California Pizza Kitchen

Statement of the Problem 

The company has experienced a recent 10% share decline in the month of June 2007. The CPK management is considering if this is going to be the right time to repurchase the shares of the company and thus leverage its balance sheet as there are ample borrowings which are listed on the credit line. The firm is thus open to adapt to any financial strategies so as to return capital to the shareholders and this would align with the goals of the management which is to grow the business. The problem is thus the structure policy that CPK should use so as to realize its aim of growth and expansion. 

List of Critical Factors 

There are multiple financial constraints that CPK should critically analyze before making its decision. One of the factors that should be put to consideration is the level of debt. From the given scenario, the level of debt varies from 10%, 20%, to 30%. The other factor that should be considered is the ROE which provides the return that investors get from their equity investments. The weighted average cost of capital (WACC) gives the rate which the company is expected to pay to its equity holders and is likely to change with the introduction of additional debt. The number of shares and change in the value of shares that the company experiences as a result of the additional debt may also be considered. Additional debt creates a tax shield benefit that should be considered when analyzing a company. The addition of debt may also create additional risks for the company. 

Definition of Alternatives 

When considering the alternatives that should be undertaken by the company, one should consider the ways that Susan Collyns can assist in facilitating the success of the company. Collyns can ensure the continual success of CPK through weighing the different options and then choosing one that would averagely lever-up CPK. Leveraging by borrowing would be a strategy to acquire more assets and will thus be a strategy to increase the ROE of the company. Leveraging this way would come with the added advantage of reducing the corporate income tax liability of CPK (Faulkender & Smith, 2016). Through the corporate tax shield, CPK would reduce the overall amount they are owed in taxes and this ultimately results in an additional operating cash flow. The company can also borrow given the conditions of low interest rates. The company has also avoided putting any debt on the balance sheet and this has maintained the borrowing ability that should be used to support the growth of CPK. However, there would be more benefits with leveraging CPK’s equity. From the given scenario, Collyns can facilitate the success of CPK by opting for a strategy that mildly leverages the company. 

ROE 

The analysis of Exhibit 9 showed that CPK considers to alter their capital structure by opting for debt that ranged from 10%, 20%, and 30% based on their total book value. The analysis showed that such a strategy is going to have an impact on their ROE. The ROE was calculated through the formula ROE = Net Income / Total shareholder’s Equity. From the analysis it was shown that the given alternatives of debt at 0%, 10%, 20% and 30% resulted in a decrease in the ROE to 8.99%, 9.52%, 10.19% and 11.05%. This showed that having more debt increased the ROE from the current 8.99% to 11.05%. A high ROE was more beneficial as it showed that shareholders were experience greater returns per share (Estrin et al., 2018). This indicated that the company does not take the advantage of leveraging its debt in order to increase the returns for the shareholders. 

Table 1. Calculation of ROE 

		Debt/Total Capital
	Actual	10%	20%	30%
Net income	20,299	19,359	18,419	17,480
Equity	225,888	203,299	180,710	158,122
ROE = Net income/Equity	8.99%	9.52%	10.19%	11.05%

WACC 

While having a financial leverage for CPK will increase the ROE, it can also involve having a high risk. The second critical factor that was considered was the cost of capital which was identified by first calculating the company’s beta through the use of the Capital Asset Pricing Model (CAPM). The unlevered beta was 0.85 as shown in exhibit 7. Unlevered beta is a metric which is used to compare the risk of a company that is unlevered (without any debt) without to the risks of the market (Lesseig & Payne, 2017). The levered beta was calculate as shown in table 2 through the following formula. 

B L = B U * [1+(1-T C ) * D/E] 

Table 2. Calculation of Levered Beta 

The cost of capital was then calculated from the levered beta. This was through the formula for CAPM equation which is given as :  

R E = R f + Beta x (R M – R f ) 

Table 3. Calculation of Cost of Capital 

The cost of capital was then used to calculate the WACC through the formula : 

WACC = R E *E/V + R D *(1-T) * D/V 

Table 4. The calculations of WACC 

From the given analysis the higher the financial leverage, the lower the cost of capital. The analysis thus showed that increasing the company’s debt through its capital structure would have a more favorable effect on the WACC. The WACC decreased from 8.43%, 8.36%, 8.28%, to 8.22%. The decrease in the WACC indicates that the company is paying less for its cost of capital as the cost of borrowing was less than the cost of equity was shown in the table 4 (Frank & Shen, 2016). However, it was also shown that the company increasing the debt of its capital structure resulted in an increase in the levered beta of the company from 0.85 to 0.915 at 30%. This resultantly increases the cost of equity since the cost of equity has a direct relationship with the levered beta as shown in the CAPM formula. The increase in the cost of equity was in the values 8.43%, 8.51%, 8.58%, and 8.68%. From the given analysis, it was revealed that having additional leverage could introduce some risks. However, most of the risks were somehow favorable. 

Share Price 

The value of the firm increased as a result of the debt and this introduced a tax shield effect. The announcement of the company’s recapitalization also resulted in a rise in the share price. The stock price of The new share price is thus given through the formula shown and the share price was as shown in table 5. 

P1 = P0 + (Tc*Debt)/Number of outstanding shares. 

Table 5. Share Price 

Repurchased Shares 

The repurchased was identified by calculating the number of repurchased shares as through debt issued divided by the price per share. The shares after repurchasing was calculated by finding the difference between the shares after repurchasing and repurchased shares. The calculations were as shown in table 6. 

Table 6. Repurchased Shares 

Effect on Earnings Per Share (EPS) 

Taking leverage was also found to have an effect on the earnings per share. The earnings per share was identified as shown in table 7 and was identified through the formula 

EPS = Net income/new number of shares. 

Table 7. Earnings Per Share Calculation 

When a company identifies that its stock price is undervalued, it can choose to purchase its stocks so as to increase the excess returns to the market. From the given scenario of CPK, the company company’s stock price is at $22.1 with the number of shares being 29.13 million giving a total market value of $643,773,000. When CPK chooses to borrow additional debt, it is evident that the price per share increases. The company taking additional debt increases the company’s leverage to buy its shares and this reduces the total equity of CPK and thus the share price of the company’s stocks increases. 

From the analysis, the other benefit that the company can gain is from the tax shield. The tax shield is calculated by taking the debt multiplied by multiplied by the tax shield. The tax shield involves the reduction in the income taxes that was allowed to be deducted from the taxable income. The interest on debt is thus a tax deductible expense. CPK can thus benefit by taking debt and having a tax shield. The tax shield is directly proportional to the company’s debt. Therefore, the more the percentage of debt, the more the tax shield. This presents one of the advantages of debt financing and it shows that it is a strategy that the company can use to improve its cash flows. 

Alternative Actions 

The first course of action was to leverage the balance sheet of CPK through 10% debt with an interest rate of 6.16%. This option was advantage of such an approach is that the company would enjoy a tax shield. The market value of the company’s capital is also expected to increase. Using this approach would also enable the company to increase its total cash available and to repurchase the stocks that were issued to the public (Lei & Zhang, 2016). However, the disadvantage is that the company would have additional debt which increases the expenses of the company. 

The second alternative for the company is to finance 20% of its capital through debt and it would also result in the advantage of the tax shield from the total capital through debt. The company will also purchase more shares when compared to the first alternative. However, such an approach will be disadvantageous as the company will experience an increase in its total expenses. 

The third alternative is for the company to finance 30% of its capital through debt. This will result in a higher tax shield compared to any of the other options. The market value of the firm will also increase and it will be higher compared to the previous two scenarios. However, the disadvantage of such an approach is that the company may be considered to be highly leveraged and it would have a more impact on the profitability as it would pay high interests. The alternative may thus affect the company’s position in the long run if the costs become difficult to pay as inflation can impact the debt and the interest which the company pays (Hatchondo et al., 2016). The alternative would thus have more negative outcomes. 

Conclusion 

From the given analysis, CPK should strive to have a proportional use of debt and equity which should support its assets and thus indicate the strength of the balance sheet. A capital structure that is healthy will involve the company having low debt and a high equity. Based on this perspective, the company should repurchase its stocks and opt to refinance it through a 20% debt. Even though the third alternative appears to be advantageous as it would result in a higher tax shield, this option would not be recommended as the company may want to increase its credit in future. 

References 

Estrin, S., Gozman, D., & Khavul, S. (2018). The evolution and adoption of equity crowdfunding: entrepreneur and investor entry into a new market.  Small Business Economics ,  51 (2), 425-439. 

Faulkender, M., & Smith, J. M. (2016). Taxes and leverage at multinational corporations.  Journal of Financial Economics ,  122 (1), 1-20. 

Frank, M. Z., & Shen, T. (2016). Investment and the weighted average cost of capital.  Journal of Financial Economics ,  119 (2), 300-315. 

Hatchondo, J. C., Martinez, L., & Sosa-Padilla, C. (2016). Debt dilution and sovereign default risk.  Journal of Political Economy ,  124 (5), 1383-1422. 

Lei, Z., & Zhang, C. (2016). Leveraged buybacks.  Journal of Corporate Finance ,  39 , 242-262. 

Lesseig, V., & Payne, J. D. (2017). The precision of asset beta estimates.  International Journal of Managerial Finance . 

Appendices 

Exhibit 9 

CALIFORNIA PIZZA KITCHEN
Pro Forma Tax Shield Effect of Recapitalization Scenarios
(Dollars in thousands, except share data; figures based on end of June 2007)
		Debt/Total Capital
	Actual	10%	20%	30%
Net income	20,299	19,359	18,419	17,480
Equity	225,888	203,299	180,710	158,122
ROE	8.99%	9.52%	10.19%	11.05%
Interest rate (1)	6.16%	6.16%	6.16%	6.16%
Tax rate	32.5%	32.5%	32.5%	32.5%
Earnings before income taxes and interest (2)	30,054	30,054	30,054	30,054
Interest expense	0	1,391	2,783	4,174
Earnings before taxes	30,054	28,663	27,271	25,880
Income taxes	9,755	9,303	8,852	8,400
Net income	20,299	19,359	18,419	17,480
Book value:
Debt	0	22,589	45,178	67,766
Equity	225,888	203,299	180,710	158,122
Total capital	225,888	225,888	225,888	225,888
Market value:
Debt (3)	0	22,589	45,178	67,766
Equity (4)	643,773	628,516	613,259	598,002
Market value of capital	643,773	651,105	658,437	665,769