California Kitchen Case Study

Topics: Stock, Stock market, Corporate finance Pages: 9 (1461 words) Published: March 5, 2015
California Pizza Kitchen Case
California Pizza Kitchen has been operating since 1985 predominantly in California. As of June 2007, they had 213 retail locations in the US and abroad. Analysts have put estimates on the potential of 500 full service locations. CPK's strategy includes the opening of 16 to 18 new locations this year including the closing of one location. In the second quarter of 2007, revenue increased 16% while comparable restaurant sales grew by 5%. Performing comparatively well against its competitors, CPK's stock has been depressed recently falling to $22.10 in June making their P/E equal to 31.9 time current earnings. In comparison with BJ's Restaurants with a P/E of 48.9, CPK appears undervalued. CPK's direct competitor, BJ's pays no dividend and has a similar beta and therefore it makes for a good comparative company. Despite uncertainty in the industry and general poor performance among competitors, CPK is performing marginally better than the overall industry. Susan Collyns has several decisions that need to be made. Her two primary issues are how to finance expansion and the firm’s most appropriate capital structure. The focus of this analysis will be on the change in capital structure through the repurchase of shares at today’s market price of $22.10. The effect of the repurchase will be analyzed from an EBIT breakeven, ROE, EPS, Cost of Capital, and stock price perspective. It should be noted that there is an $85 million cost to fund further expansion of their full service restaurants. This is a known expense that will have to be financed by issuing equity or leveraging the company by taking on debt.

How does debt add value to CPK?
By moderately levering up and repurchasing shares, companies can normally increase their EPS because of the interest tax shield. This typically makes the cost of issuing debt cheaper, than that of issuing equity. The interest tax shield will reduce taxable income so that when debt is used to repurchase shares outstanding, there will be a subsequent increase in EPS. A similar effect happens with ROE. Because less of the company is being financed with equity, earnings are spread out over less equity and therefore increase ROE. Cost of Capital

CPK has an equity cost of capital of 5.03% and a debt financing rate of 6.16%.

5.03% = 0.052 + 0.85(0.05-0.052)

WACC

10% Debt scenario

30% Debt scenario

Based on our WACC calculations neglecting tax, we found that as CPK acquires debt, their cost of capital increases. Based on this finding, it is not sensible for CPK to take on debt. If their cost of capital increases, it will affect every project they take on by lowering their returns on every capital project. This can be seen in the graph below.

Because the cost of debt is higher than the firm’s unlevered cost of capital and their cost of equity, adding debt to the business does not add value to California Pizza from a cost of capital perspective. Return on Equity

The Return on Equity is rising as the firm takes on more debt, becoming more leveraged. This is true as interest payments to creditors are tax deductible and therefore the company is able to generate a higher return on fewer shares outstanding because of the repurchase. The result is that a higher proportion of debt in the firm's capital structure leads to higher ROE as earnings are spread over a reduced amount of equity.

Share Price

 

 
 
 
 
 
 
 
 
 
 
 

0% Debt
Share Price = E/CSO
Share Price = 643 773 000/29 130 000
Share Price = 22.10$

10% Debt
Share Price = E/CSO
Share Price = 628 516 000/28 108 000
Share Price = 22.36$

20% Debt
Share Price = E/CSO
Share Price = 613 259 000/27 086 000
Share Price = 22.64$

30% Debt
Share Price = E/CSO
Share Price = 598 002 000/26 064 000
Share Price = 22.94$

The share price of the firm’s stock rises as it increases its debt. Share price being determined by the Total...
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