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Will This Harm McDonald’s Corporation (MCD)?

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The debate over raising the minimum wage is likely to heat up as the bill becomes more relevant. The current minimum wage is set at $7.25 per hour; under new current bill, known as the “Fair Minimum Wage Act of 2013,” within two years the minimum wage will increase to $10.10 per hour on a federal level. Such a wage bump raises the concerns of many business owners and investors that it will lead to a rise in unemployment, which is already high, and cut the profit margins of businesses (or even worse, close companies). How will raising the minimum wage affect the big fast food companies?

I recall debating this issue with my former boss; he stuck to the basic notion from economics 101 that raising the minimum wage will cause an increase in unemployment. When considering this simplistic point of view, that makes sense at least two problems come to mind:

1. It doesn’t consider the positive effect of an increase in minimum wage may have on the economy

2. It assumes there are no market-failures – and in real life there are always market failures

McDonald's Corporation (NYSE:MCD)

When a minimum wage is raised, it doesn’t only affect the labor market, it also has an effect on other markets, including consumer goods. After all, who are the people eating in McDonald’s Corporation (NYSE:MCD) or Taco Bell? Young people. Who will benefit from a wage increase? Young people! So a wage increase could actually lead to a rise in revenues for fast food companies.

If there is one thing I did learn from all my studies in economies (and there aren’t too many) it’s that in almost any market there is a market failure that prevents the simple economic outcome from realizing. This is mostly true in the labor market where such factors as imperfect information, bargaining power and many more can lead to a market failure.

But let’s put these issues aside and examine several fast-food companies that are likely to be affected by raising the minimum wage. Let’s see the impact it could have on their profitability, and let’s also consider the worst case scenarios, i.e. only a negative impact on wages with no growth in revenues. I will also assume that the big fast food companies only pay the federal minimum wage, while in certain states the minimum wage is higher than the federal’s.

McDonald’s Corporation (NYSE:MCD)

McDonald’s Corporation (NYSE:MCD) U.S sales account for nearly 32% of the company’s total revenues in 2012 (opens pdf). This rate was slightly lower in 2011, which means the market share of U.S in the company’s total revenues remains stable.

McDonald’s Corporation (NYSE:MCD) revenues are divided between its operated sales and its franchise sales. The franchise sales accounted for nearly 32% of its revenues. The franchise revenues are based on property rent and royalties, which are derived from a percentage of sales, fees and rent payments. So the rise in labor expenses might not affect McDonald’s Corporation (NYSE:MCD) franchise revenues or its operating profitability.

Regarding the company’s operated sales, they accounted for 68% of its total revenues in 2012 and nearly 67.3% in the first quarter of 2013. The share of revenues from the U.S was only 16.4% out of total revenues. The company’s operating profitability from the U.S operated sales was 19.5%.

Assuming the labor costs account for 25% of its operated sales and assuming most of these labor costs are for minimum wage employees, then raising the minimum wage from $7.25 per hour to 9.19 per hour in 2013 – a 26.7% bump – means the labor cost will rise to 31.5%, so that the profit margin in the U.S will drop from 19.5% in 2012 to 13% in 2013.

The operating profitability of the company’s entire operations will decline from 31.2% in 2012 to 30.1% – roughly a 1 percent point drop.

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