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California Pizza

Kitchen

Section A
PGDM (GM)
Members:
Abhinav Sultania
(G16003)
Abinash Mishra
(G16005)
Amit Ashish (G16008)
Azhar Jalal Haider
(G16018)
Helen Nirmala N
(G16025)

Executive Summary:
California Pizza Kitchen (CPK) based out of Beverly Hills, California is a
well-known chain of restaurants. In 2007, CPK was about to announce a
second-quarter profit of over $6 Million. The profit expansion in the
quarter may have been due to the strong revenue growth with
comparable restaurant sales up over 5%. The results were as per the
companys forecast figures. Despite the strong performance showed by
the company, due to the market conditions, its share price declined by
10% to the current value of $22.10 per share. This price drop prompted
the management to discuss the re-purchase of shares. As the company
little excess cash with them, they were planning to move with debt
financing. Prior to this, the company had never taken any substantial
debt. Financial policy was conservative. CPKs book equity was expected
to be around $226 Million at the second quarter. With the current share
price, market capitalization stood at $644 Million. The company had
recently issued a 50% stock dividend, which ultimately split CPKs shares
on a 3-for-2 basis. CPK had serviced all of its debt with the returns from
the IPO in 2000. CPK maintained borrowing capacity available under an
existing $75 Million. The recent decline in the share prices made the
company to consider leveraging the companys balance sheet with debt
on its existing line of credit. Reduction in the income tax liability was
one of the arguments in favor of the debt financing. But company
needed to preserve its capacity to grow. A decision had to be taken while
balancing the managements goal of growth and the return of capital to
shareholders.
Case Details:
California Pizza Kitchen has been operating since 1985 predominantly in
California. As of June 2007, they had 213 retail locations in the US and
abroad. Analysts have put estimates on the potential of 500 full service
locations. CPK's strategy includes the opening of 16 to 18 new locations
this year including the closing of one location. CPK derived its revenue
from three major sources: sales at company owned restaurants, royalties
from franchised restaurants, and royalties from the partnerships. While
the company had expanded from its original concept with two other
brands, the main focus remained on operating the 170 units of
company-owned full-service restaurants. In 1996 the company came up

with the concept of ASAP outlets at airports. Sales and operation from
these outlets were not satisfactory as per the management. In 2007, the
management indefinitely halted the development of all of its ASAP
centers and planned to record a consolidated expense of $770000 in the
coming quarter. At the beginning of 2007, the company had 15
international franchised locations with more openings planned.
Franchising agreements typically generated a revenue of $50000 to
$65000 for each location and 5% of sales growth. While other businesses
of the sector saw weakening sales and earnings growth, CPKs revenue
increased by 16% to $159 Million in the second quarter of 2007.
Royalties increased from partnerships and franchises by 37% and 21%
respectively. CPKs growth plans required a capital expenditure of $85
Million. The company had successfully managed the rising labor costs
and food costs. Labor costs were kept in control from 36.6% to 36.3% of
total revenues in the second quarter of 2007. The company had
implemented many initiatives to deal with the commodity price
pressures.
Performing comparatively well against its competitors, CPK's stock has
been depressed recently falling to $22.10 in June making their P/E equal
to 31.9 time current earnings. In comparison with BJ's Restaurants with a
P/E of 48.9, CPK appears undervalued. CPK's direct competitor, BJ's pays
no dividend and has a similar beta and therefore it makes for a good
comparative company. Despite uncertainty in the industry and general
poor performance among competitors, CPK is performing marginally
better than the overall industry.
Calculation of Cost of Debt:
Cost of debt is estimated based on following expression,
r d =LIBOR+ 0.80
Where,
LIBOR=5.36 , so

r d =6.16

Calculation of Levered Beta ( ) for Recapitalization Scenarios


Market Value Weight:

CPK unlevered beta for 0% debt to capital ratio is given as 0.85. Levered
beta for the three recapitalization scenarios of 10% debt-to-capital ratio,
20% debt-to-capital ratio, and 30% debt-to-capital ratio is calculated
based on financial leveraging of capital. Financial leveraging equation to
compute levered beta is given below.

L = u 1+

( 1T )D
E

Where,
L = levered beta for equity in the firm
u = unlevered beta of the firm
T = Marginal Tax rate for the firm = 32.5%
D
= Debt/Equity ratio
E
Table below shows the final estimates of levered beta.

Debt to Capital ratio


0%
10%
20%
30%

Levered

0.85
0.91
1.09
1.42

Calculation of Cost of Equity:


Cost of equity was calculated based on Capital Asset Pricing Model
(CAPM). As per CAPM model following equation was used to estimate
cost of equity:
r e =r f + (r mr f )
Where,
r m = expected market rate
r f = risk-free rate or US Treasury YTM rate
= levered risk coefficient

Tabulated data on US treasury yield to maturity (YTM) for different


maturity period is provided in Exhibit 8. To estimate cost of equity YTM
for appropriate maturity year is chosen. Risk free rate (r f ) of 10 year is
used in estimating cost of equity for firm i.e. 5.1%.
In order to calculate the market premium rate, one needs to look at
Exhibit 6. Using Exhibit 6, one can see that the value of $100 invested
on 7/3/2006 in the S&P Small Cap 600 Restaurants index is around worth
$109 on 6/3/2007. As a result, one can conclude that the market return
is 9% ($109/$100 1).
Table below shows the final estimates of cost of equity based on market
value weights.

Debt to Capital ratio

Cost of Equity (re) (Market value)

0%
10%
20%
30%

8.42%
8.50%
8.58%
8.67%

Calculation of WACC
To estimate cost of capital for CPK and each of its three recapitalization
scenarios, formula for weighted average cost of capital (WACC) is
utilized as shown below,

WACC=

r d( 1T )D r eE
+
V
V

rd = Cost of debt
re = Cost of equity
D = Market value of debt
E = Market value of equity
V = D + E = Value of the company (or division)
T = Tax rate

Table below shows the final estimates of cost of capital based market
value weights.

Debt to Capital
ratio
0%
10%
20%
30%

WAC
C
(Mar
ket
value
)
8.42%
8.26%
8.10%
7.92%

Figure below shows that as CPK acquires debt its cost of capital
increases.

Optimal Capital Structure


Based on the details and assumptions of pro forma recapitalization
estimates of EPS, RoE, and WACC was calculated. While issuing debt and
adding capital by repurchasing common stock some assumptions was
made.
Table below demonstrates, pro forma of alternative capital structures
along with key performance indicators of concern for investors. A
decrease in earnings per share and increase in return on equity was
seen with increasing debt-to-capital ratio; and as CPK acquires debt its
cost of capital increases. So it does not make sense for CPK to take debt.
Moreover, the cost of debt is higher than the firms cost of equity,
adding debt to the business does not add value to CPK from a financial
risk perspective.
As the company changes their capital structure to incorporate
varying levels of debt, they are reducing their common shares
outstanding and equity within the company.
Proforma Tax shield effect of recapitalization scenarios (End of june 2007) (in

thousand USD)
Actual
Interest Rate
Tax rate
EBIT
Interest Expense
EBT
Income Tax
Net Income

10% Debt-to 20% Debt30% DebtCapital


to Capital
to Capital
6.16%
6.16%
6.16%
6.16%
32.50%
30054
0

32.50%
30054
1391

32.50%
30054
2783

32.50%
30054
4174

30054
9768
20286

28663
9315
19347

27271
8863
18408

25880
8411
17469

0
225888
225888

22589
203299
225888

45178
180710
225888

67766
158122
225888

0
643773

22589
628516
0.036

45178
613259
0.074

67766
598002
0.113

643773
22.1

651105
22.36

658437
22.64

665768
22.94

1022118

2044235

3066353

29130000
0.70
8.98%
8.42%

28107882
0.69
9.52%
8.26%

27085765
0.68
10.19%
8.10%

26063647
0.67
11.05%
7.92%

Book Value
Debt
Owner Equity
Total Capital
Market Value
Debt
Equity
D/E Ratio
Market Value of
Capital
Share Price Unit
No. of Shares
Purchased
Common Shares
Outstanding
Earnings Per share
Return on Equity
WACC

Conclusion:
As per the calculations, if the company goes for any repurchase of
shares by taking debt of 10%,20% and 30% respectively their WACC will
reduce to 8.26%, 8.1% and 7.92% respectively although EPS will reduce
from 0.7 to 0.67. But, there is no significant change in the share price of
the company.
Hence the company can take debt for expansion plans, as the growth
rate positive. But it is not advisable to repurchase shares by debt
financing.