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Case 33: California Pizza Kitchen

Spring Semester 2017 – 2018

Written By

Maryam Barifah 1420023

Nour Abdulaziz 1420149

Shrouq Al-Jaaidi               1420072

Balqees Mekhlafi 1420231

Submission Date

22/03/2018

CASE 33

CALIFORNIA PIZZA KITCHEN

Guidance Sheet

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.

The case serves to motivate the following learning objectives:

· 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.

Questions

1. What is going on at CPK? What decisions does Susan Collyns face? In what ways can she facilitate the success of CPK? What do you recommend?

1. Using the scenarios in case Exhibit 9, what role does leverage play in affecting the return on equity (ROE) for CPK?

1. Is the capital structure decisions relevant for maximizing the shareholders’ value? What is the ratio of debt-to-equity that maximizes the shareholder’s value? Why should the stockholders care about maximizing firm value? Shouldn’t they be interested in strategies that maximize shareholder value only?

What are the key drivers for increasing value of CPK how it affects its capital providers i.e. shareholders and creditors.

1. How does debt add value to CPK?

1. What is the case for not doing the recapitalization?

1. What should Collyns recommend?

Note: A spreadsheet is provided to assist students. Students however can create their own analysis, financial model, spreadsheet, schedule or tables.

Please submit your case write up, presentation and spreadsheet. Please put you names on the spreadsheets as well,

Table of Contents 1. What is going on at CPK? What decisions does Susan Collyns face? In what ways can she facilitate the success of CPK? What do you recommend? 3 2. Using the scenarios in case Exhibit 9, what role does leverage play in affecting the return on equity (ROE) for CPK? 5 3. Is the capital structure decisions relevant for maximizing the shareholders’ value? What is the ratio of debt-to-equity that maximizes the shareholder’s value? Why should the stockholders care about maximizing firm value? Shouldn’t they be interested in strategies that maximize shareholder value only? 7 Distribution of Shares Between Controlling & Non-Controlling Shareholders 8 Distribution of Shares Between Controlling & Non-Controlling Shareholders After Buyback 9 4. How does debt add value to CPK? 9 5. What is the case for not doing the recapitalization? 10 Sources of cash = NOPAT + Net new debt 10 Growth in total capital = ROC + Change in D/TC – Payments/TC 11 6. What should Collins recommend? 11

1. What is going on at CPK? What decisions does Susan Collyns face? In what ways can she facilitate the success of CPK? What do you recommend?

Susan Collyns’ currently led California Pizza Kitchen Company, is a company that came to be through an ideology of the two defense legal representatives. CPK started its operation in Beverly Hills during the year 1985 and later increased its areas of operation to two hundred and thirteen outlets later in the year 2007. These outlets are all distributed globally but a good number of them about 85 in number, operate in California. CPK’s primary source of its revenue is through its profits which are used to open new outlets while some of them come as a result of partnership by other able stakeholders.

Due to the drop of share price of the company, there was a need to call for a review of the preliminary results by the financial taskforce that was founded in the year 2007 which found that the share price had a drop of approximately 10% to a figure of about $22.10 in the second quarter as compared to the previous performance of the same quarter. At a time like that the previous month the company was enjoying its maximum profits as compared to its competitors in the industry something that the management of CPK was very proud of. There were a general increase of row products which led to an increase in the prices in all the business at the time and the management of CPK framed a financial policy which restricted any form of debt in their business something that ensured there is continuous growth of the business operations.

Because of the deterioration of some outlets business, the management led by Susan is having a plan of reviewing its outlets and sell some of them in order to raise the capital to open other outlets. The proposed source of capital will be from suitable capital structure in this case repurchasing new outlet by the amount sourced from the sold outlets.

Considering the share market currently, this will be of favor to CPK because of its reputation and that the share price is depressed at the moment. This will see CPK have its stock taken care of, through a projected return on equity share, therefore an advantage to the firm. In addition to that the company is expected to enjoy reduced amounts of capital and a reduced price of stocking the goods. The management might decide to employ creditors financing though it is restricting itself from addition of more debts to the company. By a good financial plan this will be of help to the business in dealing with the capital issue which is the greatest challenge at the moment being faced by the CPK firm.

The firm has different ways of financing its capital which are using the profits from the already owned business, the funds from partners and some royalties from franchised restaurants. Therefore, for sustainability plan of CPK to work well the firm must continue with this tradition. This is a suitable plan that has worked well over years and if improved it will be of great help to the firm in the future.

This firm is a well-established company which has for the past controlled and commanded a good part of the market. This gives the management a reason of having to work even harder because the firm has a future from the look of things. The estimate of the firm’s revenue growth over the years is a clear indicator that the business is doing well and the management is doing a good job in performing its business therefore a pointer of the existence of the CPK even in the future is guaranteed by a larger percentage.

I recommend that the management led by Susan employ the sourcing of the capital from partnering with other willing and able stakeholder and profits from the running restaurants to set up new outlets in order to increase the revenue of this reputable firm.

As we computed the financial leverage for CPK from 1-1-2006 to 1-7-200, we have found that the financial leverage was 28% in 1-1-2006, 32.5% in 32-12-2006 and 33.5% in 1-7-2007. The financial leverage of the company has slightly increased during 1.5%

The financial leverage increasing may improve the ROE for a company because a company could outsource money in the utilization of a company’s operations with a few or even without requiring investments from equity.

Looking at a company’s income statement during 2006 to 2007 in Exhibit 3, we find that the net income was 19,490 and 21,000.

Calculating the ROE, we found the ROE was 9.88% in 2006 and 10.08% in 2007. This means that the ROE of the company has improved because they had expanded their business by using higher debt for the company’s operations while slightly increasing the equity as part of the expansion.

As for the cost of capital, our calculation has shown a different WACC for three different Debt/total capital scenarios of 10%, 20% and 30% in Exhibit 9. Posed at 8.35%, 8.82%, and 8.17% respectively. The financial leverage impact to cost of capital in term of increasing the financial leverage was the WACC decrease due to the proportion differentiation of debt to total capital from 10%, 20% and 30% respectively.

The effects of financial leverage on BETA was the increase the ROE but it entails high risk. The second concern that we have was the effect of leverage on the WACC by calculating the company’s beta using the CAPM model. The unlevered beta was 0.85, which is the beta of the company without any debt. It removes the financial effects from leverage. We have used the formula “ Where BL is the firms’ beta with leverage, Tc is the tax rate and D/E is the company’s debt to equity ratio. Coming with 0.87, 0.89, and 0.915 at a debt to total capital of 10%, 20% and 30% respectively.

The effects if financial leverage on cost of equity was that the higher the financial leverage, the higher the cost of equity as we have calculated in exhibit 9. We have concluded this after we have used the formula Rf= Rf+ Beta x (Rm - Rf)

What are the key drivers for increasing value of CPK how it affects its capital providers i.e. shareholders and creditors.

Modigliani-Miller theory basically states that the market value of any firm is determined by their earning power, any risk from underlying assets and its independent way of them choosing to finance their investments. So the basic idea behind this theory is that it does not make any difference whether a firm will finance itself with either debt or equity. So the way that it is applied in this case is that the value of CPK does not depend on the way the profits are divided up but on the total size of profits.

When calculating what the effect of a share repurchase will do to the firm, the calculations are shown below. Using a 10% debt to total capital structure will drive up the price of the stock up to $22.35, this will cause a 1.13% increase and will allow a possible buy back of 1,011,000 shares which is equal to a 3.47% decrease in shares. A change of 20% debt to total capital structure will move the price to $22.60, it will cause a 2.26% increase and this will help buy back 1,999,000 shares to be bought back and a 6.685 decrease. A 30% debt to total capital structure will jump the stock price to $22.86, a 2.99% increase and allow a repurchase of 2,965,000 shares, a 10.18% decrease in shares.

It is our opinion, a debt issuance to buy back shares is the best step forward for the company to do. What is recommended is for them to issue around $45,178,000 worth of debt in order to achieve a 20% debt to total capital structure. It is also recommended for CPK to use this money to buy back approximately 1,999,000 shares of their stock. This will cause an increase of 2.26% of share price which will be appeasing to their shareholders. This level is chosen because of the obvious benefit to the shareholders and because the level of risk that is involved for the shareholders is considered to be moderate. Even though if they use a 30% debt to total capital structure it will be more beneficial to shareholders, this carries too much of a risk for Collyns. By going for the most conservative 20% leverage, it will leave more room for a change in capital structure in the future, so if they want to further expand it will be possible.

The states of shares which are owned by two different sets of shareholders which is shown in the below table;

In the proposed scenario, the controlling shareholders will not want to lose any shares because of the controlling issues. Because of this the non-controlling shareholder will be the ones to lose some of their shares. With CPK’s case when repurchasing the shares from the non-controlling share, this repurchase which will be done by tender offer will lead to the controlling shareholders to have a significant number shares more than their counterparts and will have a marginal increase in company decisions.

In many instances, the debt is said to cause negative growth to the business or organizations. This is because of the debts implications that may cause the normal running of the business during the repayment period if the plan to repay it is not well thought of. In spite of these negative implications, there are some positive implications of the debt to the business which wants to grow and go further, and CPK is no exempt. By acquiring the debt, the firm will also benefit during the period of resurfacing it in that the tax implications of the debt differs from the equitable shares this will in turn see a drop of the amount being paid as tax due to lower taxable income. In addition to the above, the firm is currently suffering from the general degeneration of the stock a situation caused by the firm’s undervaluation. This can be remedied by the stock repurchase using the borrowed amounts in order to retain its value without necessarily affecting the value of the stock. This might even translate to increased level of incomes of the stakeholders since the amount used to purchase the stock may change and increase in future when CPK is repaying the debt therefore a positive implication to the business which will see it grow.

The CPK management is known for its conservative financial policy as per its concern for maintaining power. The management should keep in mind the benefits of leverage and tax-shields gains when contrasted with the cost of using all of the borrowing capacity for the future. As CPK has an important growth trajectory, we ought to question whether the growth exceeds the firm’s ability to sustain this growth. To see whether or not this is an issue, we have to analyse the sustainable growth rate through the sources and uses of cash. This method excludes the possibility of new equity financing.

Since the formulas are presented as follows:

Uses of Cash = change of NWC + change of PPE + Dividends and repurchases + Interest Payments.

We equaled both of the formulas to each other and rearranged the new formula.

We got the equation:

Where the growth in total capital is equal to change in TC/TC, ROC is equal to NOPAT/TC, and payments are equal to dividends plus repurchases plus interest payments.

According to the available financial information, it is most suitable for CPK to finance their debt at 30%. Since CPK did not acquire debt earlier, it is considered risky for them, but the benefits that will arise from it are greater than not having debt at all. Greater returns are forecasted when obtaining debt. Moreover, this time is considered ideal for CPK debt acquirement, as positive prospects are assured from the outperformed benchmarking and the steady growth rate the past 4 years in sales, net operating income and net income. Although we mentioned earlier that there is a slight benefit of repurchasing their stock; as it will raise its value, it is not considered an investment to the firm. In case of a repurchase of stocks, the company will only need to refinance with 20% of the debt, in order to not exceed their credit line of 75 million dollars. The rest of the money could be used in other aspects of the company as to improve and innovate their products.