California Pizza Kitchen Case
Summary of California Pizza Kitchen Recapitalization Proposal
* Brief history of CPK (p.3)
* Reasons for CPK’s success (p.3)
* Ways to facilitate the success of CPK (p.3-4)
* Anticipated effect of changing the capital structure on return on equity (p.4)
* Anticipated effect of changing the capital structure on cost of capital (p.5)
* Expected number of shares of CPK that can be repurchased (p.6-7)
* Anticipated effect of changing the capital structure on CPK’s stock price (p.6-7)
* Our recommendation (p.7)
In order to explore whether or not California Pizza ...view middle of the document...
These factors, along with others, have contributed to CPK’s stock price beating the S&P Small Cap 600 for restaurants, as shown in Exhibit A in the appendix.
As the CFO, you, Susan Collyns, can continue the success of California Pizza Kitchen by suggesting the company add debt to its balance sheet. The low interest rates because of the recession make our proposal the most attractive since CPK can issue debt at a low cost. Since the company currently has no debt, a modest increase in debt would not be very risky and it would increase the value of CPK due to decreased taxes. You can take this proposal one step further and use the added debt load to repurchase shares of CPK from investors. This move would please the shareholders since their shares would represent a larger stake in the company due to the decreased overall shares outstanding. The results of the share repurchase would be seen in the form of a higher stock price. We have outlined the reasons why you should adopt our proposal of a modest increase in debt in the sections below. Keep in mind that any increase in debt will most likely be opposed by the CEO, Rick Rosenfeld. Mr. Rosenfeld’s philosophies go against our proposal because he dislikes any amount of debt due to his want to maintain CPK’s borrowing ability, or staying power. He argues that a restaurant’s success depends on having capital and staying power and the staying power of CPK will be reduced if the company adds any debt. For this reason, we will show you the added benefits to shareholders at different debt loads of 10%, 20%, and 30% debt to total capital levels.
Adding debt to the capital structure of California Pizza Kitchen, up to a certain point, will increase the overall value of the firm, and also increase the return on equity (ROE) for an investor of the firm and decrease the cost of capital for the company. In a recapitalization scenario similar to ours with California Pizza Kitchen, we would use the issuance of new debt to repurchase shares of our common stock. The subsequent tax shield that will be realized by the issuance of new debt will be the major factor in the increase of our ROE.
ROE is calculated by taking the net income for the current period and dividing it by value of shareholder’s equity. We see our increase in ROE because as we pay interest expense our taxable income shrinks, while at the same time shareholder equity is declining, but at a larger pace. As we see in Exhibit B in the appendix, with an increase of 10%, 20%, and 30% debt to total capital, we see our ROE increase to 9.52%, 10.19%, and 11.05% respectively.
However this increase in ROE comes at a price, as the overall risk of the company is increased with the addition of the debt obligations. In Exhibit B, we see that the beta of equity increase as we increase our debt in the capital structure, and increasing beta indicates increased systematic risk for the firm. This increase in beta is also a factor that contributes to the...