The California Pizza Kitchen
Introduction
The California Pizza Kitchen (CPK) was founded by Larry Flaxx and Rosenfold in 1984. The initial location was based in Beverly Hills, CA. The California Pizzah kitchen was to focuss on offering the designer pizzah at the prices which were off the rack. The casual dining model of the CPK have also enhanced the rapid expansion of the restaurants. CPK company has further managed to expand into 213 locations in the more than 28 states in 6 countries. By targeting market relatively high income earners, the company have been focusing on dedication to satisfy customers rather than innovation. This has highly improved success of the CPK as the company did not feel the effects of the customers behavior of reducing the consumption habit when the prices increased.
The revenues for the company was obtained from the tree main sources; Partnership royalties with Kraft Foods, sale of the company owned products, royalties obtained from the restaurants which are franchised. CPK mainly focuses on the on operations with regards to company owned full service restaurants. CPK obtained 15 international locations which were franchised and enhanced with several scheduled openings which are planned for the remaining half of the year. CPK managed to get initial payment of $50k-$60k with an estimate of 5% gross sales from the agreement of franchising for every location which was opened.
Taxation was imposed on the Susan Collyns, who is the chief financial officer with the underlying mission on either changing the financial structure of the company or not. The share price of the CPK is approximated to have declined by 10% in mid-2007 even though the company managed to generate a strong revenues growth which is contrasting the establishment of other casual dining. By that period, CPK possessed a high conservative policy of finance without any outstanding debt on the books of account. Collyns was equipped by awareness of the moderate leverage on the company and had to focus on determining the adequacy of $85 million in capital investment in opening 16 – 18 locations by the end of 2007 and whether the amount should come from debt financing or equity finance. Despite of consistent generation of strong returns on operations, the CPK were unable to benefit from the financial leverage.
Arguably, CPK policy had been focusing on the key measures to avoid debt financing before 2007, so as to give the company ‘staying power’. The company had since maintained their maximum borrowing to $75million which incurred a total interest of 6.16%. Corporate tax shield of approximately $10 million was the main benefit of leverage, which allowed the CPK Company to enhance reduction of the corporate income tax in the year 2006. Collyns had a task of finding the optimal structure of finance for the company which would made the CPK to take levering up advance and to proceed with improvement on the goals of the management of growth and expansion of CPK. Therefore there is need for review on the options presented by Collyns with the aim of determining the optimal financial structure of the company.
Questions
- In what ways can Susan Collyns facilitate the success of CPK?
Collyns can assist in the facilitation of the continuation of success of the CPK, which can be achieved by balancing the given options to lever up the company in a mildly manner. When CBK has made a decision to allocate a particular amount of balancing debt on the balance sheet, they gain the ability to borrow at an interest rate which is low and also obtains corporate tax advantage. The corporate tax shield allows CPK to emphasize o the reduction of the overall amount of money owed in taxes, which gives ultimate operating cash flow for the company. In addition, if CPK decided to use debt in purchasing equity shares, the company will be in a position to increase the value of the shares as there would be less outstanding shares. This would further increase the ownership stake of the investors. Furthermore, there is an underlying importance of staying in power even though the current capital structure makes the company unable to possess tax savings advantage on low interest borrowing. By the continued increase of the in revenue than other competitors, CPK has undoubtedly proved that they have got successful model of business. Collyns could further improve the success of CPK by examining on the mildly levering of CPK.
- 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 the process of assessing the effect of the leverage on the cost, of capital, the assumption is made in that CAPM of the firm is modeled in this manner: bL = bU[1 + (1 − T)D/E] , where bU is the beta of the firm without leverage, T is the rate of corporate income tax , D is the debt value of the market, and E is the market value of equity.
Table A
As evident in exhibit 9, there are consideration by the CBK company to alter the structure of the capital by including debt to ether of the following10%, 20% or 30% of the total book value. In undertaking this, several impacts will be seen differently. By calculating the ROE by the use of the formula (Revenue-Cost-Interest) x (1-T)/Equity, it can be seen that an increase in percentage of debt on CPK from 0% to 30% increases the ROE from 8.98 to 11.05%. This increment provides a result which is favorable because the company shows profitability. Despite of paying more interest expenses as the percentage of debt increases, the equity finance of the company reduces, which implies that more profit is being ascertained by less capital investment. There is also a favorable effect on the weighted average cost (WACC) of CPK when the debt in the capital structure of the company is increased. In table A, WACC of the company decreases as the percentage of debt increases. This change implies that the borrowing is lower than the equity cost and the company and the company is paying less for the cost of the capital. However, the systematic risk (β) of the company increases even as capital debt of the company increases. As shown in the Table A, there is an increase in leverage (β) from 0.85 to 0.92 with capital structure debt of 30%. The increment in (β) has got an impact on the cost of equity as it is directly used in the formula of CAPM. The equity cost increases from 9.35% to 9.68% with the percentage debt of 30% only when (β) increases within the capital structure. In addition, the result of risk adding appears to be more favorable when the risk possesses negative effects for the company.
- 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?
In a situation when the company realizes that the price of the stock in the company is undervalued, CPK can decide to purchase the available stock with an aim of increasing the excess market returns. The current stock price of the CPK is $22.10 without debts and the outstanding shares at 29.13 million which comprises a total market value capital of $643,773,000 (outstanding shares X price of share). The difference between the original shares and the new outstanding shares leads to repurchase of the outstanding shares. By using the above formulas, the stock price of $22.35 and a the number of the repurchased outstanding shares of 1,010,617. The improvement is ascertained when the CPK borrows a book value debt of 10%. The book value debt of 20% results to $22.60 and the outstanding repurchase 1,998,726 shares while 30% of the value of book debt will lead to $22.86 and outstanding repurchase of 2,965,028 shares. Table C shows the increment of the firm’s leverage so as to buy its shares back and reducing the equity of the CPK thereby increasing the price of CPK’s stock shares.
The tax shield equals to the multiplication of the debt by the tax rate. The reduction in the income tax causes tax shield which was to be deducted from the taxable income. CPK is allowed to take debt to aid creation of the tax shield since the interest on debt is an expense which is tax deductible. Table C shows CPK’s high book value debt percentage which has more tax shield for the company. The tax shield will further increase the EPS of the CPK and to enhance savings on the cash flow leading to great benefit in financing a debt.
- What capital structure policy would you recommend for CPK?
After the data have been gathered and analyzed based on the our analysis, the conclusion was arrived at illustrating that the company should opt to implement a debt ratio of 20% for various reasons. The first reason is that by choosing the capital structure of 20% which allow the issuance of $45,178,000. The amount will lead to acquisition of the stock worth 1,998,726 shares, which will increase the price of the stock from $22.10 to $22.60 with a change of 2.26% in price of the stock. Secondly, 20% capital recommendation is enhanced to ensure maintenance of the moderate debt worth $45 million which is involved in the policy of the CPK borrowing of $75 million. Last reason is that by having a debt, the company will be able to extract benefits from the tax shield., which allows the company to increase the flow of cash. The high cash flow is achieved because of the increase in debt which reduces the amount of tax of the company. Capital structure of 30% forms the company’s most attractive choice although it puts the CPK at a higher risk. The capital structure of the Betas increases from .89 to .92 at 20% and 30% respectively, which results to a greater risk. The utilization of the 20 percent of the policy on capital structure will enhance provision of the substancial amount of leverage on the financial team thus increasing the shareholders’ stock price and and enhance the provision of opportunities for the CPK’s future expansion.