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Choice of Capital Structure

California Pizza Kitchen

Group#

Porter's Five Force Analysis

Problem Identification

Choice of Capital Structure Theory

Capital Structure Calculation & Analysis

Recommendation

Epilogue

CPK Background

CONTENT

Company Background • Company profile • Revenue resources and marketing expenses • Challenges and longer term outlook

CPK Background

l California Pizza Kitchen – Casual dining restaurant chain that specializes in California- style pizza

l Started in 1985 by defense attorneys Larry Flax and Rick Rosenfield ↘

Company Profile

l By 2007: 213 locations in 28 states and 15 international franchises in 6 foreign countries ( while sti l l California-centric, 41% of the US stores in California)

l In July 2007, CPK got --Profit over $ 6 million --Revenue growth with comparable restaurant sales up > 5% -- Conservative finance policy of avoiding debt financing

l Core customers: average household income of > $75,000

CPK Background

CPK derived its revenue from 3 resources

• Sales at company owned restaurant (500 units, main revenue resource)

• Royalties form franchised restaurant (Init ial payment of $50,000-$65,000 for each location opened and 5% gross sales)

• Royalties from a partnership with Kraft Foods(sell CPK-branded pizza in grocery stores)

Revenue Resources and Marketing Expenses

Marketing expenses

• 50% spent on menu-development costs

• 50% consumed by typical marketing strategies such as PR, direct mail, outdoor media.

• 1% of sales on advertising , far less than 3%-4% industry average, value word-of-mouth marketing

CPK Background

Some chal lenges restaurant industry face:

Increasing commodity prices (high gas prices)

Higher labor costs(minimum wage rate increased to $7.25 per hour from $5.15)

Deteriorating housing wealth

Intense interest in the industry by activist shareholders

CPK royalt ies increased 37% and 21% in Kraft partnership and franchises respectively, food, beverage costs remained constant at roughly 24.5%.

Labor costs of CPK declined from 36.6% to 36.3% of total revenues

CPK’s cl ientele average income is higher than other competitors, so less affected by decreasing housing wealth.

One force to push CPK to adjust i ts capital structure.

Challenges and Longer Term Outlook

Longer term outlook for overall restaurant demand – stronger 💪💪💪 A study by NRA projected customers would increase the percentage of food dollars spent on dining out from 45% to 53% by 2010.

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Porter's Five Force Analysis of Pizza Industry • General Industry information • Interpret CPK in each situation

Threat of New Entrants : Moderate • Low asset requirement; Lots of suppliers in this industry • Rising prices of food, the economies of scale, heavy competition • This puts CPK under constant pressure to differentiate over competitors

Threat of Substitute products: High • A lot of other fast food restaurants • CPK offers variety of foods in their menu and competitively price their food,

reduces the threat from substitutes.

Bargaining power of suppliers: Low • Most of the products supplied to the

restaurant are standardized • But in this case CPK requires higher

standard and special menus for different countries, CPK does not hold much power but it can still influence how suppliers operate.

Bargaining power of buyers: High • Consumers are very much

fragmented • Easy to switch

Rivalry: High

• Large numbers of firms in this industry, most firms compete for the same market.

• But CPK differentiated strategy and higher income core customers make its sales increase at a steady rate

Porter's Five Force Analysis of Pizza Industry

Problem Identification • Main task right now • Restrictions on the task

Problem Identification

l CPK’s stock had declined 10% to $22.1 per share. Is this an ideal time to repurchase shares?

l CPK plans to open 16 to 18 new locations in 2017. Funding CPK’s 2007 growth plan was anticipated to require $85 million. How to balance the funding of the expansion and recapitalization?

Choice of Capital Structure Theory • Trade Off Theory • Windows of Opportunity • Signaling Theory

Choice of Capital Structure Theory Trade Off Theory: Balance benefits and cost of leveraging

• Value of firm rises and WACC is reduced until BENEFITS ＞COSTS

• Benefits from tax shield VS cost of agency and financial distress

Currently: WACC= Re Taking leverage: WACC=Re*We + Rd*Wd*(1-T)

This is how we build our capital structure in different scenarios. 12

Choice of Capital Structure Theory Windows of Opportunity

• Managers try to time the market

• They issue debt when the stock market is low and when interest rate is low

• Investment opportunity set and reserve borrowing capacity

In this case, we want to time the market if our stock is undervalued and we also should maintain borrowing capacity when we have our expanding plan .

Choice of Capital Structure Theory Signaling Theory

MM assumed symmetry information, Signaling theory is about asymmetry information: Managers often have better information than outside investors

Issuing Debt ( Initial Signal) Not enough cash Taking debt because they are confident that future is positive Positive signal

Repurchase Stock: Stock is underpriced Positive signal

This is the signal we want to send by restructuring our capital. 14

Capital structure calculation & Analysis • Why we need to recapitalize ？ • Method of calculation • Calculation process • Positive impacts • Negative impacts

Capital Structure Calculation & Analysis Why we need to adjust CPK capital structure?

Based on the 3 theories we are using in this case, we should take advantage of tax benefits by issuing debt to repurchase our stocks.

Our stock is undervalued. Our tax rate is 32.5%, tax benefits are important. CPK has growing sales. Borrowing capacity is $75 million under a low interest rate.

It sends good signals to the market. Please activist shareholders.

Capital Structure Calculation & Analysis Calculation Method in Exhibit 9

In Exhibit 9, the 10%, 20%, 30% is debt/ book value of capital, Debt is set first, and calculate the interest expense, get the NI. The market value of capital is calculated by current market value+tax shield-Debt, and then they get the market value of capital And then if we follow this method, we should calculate under different debt ratio, its price per share, which equals to current per share price + interest expenses/ current shares outstanding. And using debt/ new price per share, we get the numbers of shares repurchased. And leveraged beta , cost of equity, WACC will be calculated at last.

Capital Structure Calculation & Analysis Our way of calculation is based on the textbook, debt ratio is debt/ market value of capital, we calculate WACC first, estimate growth rate, determine the Corp value, calculate debt, shares repurchased and finally get the new stock price.

Currently is all-equity financed Current num. of shares outstanding: $29.13million Current per share price: $22.1 Current market value: $643.773 million Tax rate : 32.5% Unleveraged Beta: 0.85 Risk-free rate: 5.2% (30-year U.S. Treasury bonds in 2007)

Market return: 12.30% Risk premium: 7.1% g= 5.5% Rd=interest rate= LABOR plus 0.8%=6.16% (in the line of credit of 75 million) 18

Capital Structure Calculation & Analysis

Cost of equity

• Hamada’s Equation: leveraged beta = unleveraged beta*(1+(1-T)/(D/S))

• CAPM: r = rRF + (rM - rRF) * β

WACC= WdRd*(1-Tax) + We*Re

We set our debt ratio from 5% to 12%

Wd D/E Leveraged Beta Rd Re WACC

0% 0.00 0.85 6.16% 11.24% 11.24% 5% 0.05 0.88 6.16% 11.45% 11.18% 6% 0.06 0.89 6.16% 11.50% 11.17% 7% 0.08 0.89 6.16% 11.54% 11.16% 8% 0.09 0.90 6.16% 11.59% 11.15% 9% 0.10 0.91 6.16% 11.64% 11.14% 10% 0.11 0.91 6.16% 11.69% 11.13% 11% 0.12 0.92 6.16% 11.74% 11.12% 12% 0.14 0.93 6.16% 11.79% 11.11%

Capital Structure Calculation & Analysis

Wd D/E Leveraged Beta Rd Re WACC FCF(1+g) Corp.Value Debt $ Shares

Repurchased Stock Price $

0% 0% 0.85 6.16% 11.24% 11.24% 36920382 643773000 0 0 22.1

5% 5% 0.88 6.16% 11.45% 11.08% 36920382 661083215.4 33054160.77 1495663.383 23.92

6% 6% 0.89 6.16% 11.50% 11.05% 36920382 664657568.5 39879454.11 1804500.186 24.32

7% 8% 0.89 6.16% 11.54% 11.02% 36920382 668270783.5 46778954.85 2116694.789 24.74

8% 9% 0.90 6.16% 11.59% 10.99% 36920382 671923497.6 53753879.81 2432302.254 25.17

9% 10% 0.91 6.16% 11.64% 10.96% 36920382 675616362 60805472.58 2751378.85 25.61

10% 11% 0.91 6.16% 11.69% 10.93% 36920382 679350042.4 67935004.24 3073982.092 26.07

11% 12% 0.92 6.16% 11.74% 10.90% 36920382 683125219.3 75143774.12 3400170.775 26.55

12% 14% 0.93 6.16% 11.79% 10.87% 36920382 686942588.2 82433110.59 3730005.004 27.05

Debt ———————— current share price

(FCF(1+g)) ————— (WACC-g)

The debt is out of our line credit $75milion

Corp.value ———————— shares outstanding after repurchase20

Capital Structure Calculation & Analysis ROE measures a corporation’s profitability By revealing how much profit a company generates with the money shareholders have invested.

Debt/Market value of capital 0% 6% 8% 10% Formula

Interest rate 6.16% 6.16% 6.16% 6.16% Libour(5.36%)+0.8% Tax rate 32.5% 32.5% 32.5% 32.5%

Earnings before income taxes and interest 30,054 30,054 30,054 30,054 EBIT

Interest expense 0 2,457 3,311 4,185 Interest rate * Debt Earnings before taxes 30,054 27,597 26,743 25,869

Income taxes 9,755 8,958 8,680 8,397 Net income 20,299 18,640 18,063 17,473

Book value: Debt 0 39,879 53,754 67,935

Equity 225,888 186,009 172,134 157,953 Total capital - Debt

Total capital 225,888 225,888 225,888 225,888

Return on equity ( ROE) 8.99% 10.02% 10.49% 11.06% Net income/ Equity Return on capital ( ROC) 8.99% 8.25% 8.00% 7.74% Net income/Capital

Market value: Debt 0 39,879 53,754 67,935

Equity 643,773 39,531 30,159 20,581

Market value of capital 643,773 66,466 67,192 67,935

Price per share $22.10 $24.32 $25.17 $26.07 Shares repurchased ( thousands) 0 1804.5 2432.3 3074 Shares outstanding ( thousands) 29130 27325.5 26697.7 26056

Earnings per share (EPS) 0.70 0.68 0.68 0.67 Price to earning ratio 31.71 35.66 37.20 38.88 Price/ EPS

P/E ratio shows what the market is willing to pay today for a stock based on its past or future earnings. A low P/E might indicate that the current stock price is low relative to earnings which is undervalued.

Capital Structure Calculation & Analysis Positive impacts:

Huge tax shield from interests paid (10%, 1.36million)

Investors review the obligation that debt creates as a benefit. Debt is a disciplining force because it would motivate CPK to take fewer risks and focus on generating earnings to meet existing obligations.

Investors review CPK repurchasing stock as good signals.

Interest rates are currently low but projected to increase, so if we are going to borrow now is the right time.

Capital Structure Calculation & Analysis Financial leverage and financial risk

EBIT * 1.3 Debt/Market value of capital 0% 6% 8% 10%

Interest rate 6.16% 6.16% 6.16% 6.16% Tax rate 32.5% 32.5% 32.5% 32.5%

Earnings before income taxes and interest 39,070 39,070 39,070 39,070

Interest expense 0 2,457 3,311 4,185 Earnings before taxes 39,070 36,614 35,759 34,885

Income taxes 9,755 11,899 11,622 11,338 Net income 29,315 24,714 24,137 23,548

Book value: Debt 0 39,879 53,754 67,935

Equity 225,888 186,009 172,134 157,953 Total capital 225,888 225,888 225,888 225,888

Return on equity ( ROE) 12.98% 13.29% 14.02% 14.91%

EBIT * - 1 Debt/Market value of capital 0% 6% 8% 10%

Interest rate 6.16% 6.16% 6.16% 6.16% Tax rate 32.50% 32.50% 32.50% 32.50%

Earnings before income taxes and interest -30,054 -30,054 -30,054 -30,054

Interest expense 0 2,457 3,311 4,185 Earnings before taxes -30,054 -32,511 -33,365 -34,239

Income taxes 9,755 10,552 10,830 11,113 Net income -39,809 -43,063 -44,195 -45,352

Book value: Debt 0 39,879 53,754 67,935

Equity 225,888 186,009 172,134 157,953 Total capital 225,888 225,888 225,888 225,888

Return on equity ( ROE) -17.62% -23.15% -25.67% -28.71%

Negative impacts: Leverage comes with additional risk 23

Capital Structure Calculation & Analysis Negative impacts: Less financial flexibility

l CPK has a tradition of conservative financial policy based on its concern for maintaining staying power. Senior management may be leery of the benefits of leverage and tax-shield gains when contrasted with the cost of using up borrowing capacity for the future.

l By using debt capacity to repurchase shares, management restricts the funding of business growth to the level generated by the operations of the business, ROC. When debt ratio is 10%, ROC is 7.74%. The growth in new stores for 2007 was estimated at 16-18 on a base of 213 stores, representing a 7.5% to 8.5% expected growth rate. The 2007 capital expenditure was expected to be $85 million; Depreciation was estimated to be 36 million ( based on the three month in 2007 data in Exhibit 3).

l This means a $49 million increase in NPE ( net property and equipment ) on a book capital base of 225.9 million represents a 22% growth rate in total capital.

l The internally generated funding for growth will be adversely affected if the industry’ s economics deteriorate further and reduce ROC.

Recommendation

Recommendation for CPK l We recommend to lever up the business, not only pleasing influential

shareholders, it has more to do with the tax savings and the disciplining effects of taking on debt. We have already proven to the market that this business has a differentiating strategy, better performance than competitors during the challenging economic conditions, disciplined approach to growth, the strong cash flows and general stability of business situation from historical data shouldn’t hold us back from levering for a share repurchase.

l It’s reasonable to take on an additional 10% of debt which yield us a tax saving $1.36 million and boost our ROE to 11.06%. The debt will be around $68 million, still in the range of our credit of $75 million, and leave some room for future expanding business.

l We also recommend to re-evaluate the $85 million investment more carefully, though we are doing a good job now, the challenges of external factors still pose a threat and our recapitalization restraints on our financial flexibility.

Recommendation for CPK （Con't） l The whole industry is challenged by higher commodity prices, rising minimum

wage, higher energy prices, and eroding consumer discretionary income, but the long term prospects of our business look much better. To make sure that we are careful enough, maintain flexibility in the interim, we recommend them to check their debt structure on a quarterly basis once they make the decision to lever up. This will allow CPK to avoid a situation where they can’t invest in positive NPV projects, or get themselves into a situation facing the risk of bankruptcy.

l If they are to act on this idea, we believe they should act now. Access to low interest rates are not going to last much longer and they should lock rates in now before the market deteriorates further.

Epilogue • What happened in reality about CPK

recapitalization ? • CEO statement

Epilogue for case CPK February 01, 2008 08:55 AM Eastern Standard Time

LOS ANGELES--(BUSINESS WIRE)--California Pizza Kitchen, Inc. (NASDAQ:CPKI) today announced that it has entered into an agreement with Bank of America, N.A. to repurchase $46.3 million of its common stock in an accelerated stock repurchase program (“ASR”). The repurchase agreement is under the Company’s previously announced $50 million stock repurchase program authorized by its Board of Directors in August 2007. The Company currently has 28.9 million shares of common stock outstanding.

Rick Rosenfield and Larry Flax, co-CEOs of CPK stated: "Management and our Board are confident about the strength and long-term growth prospects of our Company. The ASR, in conjunction with our expanded credit facility, is an effective way for us to return capital to stockholders, leverage our balance sheet and reduce our overall cost of capital.” 29

Thank you.