Teachings Note California Pizza Kitchen Essay

2421 words - 10 pages

CALIFORNIA PIZZA KITCHEN

Teaching Note

Synopsis and Objectives

This case examines the question of financial leverage at California Pizza Kitchen (CPK) in July 2007. With a highly profitable business and an aversion to debt, CPK management is considering a debt-financed stock buyback program. The case is intended to provide an introduction to the Modigliani-Miller capital structure irrelevance propositions and the concept of debt tax shields. With the background of a pizza company, the case provides an engaging context to discuss the “pizza graphs” that are commonly used in corporate finance curriculum to illustrate the wealth effects of capital structure decisions.

The case ...view middle of the document...

What capital structure policy would you recommend for CPK?

Supplementary Material

A spreadsheet (Case_33.xls) is available for students. The technical note, “The Effects of Debt Equity Policy on Shareholder Return Requirements and Beta,” (UVA-F-1168) is available as a review of the theory and application of the issues surrounding financial risk. A spreadsheet (TN_33.xls) is also available for instructors.

Teaching Plan

1. What is going on at CPK? What decisions does Susan Collyns face? What do you recommend?

This question affords an outline of the issues regarding the capital structure decision at CPK. End with a class vote on the alternatives.

2. Maybe we can all be right. Is there a case for that?

This question is designed to introduce a discussion of the Modigliani-Miller value irrelevance of capital structure decisions.

3. How does debt add value to CPK?

This question allows the class to go through the concepts and mechanics of leverage and debt tax shields. Using case Exhibit 9, the class can discuss ROE, levered betas, and the concept of risk-sharing.

4. What is the case for not doing the recapitalization?

This question affords a discussion of the counterpoint that completing the recapitalization diverts the current borrowing capacity away from funding CPK’s growth trajectory.

5. What should Collyns recommend?

This question invites a wrap-up of the case discussion.

Case Analysis

1. What is going on at CPK? What decisions does Susan Collyns face? What do you recommend?

The instructor should allow the students to develop the lay of the land for the case. Of particular importance are the following points.

• CPK has shown strong operating performance recently despite industry challenges of increasing labor, food input, and energy costs.

• Its management has an agenda of expanding the company with 2007 growth requiring $85 million in capital expenditures. “Staying power” requires a strong balance sheet.

• CPK’s stock price is down 10% to $22.10. Management is considering the benefits of borrowing to repurchase shares

The four alternatives considered explicitly in the case are

1. Maintain existing financial policy with no debt;

2. Borrow $23 million (10% debt to total book capital);

3. Borrow $45 million (20% debt to total book capital);

4. Borrow $68 million (30% debt to total book capital).

This discussion can end with the instructor inviting each student to vote on the alternatives at hand. Representative student “champions” can be recorded to facilitate subsequent discussion.

2. Maybe we can all be right, is there a case for that?

This question is designed to introduce a discussion of the Modigliani-Miller value irrelevance of capital structure decisions. Since this is a “pizza case,” an engaging way to stimulate this discussion is with the...

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