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 Market Value of Equity divided by the current number of shares outstanding. As the firm increases its leverage, it buys back shares, as well as reduces its equity. The rate that equity decreases is smaller than that of shares being bought back, thus causing an increase in share price.

Shares Outstanding
Shares outstanding decrease as the firm takes on more debt. The reason being is that the firm buys back shares with the newly acquired cash from issuing debt. By leveraging their company, California Pizza Kitchen adds value to their Total Market Value of Capital. They also increase their share price. It should be considered that as they increase their debt to equity ratio, they also increase their risk of default. Breakeven levels of EBIT for each scenario

No Leverage
10%
20%
30%
Debt

22589
45178
67766
Equity
225888
203299
180710
158122
Total Capital
225888
225888
225888
225888
Interest on Debt

1391
2783
4174

CSO
29130
28108
27086
26064
CSOU/CSOL
n/a
1.036
1.075
1.118
Breakeven EBIT
n/a
$40,166.67
$37,106.67
$35,373.00

10%

20%

EBIT/CSOU=(EBIT-i)/CSOL

EBIT/CSOU=(EBIT-i)/CSOL
EBIT=(CSOU/CSOL)(EBIT-i)

EBIT=(CSOU/CSOL)(EBIT-i)

EBIT=1.036(EBIT-i)

EBIT=(1.075)(EBIT-i)
EBIT=1.036(EBIT-1391)

EBIT=1.075(EBIT-2783)
-.036EBIT= -1446

-.075EBIT=-2783

$40,166.67

$37,106.67

30%

EBIT/CSOU=(EBIT-i)/CSOL

EBIT=(CSOU/CSOL)(EBIT-i)

EBIT=(1.118)(EBIT-i)

EBIT=1.118(EBIT-4174)

-.118=-4174

$35,373.00

The results from the breakeven EBIT analysis are calculated to current market conditions. The market has equities; in particular, California Pizza priced its prices at very high valuations. This is exhibited by California Pizza’s price/earnings ratio of 31.9. Because of this lofty valuation, if California Pizza is going to repurchase shares at the current market price of $22.10, it will be costly to investors. It will be especially expensive to investors to buy back shares if California Pizza using debt because their cost of debt is higher than their cost of equity. California Pizza has decreasing break even EBITs because the numerator (interest expense) is expanding with each scenario of debt financed stock repurchases. Because the cost of debt is higher than the cost of equity, the breakeven EBIT is decreasing with each increased debt scenario. What happens to ROE and EPS if…?

As the company changes their capital structure to incorporate varying levels of debt, they are reducing their common shares outstanding and equity within the company. In all three cases, ROE continues to rise as more debt is added in. When EBIT is at a point that is above the Break-even point, ROE increases at a much larger rate, compared to if EBIT is below the Break-even point. As seen under the 100% EBIT chart, ROE increases at a much higher rate than compared to the 50% reduced EBIT tables, which is below the break-even EBIT.

Current EBIT

Actual
10%
20%
30%
EBIT
30,054
30,054
30,054
30,054
Interest

1,391
2,783
4,174
Taxes
9,755
9,303
8,852
8,400
NI
20,229
19,360
18,419
17,480
ROE
8.99%
9.52%
10.19%
11.05%
EPS
$0.69
$0.69
$0.68
$0.67
Because the repurchase cost of shares is so high, the number of shares outstanding after the repurchase is not enough to offset the additional interest costs making for a reduction in EPS.

EBIT Reduced 50%

Actual
10%
20%
30%
EBIT
15,027
15,027
15,027
15,027
Interest
0
1,391
2,783
4,174
Taxes
4,877
4,426
3,974
3,523
NI
10,150
9,210
8,270
7,330
ROE
4.49%
4.53%
4.58%
4.64%
EPS
$0.35
$0.33
$0.31
$0.28

When EBIT is reduced by 50%, EPS shows a declining trend from 0.35$-0.28$. In this case, EPS declines because the interest from the added debt is decreasing your EPS. When EBIT is reduced by 50% the EPS lies below the break-even point, any additional debt at this point is a disadvantage.

100% EBIT

Actual
10%
20%
30%
EBIT
60,108
60,108
60,108
60,108
Interest
0
1,391
2,783
4,174
Taxes
19,510
19,058
18,607
18,155
NI
40,598
39,658
38,718
37,779
ROE
17.97%
19.51%
21.43%
23.89%
EPS
$1.39
$1.41
$1.43
$1.45

When EBIT is increased by 100%, EPS shows an increasing trend from $1.39 – $1.45. EPS increases as more debt is added because it is above the break-even EBIT point. Because we are above the EBIT breakeven point, the firm benefits from the increased leverage which raises the EPS as more debt is added. Conclusion & Recommendations

In conclusion, it is the analysts’ recommendation that California Pizza Kitchen change its capital structure by issuing debt and repurchasing shares. This instates a tax shield, which reduces taxable income, increases the value of the company, and in turn increases the return to shareholders. Subsequently allowing earnings to be spread out over fewer shares and as the market increases, shareholders will have greater ROE and EPS.