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Emba Paper

1636 words - 7 pages

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, ...view middle of the document...

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+βRm-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% = .70.0503+.30.0616
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.

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
|
VL=VU+T*D
VL=VU+T*D
PV=PMTr
PV=PMTr
NPV=D+PV
NPV=D+PV
 Share Price=EquityShares Outsanding
 Share Price=EquityShares Outsanding
  |
|   |   |   |
  |   |   |   |
  |   |   |   |
| | | |
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...

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