California Pizza Kitchen

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What is going on at CPK?

California Pizza Kitchen is a firm that has dominated the restaurant industry for some years.
California Pizza Kitchen (CPK), a business formed on the premise of an escape for two defense
attorneys, is currently run by Susan Collyns, Chief Executive Officer (Rose et al., 2019). CPK
was formed in California in 1985. By 2007, it had grown to 213 retail locations in the United
States and overseas, with 40% of its activities based in California. Currently, CPK operates
entirely owned locations; some are partnerships, and the others are franchises; these locations are
the primary revenue source.

After compiling the preliminary results for the second sector of 2007, the financial investigation
reveals that, despite the firm's market capitalization falling 10% in the previous month to $22.10,
CPK maintained an impressive profit margin, fueled by a faster revenue rate of economic growth
than its competition in the industry. Who suffers from increased commodity prices and an
increasing economy? However, California Pizza Kitchen faces several financial issues which
need to be addressed (Song et al., 2017). One of the main concerns is the sharp decline of the
value of shares. This is a problem as it weakens a company because California Pizza Kitchen
loses customers to other firms. This is mainly because shares are an essential aspect of many
saving portfolios.

Moreover, shares contribute to capital growth, and therefore, the decline in the value of shares in
California Pizza Kitchen limits the firm's development. A reduction in the value of shares causes
lower dividend income, which hurts the firm. In turn, the financial management team at
California Pizza Kitchen loses control of the firm due to the unpredictability of the prices of
shares.

What Decisions does Susan Collyns Face?

The reduction of share prices at California Pizza Kitchen causes the financial management team
to introduce strategies that curb the company's downward trajectory. First, the management team
discusses repurchasing the company shares (Schill & Shumadine, 2018). This plan from the
management team helps the company benefit from the provisional undervaluation of shares.
Furthermore, repurchasing shares means that Collyn and her team mean debt financing (Rose et
al., 2019). In addition, the repurchase of shares sends positive signals to the market since the
future values of the shares are expected to escalate.

Additionally, the finance team must decide on the capital structure that is best suited. This is
because low-interest rates aid the CPK in issuing the required debt agreements at a low cost.
Moreover, since there are no previous debts, the risk is minimal since leverage, as seen in exhibit
9, has a variety of consequences on return on assets and capital expenses.

In what ways can she facilitate the Success of CPK?

Thus, by purchasing the shares, the decline in the share value is temporarily curbed. By using the
buyback strategy, California Pizza Kitchen reduces its cost of capital, which is of essence to its
financial metrics (Schill & Shumadine, 2018). Moreover, the buyback of shares by the firm
reduces the number of remaining shares in the market, which in turn increases the proprietorship
stake of the stockholders. In the long run, the strategy helps improve the financial ratios of
California Pizza Kitchen. However, the company suffers a setback as it lacks finances and hence
requires debt financing. Debt financing is disadvantageous as it puts the firm at substantial
financial risk, and the management of California Pizza Kitchen avoids putting debts on its
balance sheet. Additionally, CPK's oversight ensures that the company maintains a cautious
financial stance, preventing the appearance of debt on the balance sheet statements.

A strong balance sheet is essential to the administration of California Pizza Kitchen in several
aspects. First and foremost, a strong balance sheet helps the firm become dominant in the market.
When California Pizza Kitchen has a strong balance sheet, it maintains its high borrowing
ability, growing. This is because the high borrowing ability supports the firms' growth trajectory.
CPK's financial debts also dent CPK as they are forced to repay the loans they take with high-
interest rates. This hinders the growth of CPK since some of the profits they gain are given to the
lenders of the loan.

Moreover, loans affect the credit rating of California Pizza Kitchen. This puts the company at a
disadvantage because CPK has few loan options and higher rates of interest. This makes it harder
for the CPK to acquire certain services that it requires due to shortlisting. Besides, paying high
interest on loans impacts the company's cash flow since the high interest lowers the asset's cost.

CPK is contemplating opening at least 16-18 new branches and maybe closing an existing unit
shortly. To finance such a project, Collyns must determine the most acceptable capital structure
to use. The activity under consideration is share buyback, which is driven by the circumstance
that the share value is now low. The market now monitors the impact of this share buyback, and
what can be predicted is future growth in the value of the stock due to the enhanced return on
equity, decreased capital cost, and stock price increases. However, to do this, CPK may need to
contemplate debt financing, despite its efforts to avoid adding to the firm's debt. Thus, the capital
structure is the primary challenge she is now confronted with. Nevertheless, CPK has a robust
foundation, which translates into an optimistic future outlook, measured by market analysis and
company management confidence (Song et al., 2017). The statistics in the reports and the firm's
proceeds growth compared to the industry are excellent indicators of the firm's future success.

A recommendation to assist Collyns in facilitating CPK's success is to continue establishing

locally and globally branches, as shown by the financial statements, which show CPK growing at
a 15% rate in the second quarter of 2007, while rivals expanded at a 5% rate. What Collyns can
also do is boost the firm's marketing approach to attract more clients. Because CPK is presently
spending less on marketing than its rivals, it is expected that marketing may increase sales. In
addition, CPK generates money in three ways: via sales at corporation restaurants, revenues from
numerous casual dining restaurants, and payments from its collaboration with Kraft Foods.
Therefore, CPK should continue to grow and improve the firm's overall performance by
maintaining this pattern while also developing alternative revenue streams.
Additionally, to help CPK's performance, consider merging or assimilation with other firms to
extend channels and enhance control over production's cost of goods levels. Finally, we propose
that Collyn seek debt financing to buy back the company's shares to improve its value; moreover,
the money might be used for other business purposes to expand the branch network.
Additionally, the company will reap numerous benefits from capital restraint, specifically, debt
financing, the primary advantage being interest tax evasions. If Collyns does not take this path, it
may increase equity, which is a difficult task.

Several problems arise in the restaurant industry that in turn affect the CPK and its progress. An
increase in the prices of commodities such as gas and labor costs affects CPK in several ways.
Firstly, they affect dining-out demand since food becomes expensive, hence reducing the traffic
in restaurants. When gas prices increase, restaurants have no choice but to increase the cost of
the menu they offer. As a result of the increase in price levels, consumers prefer to purchase food
in grocery stores to economize on their spending. Secondly, the increase in wages of the
personnel serving in the hotel impacts as the management of the restaurants increases the price of
meals to accommodate the workers' salaries. Lastly, restaurants with massive franchising
operations do not invest heavily in company-owned units.

Softening demands due to the high gas prices is also a challenge faced by the CPK restaurant.
According to the case study, CPK is poised to declare near-record quarterly earnings of more
than $6 million despite growing labor, energy, and commodity expenses. CPK's profit rise is
attributed to excellent revenue growth, with comparable restaurant sales increasing by more than
5%. The stated figures were entirely consistent with the company's previously provided advice to
investors (Schill & Shumadine, 2018). The company's results were incredibly excellent
compared to several other casual dining establishments that had seen significant drops in client
traffic. Despite the outstanding results, industry headwinds caused CPK's share price to fall 10%
in June to a current value of $22.10. The administration team explores buyback firm stocks in
light of the price decline. With minimal extra cash, a significant share buyback program, on the
other hand, would need debt funding.

2.Using the scenarios in case Exhibit 9, what role does leverage play in affecting the return on
equity (ROE) for CPK? How does debt add value to CPK? (LOE)
Despite growing market constraints on customer expenditure, the California Pizza Kitchen brand
has increased. CPK's inventive menu, short checked average, and excellent service standards
have uniquely situated the notion for accomplishment in a challenging macroeconomic
environment for consumers. While sales and efficiency growth stalled at rival restaurant chains,
CPK's revenues increased by more than 16% to $159 million in June of 2007. Notably, gains
from the Kraft cooperation and international franchises climbed by 37% and 21%, respectively,
in the second quarter(Schill & Shumadine, 2018). For 2007, plans to build an additional 16 to 18
sites were on track. Capital expenditures of $85 million were estimated to be required to fund
CPK's 2007 expansion strategy.

California Pizza Kitchen's CEO is unsure if now is the best moment to buy back shares, utilizing
its balance sheets and readily accessible borrowing on its current line of credit. First, it is
necessary to understand what the market operates under. The unwritten rule that debt financing
benefits investors and acts as a sign to them, given, of course, that we may be talking about a
robust and successful corporation like CPK. While it is generally documented that growing a
firm's leveraged may result in an even worse credit score, which results in increased funding
costs, it can also result in more significant bankruptcy risks and expenditures. At this level, the
actual cost of debt affects profitability and asset turn. As a consequence, it is required to
undertake a detailed analysis of the returns and expenses associated with leverage to assess if it is
a smart idea and whether the firm can manage to add debt to its financial statements to buy its
securities stock, as well as the time frame for the company's extension.

2.Using the scenarios in case Exhibit 9, what role does leverage play in affecting the return
on equity (ROE) for CPK?

According to CAPM, the equity needed Rate of Return is proportional to the firm's risk
regarding the market. According to CPK's statistics, its unlevered beta is 0.85, indicating a
reduced risk than the market. Because leveraged investments are more complex than unhedged
ones, it is reasonable to predict that the leverage raises the projected rate of return on the stock.
Additionally, the company's beta will be enhanced to bring it in line with the market. First, the
firm's beta is computed in three debt proportions using the company's debt and equity market
price. This is because shareholders are the ones who determine the firm's worth. According to the
calculations, the beta value is 0.87 in 10%, 0.89 in 20%, and 0.92 in 30% of leverage,
respectively (Song et al., 2017). The second step is to compute the needed equity value using the
levered beta, equivalent to 7.4 percent on average for small-cap 600 restaurants and risk-free US
Treasury bonds over ten years. This equates to 5.1 percent, implying that predicted returns will
be higher at each step as leverage is increased. Following that, we assessed the return on equity
(ROE), which aided in identifying underperforming areas of the firm. We broke it down into
three component sections to ascertain the kind of ROE created and the quality of returns.

We must pay close attention to the apparent attraction of leverage to raise CPK's projected ROE.
To demonstrate that leverage carries extra risk, let us alter the earnings before interest and taxes
(EBIT) line in Exhibit 9 by a specified amount in both directions. This involves several steps, as
explained below.

To begin, multiply the EBIT line by a factor of one. In this instance, the no-leverage ROE is
applicable. The low-leverage ROE decreases to 18%, while the high-leverage ROE decreases
even more to 29%. Alternatively, if the EBITDA is negative when the line is multiplied by a
factor of 2, the no-leverage ROE increases to +22%, but the high-leverage ROE remains the
same or climbs even more to +30%. We should rapidly realize how leverage magnifies risk-
returns on equity. Therefore, should stock investors be satisfied with the same rate of return for
significantly increased risk?

How does debt add value to CPK? (LOE)

Leverage is just a technique for reducing business risk. Since the prejudiced average cost of
principal is established (WACC) indicates the entire risk, the WACC should remain constant
when risk is sliced across numerous contract kinds (Song et al., 2017). The overall risk is not
adjusted for inflation. To illustrate this concept with the use of a case. For instance, we must
modify the beta calculation in the questions to eliminate the fraction of risk associated with the
government bearing the burden of the tax shield. Is the improved formula.

From the case study, CPK repurchased $16.8 million in company stock during July. The buyback
is financed using the company's line of credit, reducing the company's outstanding debt to zero.
By the end of the summer, borrowings totaled $17 million (Rose et al., 2019). The firm, which
was founded in early 2008, recently announced an extra $46.3 million share buyback. The
business intended to finance the new program via additional credit line borrowings and available
cash. When the CPK's financial leverage is calculated from 1st January 2006 to 1st of July-2007,
it is discovered that it was 28% in 1-1-2006, 32.5 percent in 32-12-2006, and 33.5 percent in1st
of July-2007. Thus, the company's monetary leverage has increased over the last 1.5 years by 1
percent. Increased economic force improves a company's ROE by outsourcing money to utilize
its operations with few or no equity investments. In Exhibit 3, it is evident that a company's net
revenue was between 19,490 and 21,000 in 2006 and 2007.

We determined the ROE to be 9.87 percent in the year 2006 and 10.07 percent in 2007. This
implies that the ROE of CPK increases due to expanding its corporate via more debt to fund
operations while maintaining a slight increase in equity. Exhibit 9 shows a varied WACC for
three distinct debt working capital of 10 percent, 20%, and 30% in terms of investment expenses.
Framed at 8.35 %, 8.82 %, and 8.17 %, respectfully. Financial leverage's influence on the cost of
capital lowered WACC when the ratio of debt to invested wealth increased from 10%, 20%, and
30%, correspondingly.

Leverage boosted BETA's ROE but at considerable risk. The second area of concern was the
impact of indebtedness on the WACC, which we estimated by calculating the company's beta
using the CAPM model. The beta coefficient was 0.85, which is the beta of the corporation in its
debt-free state. It prevents the financial costs associated with leverage. We utilized the formula
"where BL represents the firm's leveraged beta, Tc denotes the corporate tax rate, and D/E
signifies the firm's leverage ratio (Song et al., 2017). These were 0.87, 0.89, and 0.915,
accordingly, with a 10%, 20%, and 30% debt-to-total capital ratio. Financial leverage affects the
cost of equity: the bigger the leverage, the higher the equity price, as illustrated in exhibit 9. This
conclusion was reached using the formula.

The ROE grows in direct proportion to the debt level. Profit margins seem to be decreasing due
to the interest payments that a business must make, but the equity multiplier increases by a more
significant amount at each level (Rose et al., 2019). This means that the increased ROE is due to
the addition of debt to the financial statements, not to any improvements in the company's
current approach. The improvement in ROE indicates that CPK's capacity to earn profits without
massive quantities of equity capital has grown. As a consequence, CPK outperforms the market's
unbiased returns and provides superior returns to its stockholders. Additionally, there is a link
between debt and the spread between return on equity and cost of equity. When debt grows, the
ROE and cost of equity increase, resulting in higher returns to shareholders.

If the CPK makes a decision may be leveraged, resulting in a shift in its cost of capital. The new
price is calculated as the weighted sum of the cost and debt and equity. CPK has a capital
requirement of 7.05 percent when unlevered, which declines after every level of leverage. The
firm enjoys tax deductions from the tax shield. Thus the WACC becomes 6.8% at 10%, 6.55% at
20%, and 6.28% at 30% leverage. If the other elements are kept constant, the firm's value
increases and the company's costs become lower. Modigliani and Miller's hypothesis on firms'
value was developed when there were no taxes in the world, but taxes on debts had to be
deducted. Thus, it is accurate to assert that its worth grows about the amount of debt utilized. The
firm's value is equal to its free cash flow value, which itself is equivalent to the total of the firm's
unlevered market value and the tax benefit avoided. At each degree of leverage, the original
number can vary between $643.773million to $653.364million, $667.472million, and
$686.099million, respectively (Song et al., 2017). The proportion change in the exchange rate of
the enterprises grows until the cost of equity exceeds the rate of return here on assets. Whenever
the cost of money exceeds the returns on assets, Portfolio has no reason to continue using debt.
Profitability achieved by the club with money provided by equity investors exceeds the minimal
rate of return required by the company. At 10% borrowed funds, the ROE is 9.52 percent. At
20% borrowed funds, the ROE is 9.52 percent. The return on equity is 10.19 percent, while the
debt capitalization is 30%, at 11.05%. The effects of the cost of equality can be calculated using
the beta equation. From the calculations, it is evident that the cost of equity increases as leverage
increases.

For a 10% debt/capital ratio, the beta of capital is.87 and the cost of capital is 14.34 percent; the
beta of equities is.89 and the cost of capital is 14.56 percent for a 20% debt ratio, and the beta of
equity is.915, as well as the cost of capital, is 14.84 percent for a 30% deficit ratio. Additionally,
these increases suggest a rise in vulnerability for the organization as a consequence of higher
debt. When the WACC calculation is used, the cost of equity for the business reduces overall due
to low borrowing costs and the more significant tax shield. When calculating stock prices, it is
the identity that they will increase according to the percentage of debt/capital. At a debt/capital
ratio of 10%, the stock price will climb to $22.35, a 1.13 percent gain that will allow for the
buyback of 1.01 million shares. At a 20% loans ratio, the price rises to $22.60, a 13% increase.
Increase of 2.26 percent and the option to buy back 1.99 million shares. Finally, with a
debt/capital ratio of 30%, the price will range between $22.86 and $22.86, a gain of 2.99
percentages, and will allow for the buyback of 2.97 million units. Again, the firm's additional
value may be ascribed to the current value of the tax shelter created by the debt that enables them
to seize. As a result, this allows the purchase of shares at the new price. In my view, Collyns
should go for the 20% debt/capital arrangement. Under this system, they should do so by
participating in a share buyback program, repurchasing about 1.99 million shares. This will
enable shareholders to benefit from a rise in the share price. There is not much danger associated
with the 20% structure, which allows for future development while limiting the debt.

Is it necessary to optimize the capital structure to maximize shareholder value? For

example, what debt-to-equity ratio optimizes shareholder value? Why should investors be
concerned with enhancing the firm's value? Shouldn't they be solely concerned with
maximizing shareholder value?

What are the primary drivers of CPK's value growth, and how does this influence its
capital suppliers, namely shareholders and creditors?

Modigliani-Miller's theory holds that a firm's market value is defined by its earning potential,
any risk associated with underlying assets, and how it chooses to finance its investments (Rose et
al., 2019). Thus, the fundamental principle of this study is that it makes no difference whether a
corporation invests itself via debt or stock. Therefore, in this scenario, the worth of CPK is
determined by the overall magnitude of profits rather than how gains are distributed.

Calculations for determining the impact of a share buyback on the business are presented below.
Using a 10% debt-to-total capital structure would boost the stock price to $22.35, resulting in a
1.13 percent raise, and will allow for the potential buyback of 1,011,000 shares, which is
equivalent to a 3.47 percent drop in shares (Song et al., 2017). A shift of 20% in debt to the total
asset base would boost the cost to $22.60, resulting in a 2.26 percent raise to fund the purchase
of 1,999,000 shares and a 6.685 percent drop. Finally, a debt-to-capital ratio of 30% will enhance
the stock price to $22.86, a 2.99 percent gain, and allow for the buyback of 2,965,000 holdings, a
10.18 percent drop in shares.
In our judgment, a debt issue to fund share repurchases is the wisest course of action for the firm
to take. It is advised that the point about $45,178,000 in debt to attain a 20% total debt working
capital. Additionally, CPK should utilize this money to repurchase about 1,999,000 shares of its
stock. This will result in a 2.26 percent boost in the share price, which their shareholders will
welcome. This level was selected due to the evident advantage to shareholders and the modest
amount of risk involved. Even though a 30percentage debt to total investment structure is more
favorable to shareholders, Collyns cannot take this risk. Opting for the most cautious 20%
leverage will leave greater flexibility for future capital structure changes, allowing them to
develop further.

The following table details the ownership status of shares held by two distinct groups of
shareholders; Shares

Distributed between Controlling and Non-Controlling Shareholders

Shareholders Shares as a percentage Shares Issued

Shareholders in Control 51%, 14,856,300

Non-Controlling Shareholder 49% 14,273,700

Total Number of Shares 100% 29,130,000

The controlling shareholders in the suggested scenario would not want to lose any shares due to
the controlling problems. As a result, non-controlling shareholders will lose part of their shares.
When CPK repurchases shares from non-controlling shareholders, these buys, which will be
conducted via a tender offer, will result in the controlling shareholders holding a large number of
shares much as their counterparts and a slight gain in influence over business decisions.

Shares Distributed Between Controlling and Non-Controlling Shareholders after the Buyback

Shareholders Shares percentage Number of Shares

Controlling shareholders 54.7% 14.856,300

Non-Controlling Shareholders 45.3 % 12,291,321

Total Number of Shares 100% 27,147,621

The buyback will have a variety of negative consequences for the various shareholder groupings.
Non-controlling investors who did not offer their shares will see a significant boost in their share
value. Non-controlling shareholders, on the other hand, who did show their claims would have
earned an additional 20 cents per share in addition to the rise in the trading value of their shares.
The impact on ownership concentration will be as follows: it will strengthen their bargaining
position if shareholders want to offer their stakes in the future. This would result in CPK
acquiring their equity at a premium, resulting in 1) a loss of the corporation's shareholding and 2)
a loss of control value.

How does debt contribute to the value of CPK?

For many businesses, debt is seen as a liability they owe to creditors, and repayment is constant.
However, there are definite benefits to borrowing debt for a business. The same is true for CPK
since they will profit from the taxes associated with debt financing. The tax implications of debt
are distinct from those of equity. Leveraging CPK enables them to attain a lower tax burden
since reduced taxable income results in less tax.

Additionally, this will be reflected in the company's market value since a tax shield increases its
market value by reducing its cash flow (Schill & Shumadine, 2018). Another advantage for CPK
would be the increase in Return on Investment (ROE) that would result from the increased debt-
to-equity ratio (Rose et al., 2019). However, income will be relatively unaffected by the tax
shield. As per the ROE formula, as equity declines in proportion to net earnings, ROE tends to
increase. Additionally, this provides value to the business. Because CPK's stock price is
declining due to undervaluation, they might repurchase it using debt. Through this, CPK will
also influence their stock's price and maybe increase its worth. Therefore, the debt investigation
will benefit CPK and its shareholders since they will earn more money thanks to the tax shield.
What is the rationale for deferring recapitalization?

The CPK ownership is well-known for its prudent financial policies, which reflect its desire to
retain control. The management should consider the advantages of leveraging and tax-shield
gains compared to the expense of entirely using future borrowing capacity (Song et al., 2017).
Given CPK's significant growth trajectory, we should consider if this expansion surpasses the
firm's ability to continue it. To determine whether or not it is a problem, we must examine the
pace of sustainable growth in terms of cash sources and uses. This technique precludes fresh
equity funding.

Because the formulae are provided in the following manner:

Source of cash = NOPAT + Change of PPE + Dividends and repurchase + Interest payment

We equalized both formulae and reorganized the new one.

We've obtained the equation:

Growth in Total Capital = ROC + Change in D/TC –Payment/ TC

The total growth in the capital is equivalent to a change in TC/TC, ROC is equal to NOPAT/ TC,
and Payment is equivalent to Dividend + Interest Payments.

By allocating all available debt capacity to share repurchases, management limits capital for
company expansion to the amount earned by business operations, or ROC. With a ROC of 10%
for CPK, the annual growth should be equivalent to grant or take (Song et al., 2017). Based on
213 shops, an increase in-store opening was projected at 16 or 18 percent, corresponding to a 7.5
percent to 8.5 percent predicted growth rate. Capital expenditures for 2007 were forecast to total
$85 million, while depreciation was expected to total around $35 million, based on past values
and the very first six months of 2007. A $50 million rise in net property or other equipment,
NPE, and a $226 million book capital base indicates a 22% increase in total capital, excluding
any rises in proper working capital, NWC. They will be harmed if the industry's economics
continue to worsen, lowering the company's return on capital.
What is Collyns' recommendation?

According to current financial data, CPK's debt should be financed at a 30% rate. Because CPK
has never acquired debt before, it is deemed dangerous for business, but the rewards outweigh
the risks. When debt is acquired, higher returns are anticipated. Additionally, now is a good
moment for CPK to obtain debt, as bright prospects are secured by its outperformance of
benchmarks and consistent increase in sales, results of its operations, and net income over the
last four years. Although we indicated before that repurchasing their shares provides a modest
advantage in increasing its value, it will not be regarded as an investment by the corporation. In
the event of a stock buyback, the business will only have to refinance 20% of its debt to avoid
exceeding its credit line of $75 million. The remainder of the funds might be invested in other
business areas, such as product development and innovation.
References

Ross, S. A., Westerfield, R., Jaffe, J. F., Jordan, B. D., Jaffe, J., & Jordan, B. (2019). Corporate
finance (pp. 312-13). McGraw-Hill Education. https://www.cpp.edu/~psarmas/Course
%20_Outline/FRL_4401/Spring-2019.pdf
Schill, M. J., & Shumadine, E. (2018). California Pizza Kitchen.
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1418903
Song, S., Van Hoof, H. B., & Park, S. (2017). The impact of board composition on firm
performance in the restaurant industry: A stewardship theory perspective. International
Journal of Contemporary Hospitality Management.
https://www.emerald.com/insight/content/doi/10.1108/IJCHM-05-2016-0283/full/html?
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