The purpose of this study is to analyze Papa John’s current financial position and to use it to decide on whether to approve loans or to raise more equity capital.
Papa John’s is the third-largest firm in the Pizza industry in the United States, after Pizza Hut and Domino’s Pizza. The company is a public company that was established in 1984, and its headquarters are in Louisville, Kentucky. Its shares are listed on the NASDAQ stock exchange.
Papa John’s has good prospects and a bright future, judging by its current performance.
The main objective is to make a financing decision that will minimize risk and at the same time minimize cost.
The methodology that has been used is financial ratio analysis, which includes price-earnings ratio, financial leverage ratio, total asset turnover ratio, and net profit margin.
From the computation of the net profit margin for the three years, we can see that this ratio improved from 2.51 % in year 1 to 4.75 % in year 2 and 6.33 % in year 3. The net profit margin has therefore been improving, but at a declining rate, because the percentage increase in year 3 is less than that in year 2.
However, compared to Domino’s and Yum Brands Inc, Papa John’s takes the third position because in the third year, Yum Brands Inc is leading with a net profit margin of 8.62 %, while Domino’s takes the second position with a net profit margin of 7.39 %.
The total assets turnover ratio improved from 2.56 in year 1 to 2.67 in year 2 and 2.74 in year 3. This shows that the company’s ability to generate revenue from its assets has been improving over the years, although the improvement has been quite marginal.
The financial leverage ratio remained constant at 2.42 during the first two years, before reducing to 2.37 in year 3. Compared to Pizza Inn and California Pizza, Papa John’s takes the second position because, in the third year, Pizza Inn has the highest financial leverage ratio of 3.73 %, while California Pizza has the lowest financial leverage ratio of 1.44 %.
Going by the financial leverage ratio in comparison with the other firms in the industry, there is still room for Papa John’s to raise more debt funds.
Comparing Papa John’s price-earnings ratio to that of the industry, we can see that Papa John’s price-earnings ratio is relatively low, since it has a price-earnings ratio of 10, while that of the industry is 15. This means that the price that investors are willing to pay for every dollar that a share of Papa John’s earns is less compared to the industry’s average.
Papa John’s is a relatively good investment as compared to other firms in the industry.
As regards the decision on whether to raise more equity or debt funds, there is still room to borrow more. However, there is a need to consider the advantages and disadvantages of equity funds as follow:
Advantages of using equity funds
Equity financing is a permanent source of capital because ordinary shares are not redeemable; therefore the funds raised from this source are available for use as long as the company is in existence.
Dividend payment discretion
Payment of dividends is normally at the discretion of management.
Avoiding financial distress.
When a company uses debt financing, it is constantly exposed to financial distress which may come as a result of defaulting on loan repayments.
Debt contracts usually have some restrictive covenants which prevent the company from raising additional debt funds, or disposing of its fixed assets or paying dividends to equity holders.
Disadvantages of using equity funds
Loss of tax benefits
When calculating profit before tax for tax purposes, companies are normally allowed to deduct interest on debt funds as an expense, thus reducing the amount of income to be taxed, and eventually reducing the amount of tax to be paid by the company. Dividends paid to equity holders cannot be deducted from income in arriving at taxable income, which means that a company that only uses equity funds would pay more tax than a similar company that has the same gross income but also pays interest on the debt.
Equity funds are generally more costly than debt funds because of the ordinary dividends not being tax-deductible, and also because floatation costs on ordinary shares are normally higher than those on debt.
Investors normally require a relatively higher rate of return on equity funds because they view ordinary shares as riskier investments due to the uncertainty of dividends and capital gains. This makes equity funds the most expensive source of funds.
When additional ordinary shares are issued, earnings do not increase immediately, meaning that the same income has to be divided by the new larger number of ordinary shares. The shareholders who were there before the new issue would therefore experience a decrease in their earnings per share, thus a dilution in their earnings per share. For a company that uses debt funds instead of issuing additional ordinary shares each time they need funds, earnings per share are not diluted since the number of shareholders remains the same.
When additional ordinary shares are issued, ownership and control of the existing shareholders are diluted, since the company is now owned and controlled by more shareholders. Shareholders who do not have funds to invest in the additional shares are bound to lose their pre-emptive right to retain their proportionate ownership. In closely held companies, dilution of ownership assumes great significance. In companies that use debt funds instead of issuing additional ordinary shares each time they need funds, ownership is not diluted since the number of shareholders remains the same.
Lack of management discipline
Debt funds usually instill some amount of discipline in management, because they have to work hard to repay the debt otherwise there would be serious consequences. For a company that uses only equity funds, management does not fear any consequences and is, therefore, less disciplined.