[Solved] California Pizza Kitchen Case Study- Complete Financial Analysis- WACC, Beta, ROE, and Debt Analysis

California Pizza Kitchen Case Study is a Case study from HBR. The Original case study can be found here. The case presents an opportunity to do a comprehensive financial analysis of the company and fill in the shoes of the CFO. The case presents a detailed introduction to Modigliani and Miller’s capital structure irrelevance propositions and the concept of debt tax shields. Follow on for the detailed analysis

Overview of California Pizza Kitchen Case Study

The California Pizza Kitchen, also known as CPK, is a chain of restaurants in the United States that serves a wide selection of pizzas, pastas, and items from the fast food industry.

The first location of the restaurant opened in 1985, and by the time the first half of 2007 came to a close, it had grown to include 213 locations across 28 states and six international nations. The restaurant chain was initially established in 1985. The income from CPK’s own shops, the royalties it receives from its franchises, and the royalties it receives from its partnership with Kraft Foods to sell frozen pizzas all contribute to the company’s revenue.

The company’s success may be attributed to its emphasis on client satisfaction, a family-friendly environment, an innovative menu with excellent ingredients at cheaper prices than competitors, and a lasting service culture. All of these factors compensate for the lack of a 1% advertising budget by encouraging word-of-mouth marketing among the company’s patrons, which contributes to the company’s success.

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California Pizza Kitchen Case Study: Susan Collyns Dilemma

However, in recent years, executives in the restaurant industry have had to face a few challenges. These challenges include high gas prices, which cause an increase in the prices of food commodities; higher labor costs (which rose from $5.15 to $7.25 per hour in May 2007); and activist shareholders’ intense interest in the industry.

This suggests that a significant number of CPK’s competitors suffered losses as a result of these developments, whereas CPK continued to perform very well despite these developments. CPK was successfully controlling its two greatest expense areas, labor and food costs, despite the fact that both of these costs had been increasing. During the second quarter of 2007, CPK’s sales increased by more than 16 percent to a total of $159 million. At the same time, the proportion of total revenues that were spent on labor expenses decreased from 36.6 percent to 36.3 percent.

The Chief Financial Officer (CFO), Susan Collyns, is currently faced with the decision of whether or not to alter CPK’s existing financial structure in order to obtain sufficient cash for the company’s operations. Collins recognized the advantages of increasing CPK’s leverage to a moderate degree as interest rates began to rise from historically low levels.

Since the company does not carry any debt on its balance sheet, the current situation presents an excellent opportunity to buy back floating shares of the company by issuing new debt in the market.

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California Pizza Kitchen Case Study: Effect of Debt

To provide an appropriate response to this inquiry, we need to first compute the return on equity (ROE), price per share, shares repurchased, shares outstanding, earnings per share (EPS), the price-to-earnings ratio (P/E), beta (β), cost of equity (RS), and weighted average cost of capital (WACC) (RWACC).

California Pizza Kitchen Case Study: Return on Equity (ROE)

Return on equity, also known as ROE, is a measure of a company’s financial performance (more specifically, its profitability) in relation to the stockholders’ equity. It indicates how efficiently a company uses investment funds to generate earnings. ROE is a performance measure that is typically presented as a percentage and is derived by dividing a company’s net income by the book value of its equity.

+ Actual = x 100 = 8.99%

+ Debt/Total Capital 10% = x 100 = 9.52%

+ Debt/Total Capital 20% = x 100 = 10.19%

+ Debt/Total Capital 30% = x 100 = 11.05%

According to the results of our calculations, CPK’s ROE rises whenever there is a greater ratio of debt to equity. The return on equity (ROE) is 8.99% for a debt-equity ratio of 0%, 9.52% for 10% equity, 10.19% for 20% equity, and 11.05% for 30% equity (calculations are rounded to the second decimal point).

The reason why this phenomenon occurs is that when businesses increase their use of financial leverage to finance their operations, a smaller portion of the company’s operations are financed by equity. As a result, earnings from those operations are distributed over a smaller amount of equity, which causes the ROE to increase.

However, excessive leverage can result in high levels of interest payments and risk of default (trade-off theory), both of which will have the effect of lowering a company’s net income and return on equity.

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California Pizza Kitchen Case Study: Price Per Share

A company’s share price, also known as its stock price, is the monetary value that must be paid to acquire one share of ownership in that company. The price of an individual share is not stable but rather varies in response to the conditions of the market. It will likely go up if the company is thought to be doing well, but it will likely go down if the company isn’t meeting expectations.

It is important to note that the current share price of California Pizza Kitchen is $22.10, as indicated in Exhibit 7. If we use the following formula and make the underlying assumption that the market is efficient, we can calculate the share price for the situation in which the level of debt is 10%, 20%, and 30% respectively.

If we look at the table above and notice that the price of CPK shares has been going up, we can deduce that investors anticipate CPK will have higher earnings growth in the years to come. As CPK makes investments in its own operations, the company’s potential value for increased earnings rises.

This opportunity will pique the interest of potential investors. In addition, the value of each share can only continue to rise or remain high if investors perceive that CPK is meeting or exceeding their expectations about the company’s profits.

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California Pizza Kitchen Case Study: Shares Repurchases

When the management of a public company buys back company shares that had been previously offered for sale to the general public, this practice is referred to as a share repurchase.

A company may decide to repurchase its own shares for several reasons, including the desire to increase its own equity stake in the company, to send the market a signal that its stock price is likely to increase, to inflate financial metrics that are denominated by the number of shares outstanding (such as earnings per share or EPS), to attempt to halt a declining stock price, or to send a market signal that its stock price is likely to increase.

 When a company repurchases its own stock, it may be an indication that the company is facing extremely positive prospects, which will put upward pressure on the price of the company’s stock.

In order to compute the total number of shares that have been repurchased, we need to first determine the total number of shares that are currently in circulation, which comes to 29.13 million when we apply the following formulas:

Next, we calculate the number of shares that were repurchased by using the ratio of Debt to Price per share (the amount of Debt was presented in Exhibit 9, and the price per share was determined when the level of debt was 10%, 20%, and 30%).

The formula for determining the number of shares that are still outstanding is presented below, and the results of the calculation can be found in the table that follows:

The shares outstanding is calculated with the formula below: The results are computed in the table below:

According to the data presented in the table that is located above, CPK acts in good faith. A stock repurchase typically conveys to investors the message that the price of the company’s stock is likely to rise as a result of some positive factor.

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California Pizza Kitchen Case Study: Earnings Per Share (EPS)

Earnings per share, also known as EPS, is synonymous with profitability ratios and market prospect ratios. Earnings per share that are higher than average are always preferable to ratios that are lower than average because this indicates that the company is more profitable overall and that it has more profits available to distribute to its shareholders. Calculating earnings per share using the exhibit’s 9 net income yields the following results:

The results are computed in the table below:

It has been discovered that higher earnings per share ratio may cause the stock price of CPK to increase. This is the case even though many investors do not pay much attention to the EPS. Investors in CPK may look at this ratio, but they should not let it significantly influence their decision-making because there are so many factors that can affect its value.

California Pizza Kitchen Case Study: Price to Earnings Ratio (P/E)

The price-to-earnings ratio, also known as the P/E ratio, is a valuation statistic that compares the price per share of a company’s stock to the earnings per share that the company generates. In that particular situation, the stock earnings per share are used as the numerator, and the stock price per share is used as the denominator.

When determining the selling price, the price-to-earnings ratio, also known as the PE ratio (or multiple), is utilized, along with the price per share and earnings per-share data found in the tables that came before it. The following is the formula for, and the calculation of, this process.

The following table summarizes the results:

The price-to-earnings ratio, also known as P/E, is a measure of how much money investors are willing to part with in exchange for one dollar’s worth of current profits. A higher P/E can be interpreted as a sign that a company, such as CPK in the United States, has significant opportunities for future expansion.

When evaluating this ratio, exercise extreme caution because it would be extremely high if the company in question had either no profits at all or profits that were so small that they were essentially nonexistent. As a consequence of this, the PE ratio has an inverse relationship to the risk that the company faces.

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California Pizza Kitchen Case Study: Calculation of Beta (β)

The volatility is measured by beta.

The likelihood of the sovereign risk that is present in a particular market. Unlevered beta, abbreviated as “U,” is a measurement of a company’s value risk that does not take into account the company’s debt, thus isolating the risk that is entirely attributable to the company’s profits. Leveraged beta (L), which incorporates the debt-equity ratio into its formula, evaluates the level of financial risk by taking into account both debt and equity. The following equation can be used to describe levered beta:

(Levered) equals (Unlevered) multiplied by [1+ (1 – Tax Rate) x]

Because it appears that CPK’s existing capital profile does not contain any debt, the unleveled beta for CPK, which is shown in Exhibit 7, will become 0.85. The following levered betas (L) are obtained by applying the equation from the previous paragraph to debt-equity ratios of 10%, 20%, and 30%, respectively: 0.87, 0.89, and 0.92.

Because of the increased dangers associated with the issuance of debt, the beta is increased when leverage is added to the financial performance of an organization. In addition, the use of financial leverage causes the levered beta to represent both the business risk and the financial risk of the company.

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California Pizza Kitchen Case Study: WACC (R_WACC)

The total cost of production for a company is referred to as the weighted average cost of capital (WACC), which takes into account both equity and loans. This is the sum from all of the different avenues of funding, weighted according to their respective shares of the total equity. To determine WACC after taking into account taxes, use the following equation:

WACC = x Cost of Equity + x Cost of Debt x (1 – Tax rate) (1 – Tax rate)

Notes:

+ B: Market value of debt

+ S: The current market price of the equity

The cost of equity, denoted by RS, is the same throughout the entirety of this model as the one that was recently determined by CAPM. The cost of the debt is displayed in Table 9 (RB = 6.16%), as is the rate of the corporation tax (TC = 32.5%).

Because it would appear that interest expenses are deductible from taxable income, a single cost of debt (RB) is multiplied by (1 – TC), and the value of the tax shield is carefully evaluated as a result. On the other hand, the cost of equity does not have this kind of impact because dividends are paid out of after-tax profits.

When the values that were given to us are substituted into the calculation, the WACC for debt-equity ratios of 0%, 10%, 20%, and 30% comes out to 9.45%, 9.37%, 9.28%, and 9.2%, respectively. WACC and cost of equity of CPK are the same when it has been unlevered (debt-equity ratio = 0%) because equity appears to be the only amount of finance for an unlevered business, giving the cost of equity a weight of 1 and the cost of debt a weight of 0. This results in WACC and cost of equity being the same.

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California Pizza Kitchen Case Study: Consequences of Debt

It is commonly believed that the presence of debt inhibits the expansion of a company in a number of different ways. This is because of the implications of the debt, which may disrupt the normal operation of the company during the period of time that it is responsible for repaying the debt if the plan for repaying the debt is not well thought out. There are some positive consequences of debt for a company that wants to grow and expand, and CPK is not an exception to this rule. Despite these negative consequences, there are some positive consequences of debt.

In addition to the aforementioned issues, the company is currently dealing with general stock degeneration, which is the result of the undervaluation of the company’s stock. It is possible to find a solution to this problem by repurchasing stock using borrowed funds.

This will allow the stock’s value to be maintained without being diminished in any way. This may even result in higher levels of revenue for stakeholders, as the amount that was utilized to purchase the stock may vary and increase in the future when CPK repays the loan, which will result in a positive connotation for the company, which will see it develop. This is because the amount that was utilized to purchase the stock may increase in the future when CPK repays the loan.

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California Pizza Kitchen Case Study: The Benefit of Tax Shield

In July of 2007, leverage was discussed at California Pizza Kitchen (CPK). When the business was going through a business that is both profitable and debt-free. Collyns, who are aware of the benefits of modestly raising CPK’s equity, decide to buy back floating shares of the company by issuing new debt in the market. This is done even though the company does not currently carry any debt on its balance sheet. The value of the company can be visualized as a pie chart.

CPK is in a position to increase the wealth of its investors by decreasing the portion of the pie that is taken in by the government in the form of corporate income taxes. This is made possible by the fact that interest payments are deductible from taxes.

 The unlevered required return on equity is only 9% in situations where there is no debt present in the capital structure. However, the required return on equity for CPK rises to 9.52%, 10.19%, and 11.05%, respectively, whenever the amount of debt is increased by 10%, 20%, or 30%. Because of WACC, the weighted average cost of capital for debt-equity ratios of 10%, 20%, and 30%, respectively, is 9.37%, 9.28%, and 9.2%, which is lower than the cost of capital of 9.45% that is incurred when all equity financing is utilized.

This demonstrates that when the tax shield is applied, CPK’s costs are reduced, which ultimately results in the company making more money. In addition, there are two variations of the theory of the trade-off between the advantages of tax shields and the costs incurred financially (direct cost and indirect cost). The higher interest expenses stemming from debts lead to a higher probability of not being able to meet the obligations stemming from the debt, which ultimately leads to financial distress.

The calculation from up above shows that the return on equity is higher than 9.45% when there are no debts incurred because it is 9.55%, 9.66%, and 9.78% for debt-equity ratios of 10%, 20%, and 30% respectively. This substantiates the M&M Proposition II, which states that the use of leverage raises both the level of risk and the potential return for stockholders.

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California Pizza Kitchen Case Study: Analyzing The Increase in Stock Price

When a company loses the ability to take on debt, it will frequently choose equity as the method that offers the best chance of success. The choice of method that businesses make is a rational choice, according to the Pecking-Order theory. Because outside investors believe that the existing stock is overvalued when a company decides to open shares, this results in the company issuing more shares to the public.

Consequently, investors consider this to be a poor choice, and they sit tight in the hope that the price of the stock will continue to decline. The company has resorted to equity as a last ditch effort to avoid financial losses. According to our calculations, the result of raising CPK’s debt to 10%, 20%, and 30% results in an increase in share price to $22.36, $22.64 and $22.94 each in total.

They are greater than the price of debt-free stock in the capital structure, which is $22.10 per share. As a direct consequence of this, as a result of CPK’s participation in the competitive market, the stock price will immediately go up.

According to the Pecking-order theory, which was validated by the aforementioned parameters, the decision by CPK to buy more debt to buy back shares causes an increase in the price of the company’s shares because outside investors assume that the current share price is being valued. reduced in price compared to its current value. It is also the reason why the share price rises because there is a possibility that investors from other companies will consider investing in this company.

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California Pizza Kitchen Case Study: Decrease in Agency Costs of Equity

In order to grow, there has been a reduction in the proportion of shares held by existing inside shareholders. They had less incentive to work harder because every dollar they earned had to be distributed proportionally to other stockholders.

As a result, they were not as productive as they could have been. Because the interest payments on the debt are fixed, shareholders, on the other hand, will be more likely to work harder if the company chooses to issue bonds rather than pursue other financing options. As a consequence of this, they will not be required to divide the fruits of their labor with the bondholders, and they will be able to maintain ownership of the company.

Finally, CPK can reap a number of benefits as a result of its debt, including a reduction in the tax burden as a result of interest expense, an increase in the stock price as a result of asymmetric knowledge, and the elimination of agency costs.

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California Pizza Kitchen Case Study: Collyns Recommendation

The debt-to-equity ratio for CPK is increased by Collyns to 30 percent. The fact that CPK is taking on a debt of $67.8 million and buying 2,965,000 shares will cause the share price to rise to $22.86; however, CPK’s investors already knew that the company is doing well and that the stock price is currently undervalued. We are aware that CPK could go bankrupt as a result of having an excessive amount of debt financing.

However, due to the rapid growth of the company, it is in a good position to take on thirty percent of the debt. When we apply the theory of trade-offs to determine that increasing the level of debt will bring the cost of financial distress closer, we conclude that this is the case. The weighted average cost of capital (WACC) is 9.2%, which is the lowest among debt financing options and all-equity structures.

As a result, the benefits of the interest tax shield outweigh the cost of financial distress when the debt-to-equity ratio is set to the recommended level. The total financial cost incurred by CPK had the potential to significantly increase as described above. Because of the method leverage, not only does the ultimate value of CPK go up, but so does the company’s return on equity (ROE), which jumps from 9.45% under the current all-equity structure to 9.78% under the new structure.

According to the presumption made by M&M Proposition II, the utilization of leverage contributes to an increase in both the risk and the return to stockholders. The use of debt to finance projects helps to prevent shareholders from selling their shares because it maintains the same level of ownership as before, which is what we anticipated would happen.

Because current shareholders’ ownership has not been diluted, they are the only ones who will receive benefits from the increased advertising budget from its current budget of 1% of sales, advanced partnership with Kraft, and continued domestic and international expansion. Bondholders will receive a fixed amount. To summarize, the advantages will far outweigh the disadvantages, and the expansion strategies of the company will not be jeopardized in any way.

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