure is aligned with its growth strategy, risk tolerance, and shareholder value creation objectives.
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Case Description
On November 4, 2020, the group chief financial officer of Domino's Pizza Enterprises Limited was tasked with determining the cost of capital in preparation for the corporate response to the COVID-19 pandemic. In planning for 2021, the company would need to make considerable investments throughout its franchises in Australia, New Zealand, Japan, and Europe. The cost of capital would be integral to these investment decisions. In the previous year, Domino's Pizza Enterprises Limited had made A$98.9 million in investments, so the difference of a few per cent in capital costs could mean a swing in millions of dollars in expenditures. The chief financial officer had all background information including balance sheets, income statements, cash flow statements, common stock data, financial ratios, market return data, peer firm data, and an itemized list of debt obligations. Based on this information, he had to derive the company's cost of capital using a weighted average cost of capital methodology.
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