California Pizza Kitchen
Synopsis and Objectives
This case examines the question of financial leverage at California Pizza Kitchen (CPK) in July 2007. With a highly profitable business and an aversion to debt, CPK management is considering a debt-financed stock buyback program. The case is intended to provide an introduction to the Modigliani-Miller capital structure irrelevance propositions and the concept of debt tax shields. With the background of a pizza company, the case provides an engaging context to discuss the “pizza graphs” that are commonly used in corporate finance curriculum to illustrate the wealth effects of capital structure decisions.
* Introduce the Modigliani-Miller intuition of capital structure irrelevance; * Establish how the cost of equity is affected by capital structure decisions by defining financial risk and introducing the levered-beta capital asset pricing model (CAPM) equation; * Discuss interest tax deductibility and the valuation tax shields; * Explore the importance of debt capacity in a growing business.
1. In what ways can Susan Collyns facilitate the success of CPK? 2. Using the scenarios in case Exhibit 9, what role does leverage play in affecting the return on equity (ROE) for CPK? What about the cost of capital? In assessing the effect of leverage on the cost of capital, you may assume that a firm’s CAPM beta can be modeled in the following manner: L = U[1 + (1 − T)D/E], where U is the firm’s beta without leverage, T is the corporate income tax rate, D is the market value of debt, and E is the market value of equity. 3. Based on the analysis in case Exhibit 9, what is the anticipated CPK share price under each scenario? How many shares will CPK be likely to repurchase under each scenario? What role does the tax deductibility of interest play in encouraging debt financing at CPK? 4. What capital structure policy would you...