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How A Minimum Wage Increase Could Impact McDonald's Corp.

|Includes: McDonald's Corporation (MCD)

In January of 2014, President Obama spoke on increasing the federal minimum wage in his annual State of the Union Address. He soon signed an executive order for all new federal service contracts, bringing federal workers who made $7.25/hour a raise up to $10.10. And who wouldn't be for raising the minimum wage to help those people who work minimum wage jobs? According to the CBO the increase to $10.10 would boost 16.5 million workers above thepoverty level. But by the full implementation in 2016, the increase in minimum wage would have decreased the number of federal jobs by 500,000. Half a million people are projected to be fired so that some other people could make a bit more every hour.

N. Gregory Mankiw, Chairman and Economics Professor at Harvard University, explained the minimum wage as a limit placed by the government. To elaborate further, the entire market is controlled by supply and demand. There is supply of a product or service, and there is demand for the same. The market conditions adjust until the amount supplied equals the amount demanded, and an equilibrium price is reached. When supply is increased, demand shifts and prices lower until supply and demand are equal. When supply decreases, demand again shifts and prices increase until supply and supply and demand are equal. There is a seemingly invisible force that guides the market towards this equilibrium. Extending this to workers and labor, the number of people who want to work are the supply of a service. The service is their work towards the jobs that need to be done. The demand is the number of jobs that need to be done. Ideally when there is no outside interference, the amount of people who want to work will be equal to the number of jobs that need to be done. Of course that's not always true, and there will be some people who are unemployed at any given time. When there are no outside forces like wars, government intervention, or natural disasters, the number of unemployed people will be relatively small.

Source: Image by Author

Conditions change when a minimum wage is implemented. The minimum wage impels the wages to remain above an arbitrarily determined amount. More people are willing to work at this higher amount. Unfortunately for them however, fewer companies are willing or able to pay for all of them to work jobs at the higher amount. Equilibrium can't be reached under these new market conditions, which with more workers willing to work for fewer available positions, translates to unemployment. In the same way, the Federal minimum wage increase is projected to increase unemployment by decreasing the number of jobs available.

Source: Chart by Author

The CBO projects federal job losses from a minimum wage increase, but are things the same in industry? The fast food industry is a noted example, employing hundreds of thousands of workers who earn close to the minimum wage. There are pushes by low-wage workers and unions to boost the minimum wage to $15.00 per hour, more than double the current minimum wage. Some of those protests have even been successful. Should fast food companies be required to double the pay for minimum wage workers, a study showed the prices at those establishments would increase an average of 38%. This could drive away up to a third of customers. A Big Mac meal from McDonald's Corp. (NYSE:MCD) would go from $5.69 to $7.80. A Steak Burrito Bowl from Chipotle Mexican Grill Inc. (NYSE:CMG) would shoot up from $6.65 to $9.14.

To use the example of a single business, MCD reported $5.6 billion in net income for 2013, $5.55 per share. Total revenues were $28 billion for the same period. After earnings, $3.1 billion was paid out to shareholders in dividends, leaving $2.5 billion to expand the business or pay down any debts. According to the Bureau of Labor Statistics the average hourly wage for fast food cooks in 2013 was $9.07. MCD employs roughly 440,000 workers in the U.S. For the sake of simplicity if it were assumed that 400,000 of them earn the average fast food wage of $9.07 and work 40 hours a week for 50 weeks a year, it would cost MCD $4.7 billion extra to pay their workers $15.00 per hour. Including a 7.6% employer-share payroll tax on the increased amount, MCD would have to pay an additional $900 per worker per year, an extra $360 million total, leading to increased labor costs of $5.1 billion. Leaving other expenses and the dividend payout unchanged, this would leave MCD short by $2.6 billion. To avoid adding to the significant $14 billion in debt already held which was up $500 million from 2012, MCD could cut the dividend payout to $0.5 billion.

Furthermore MCD would still need to pay enough to manage the current debt. Interest expense for 2013 was reported as $500 million, which is covered by the above numbers. However MCD would need to find a way to reduce its growing debt pile, possibly by raising prices. The elasticity of demand of fast food prices was averaged to be -0.946 in the study referenced above which means that for every 1% price increase, the demand for the fast food will decrease by roughly 1%. Or for every 10% increase, demand would decrease by 9.5%. If this elasticity were a good representation, price increases would have little effect on revenues, but still would raise revenues a perceptible amount. Using 2013 numbers combined with the above proposed dividend cut, to pay down the debt by $500 million MCD would have to increase prices by 33%. A Big Mac Meal could end up costing $7.57, almost as drastically as the above study shows. Using other data reported in 2010, an aggregate elasticity of -0.74 would mean that for every 10% increase in price, demand would decrease by only 7.4% compared to the 9.46% used above. Using this more moderate estimate, to pay down the debt by $500 million an increase of only 5.4% would be needed. The price of a Big Mac Meal would only be $6.00, not as significant as above. Considering the elasticity of -0.946 to be too great of a correlation and the elasticity of -0.743 to be too little a correlation, the average of the two is -0.845. This elasticity would indicate that MCD would need to increase prices by 11.3% to gain $500 million additional revenue to pay down debt or expand the company. This price increase of would place the Big Mac Meal at $6.33.

Elasticity

Percent Increase (%)

New Price ($)

-0.743

5.4

6.00

-0.845

11.3

6.33

-0.946

33.0

7.57

Source: Table by Author

MCD does have another option to cover its new costs that might even allow the dividend to stay intact or at least decrease by a smaller amount. Hours of workers can be cut, or workers fired outright. Decreasing the average hours worked from 40 per week to 35 hours per week would save MCD $1.6 billion. This would provide $500 million for debt reduction or growth of the company, and even leave $1.5 billion to add to the dividend payout of $0.5 billion proposed above, about $2.00 per share at the 2013 share price. Decreasing the hours worked to 30 per week would save $3.2 billion, giving MCD that much more to play with all without having to raise prices. After paying off $500 million in debt there might be as much as $3.2 billion total left over to return to shareholders as a dividend, above the original dividend offered in 2013. Assuming that decreasing hours or workforce by 25% will not impact productivity significantly, this option would be most palatable to shareholders.

Proponents usually show that increasing the minimum wage is good for everybody, giving people more money to spend and increasing quality of life. Looking into more facts sometimes shows that the situation is more complex than that. Using the example of the CBO forecast on the federal minimum wage increase, 500,000 jobs could end up being cut. With the example of MCD, to meet a wage increase to $15.00 per hour the dividend could be decreased and prices increased, or hours of workers can be cut. The shareholders could end up paying, customers could end up paying, or the workers could end up paying. If the mandatory fast food wage of $15 per hour were imposed, MCD would probably combine the cost-cutting techniques from the above scenario. The dividend would be cut some, prices would increase some, and hours would be cut some. The bottom line is that by increasing the wage for 400,000 workers while not requiring them to do any additional work, everyone involved loses something. Shareholders lose dividend yield and potentially share value, customers have to pay more for the products, and the workers themselves could have their hours cut or get fired. Forced increase of the minimum wage could require abrupt business restructuring that might adversely affect share price and investor returns. Investors preparing to take positions in fast food enterprises should consider issues such as the minimum wage. Whether preparing for long or short positions, mandatory increases of the minimum wage can adversely affect the stock. Over the long term however, the stock price might stabilize as the company adjusts.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: The data provided here is for informational purposes. Before buying or selling stock you should do your own research to reach your own conclusion. Investing includes risk and potentially loss of principal. This article contains reference to a topic that might be considered political in nature. The reference to this topic is in no way supportive of any particular viewpoint on the topic. All reference to this topic is from a business standpoint and is meant to illustrate how the discussed companies might be affected. Any perceived endorsement of a particular political standpoint is unintentional.