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%.
𝑅𝑒 = 𝑅𝑓 + 𝛽(𝑅𝑚 − 𝑅𝑓)
𝑅𝑓 = 5.2% (30 𝑦𝑒𝑎𝑟 𝑟𝑎𝑡𝑒)
𝑅𝑚 = 5% (𝑆&𝑃 𝑆𝑚𝑎𝑙𝑙𝐶𝑎𝑝 600 𝑅𝑒𝑠𝑡𝑎𝑢𝑟𝑎𝑛𝑡𝑠)
𝑅𝑒 = 5.03%
5.03% = 0.052 + 0.85(0.05-0.052)
WACC
𝑊𝐴𝐶𝐶 = 𝑊𝑒𝑅𝑒 + 𝑊𝑑𝑟𝑑
10% Debt scenario
5.14% = .9(0.0503) + .1(0.0616)
30% Debt scenario
5.37% = .7(0.0503) + .3(0.0616)
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.
CPK's WACC
5.55
5.5
5.45
5.4
5.35
5.3
WACC %
5.25
5.2
5.15
5.1
5.05
A
10%
30%
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
𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒 =
𝐸𝑞𝑢𝑖𝑡𝑦
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑎𝑛𝑑𝑖𝑛𝑔
𝑃𝑉 =
𝑃𝑀𝑇
𝑁𝑃𝑉 = 𝐷 + 𝑃𝑉 𝑉𝐿 = 𝑉𝑈 + 𝑇 ∗ 𝐷
𝑟
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
Debt
Equity
Total Capital
Interest on Debt
0
225888
225888
0
CSO
CSOU/CSOL
Breakeven EBIT
29130
n/a
n/a
10%
EBIT/CSOU=(EBIT-i)/CSOL
EBIT=(CSOU/CSOL)(EBIT-i)
EBIT=1.036(EBIT-i)
EBIT=1.036(EBIT-1391)
-.036EBIT= -1446
$40,166.67
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
10%
22589
203299
225888
1391
20%
45178
180710
225888
2783
30%
67766
158122
225888
4174
28108
1.036
$40,166.67
27086
1.075
$37,106.67
26064
1.118
$35,373.00
20%
EBIT/CSOU=(EBIT-i)/CSOL
EBIT=(CSOU/CSOL)(EBITi)
EBIT=(1.075)(EBIT-i)
EBIT=1.075(EBIT-2783)
-.075EBIT=-2783
$37,106.67
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
EBIT
Interest
Actual
30,054
0
10%
30,054
1,391
20%
30,054
2,783
30%
30,054
4,174
Taxes
9,755
9,303
8,852
8,400
NI
20,229
19,360
18,419
17,480
ROE
EPS
Because the repurchase cost of shares is so high, the number
8.99%
$0.69
9.52%
$0.69
10.19% 11.05%
$0.68
$0.67
Actual
10%
20%
30%
15,027
15,027
15,027
15,027
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
EPS
4.49%
$0.35
4.53%
$0.33
4.58%
$0.31
4.64%
$0.28
of shares outstanding after the repurchase is not enough to
offset the additional interest costs making for a reduction in
EPS.
EBIT Reduced 50%
EBIT
Interest
When EBIT is reduced by 50%, EPS shows a declining trend
from 0.35$-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%
60,108
60,108
60,108
60,108
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%
EBIT
Interest
$1.39
EPS
$1.41
$1.43
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.
$1.45