group assignment topic california pizza kitchen

The important point to note would be the change in capital structure through share buybacks at that time's market price of $22.10.. 1.2 Price per share ????? ??? ?ℎ??? = ???????? ?????

VIETNAM NATIONAL UNIVERSITY – HO CHI MINH CITY INTERNATIONAL UNIVERSITY

GROUP ASSIGNMENT

TOPIC: CALIFORNIA PIZZA KITCHEN

Course: Corporate Finance_S2_2023-2024_G01

Lecturer: Trinh Thu Nga

GROUP 4

Nguyễn Ngọc Phương Linh BAFNIU21315

Table of contents

I What is going on at CPK? What decisions does Susan Collyns face? 3

II How does debt affect CPK? 1 Calculation: 1.1 Return on equity (ROE) ……….5

1.2 Price per share ………5

1.3 Shares repurchased……….6

1.4 Shares outstanding……… 6

1.5 Earning per share (EPS) ………7

1.6 Price to earning ratio (P/E) ………8

1.7 Beta ( ) ……… 8 β 1.8 Cost of equity ( RS) ……… 9

1.9 Weighted average cost of capital (WACC) ……… 10

2 How does debt affect CPK:……… … 11

III What should Collyns recommend? ……….12

IV References:

I What is going on at CPK? What decisions does Susan Collyns face?

1 What is going on at CPK?

CPK:

California Pizza Kitchen is a restaurant service company that operates a chain of casual restaurants, with a particular focus on the premium pizza segment The company was founded on the idea of two defense attorneys in 1985 in Beverly Hills and is currently led by Susan Collyns Now that CPK is known for its oven-baked chicken pizza, the concept of "designer pizza at special prices" has blossomed California Pizza Kitchen derives its revenue at company-owned restaurants, royalties, franchises, and royalties from partnering with Kraft Foods to sell CPK-branded frozen pizzas in grocery stores CPK was currently available at 213 locations in 28 states(including about 40% of stores in California) California Pizza Kitchen's main customers tended to have a median household income of $75,000 (survey results from 2005); little impact on customers' eating habits during the period of high gas and food prices In 2007, California Pizza Kitchen had moved to franchise all-inclusive restaurants worldwide to six foreign countries.Until June 2007, CPK expanded to a total of 213 retail outlets throughout the

US and internationally with 40% of their operations being centered in California At the time, CPK was operating at wholly-owned dealerships; including partnership or operating

as a franchise, which was considered the main source of income.In the second quarter of

2007, even though the share price of the firm had dropped by 10% the previous month to the current value it is at of $22.10, CPK was performing comparatively well against its competitors Compared to BJ's Investors with a P/E of 48.9, CPK looks undervalued However, CPK was doing slightly better than the industry as a whole

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

+ 95% of restaurants fail in the first two years

+ rising commodity, labor, and energy costs

+ Strong revenue (sales up over 5%),

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

+ Sharp declines in customer traffic Despite the strong performance, industry difficulties were such that CPK’s share price had declined 10%

+ CPK’s management had avoided putting any debt on the balance sheet Financial policy was conservative to preserve what co-CEO Rick A strong balance sheet would maintain the borrowing ability needed to support CPK’s expected growth trajectory

- 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: + The company was successfully managing its two largest expense items in an

environment of rising labor and food costs

2 What decisions does Susan Collyns face?

Susan faces decisions:

Susan Collyns had some decisions to make Her two main issues were how to finance the expansion and the most appropriate capital structure for the company The important point to note would be the change in capital structure through share buybacks

at that time's market price of $22.10 The effect of the acquisition would be analyzed from the perspective of breakeven EBIT, ROE, EPS, Cost of Capital and share price It should be noticed that the cost to finance the expansion of their full-service restaurants was $85 million This was a known expense that would have to be financed by issuing equity or leveraging the company by taking out debt

II How does debt affect CPK?

1 Calculation (when CPK is unlevered, and is levered at 10%, 20%, 30%)

𝑅𝑂𝐸 = 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒

𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦

Actual

Debt/ Total capital

Book value of equity 225,888 203,299 180,17 158,122

We observed that the ROE rises with increasing debt when we calculate it This shows that even though the company developed by using more debt for operations and only slightly increasing equity as part of the growth, its return on equity (ROE) has grown because the decline

in equity, or book value, is still greater than the decline in net income

1.2 Price per share

𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 = 𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑝𝑟𝑖𝑐𝑒 + 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔𝐷𝑒𝑏𝑡 𝑥 𝑇𝑎𝑥 𝑟𝑎𝑡𝑒

Actual

Debt/Total Capital

In assessing how share buybacks affect the company, applying 10% debt to the whole capital structure would increase the stock price to $22.35, yielding a gain of 1.13% and enabling the redemption of 1,011,000 shares, which would result in a 3.47% decrease in shares By adding 20% more debt to the entire capital structure, the price would rise to $22.60, yielding a gain of 2.26% and enabling the corporation to repurchase 1,999,000 shares, reducing the overall capital

structure by $6,685 According to the numbers below, a debt-to-capital structure ratio of 30% would enable the buyback of 2,965,000 shares, resulting in a 10.18% decrease in stock, and increase the share price to $22.86, a 2.99% gain

1.3 Shares repurchased

𝑆ℎ𝑎𝑟𝑒𝑠 𝑟𝑒𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑑 = 𝐷𝑒𝑏𝑡 𝑢𝑠𝑒 𝑡𝑜 𝑟𝑒𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑠ℎ𝑎𝑟𝑒𝑠𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

Actual

Debt/ Total capital

The corporation should issue a mandate for share redemption as the right course of action Should they issue $45,178,000 in debt in order to achieve a 20% debt-to-equity ratio With this money, CPK is also urged to repurchase roughly 1,999,000 shares Their shareholders will be happy as a result of the 2.26% increase in share price This threshold was selected because it clearly benefits shareholders and carries a moderate level of stockholder risk While a 30% debt ratio throughout the capital structure is better for shareholders, the organization is taking on too much risk

1.4 Shares outstanding

𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 = 𝑀𝑎𝑟𝑘𝑒𝑡𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

Actual

Debt/ Total capital

Market value of equity 643,773 628,516 613,259 598,002

𝐸𝑃𝑆 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑎𝑓𝑡𝑒𝑟 𝑟𝑒𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑑𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒

Actual

Debt/Total Capital

Shares outstanding 29,130 28,119 27,131 26,165

A stock's rate of return or market projection is represented by its earnings per share (EPS) The figures show that an increase in the earnings per share ratio may result in a rise in the price of CPK's shares However, since EPS is subject to outside variables and hence has minimal bearing on investing choices, a lot of investors decide not to consider it

1.6 Price to earning ratio (P/E):

𝑃/𝐸 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

Actual

Debt/Total Capital

More investors are ready to pay for every dollar of current profits, as measured by the price-to-earnings ratio (P/E); higher PEs are typically seen as suggesting that a CPK has substantial potential for future growth When examining a company's PE ratio, it's important to keep in mind that if earnings were low or non-existent, the ratio would be higher Consequently, the risk of the corporation is negatively correlated with the PE ratio

1.7 Beta:

𝐵𝑒𝑡𝑎 = β × [1 + (1 − 𝑇 ) ×𝑢 𝑐 𝐷𝐸]

Where:

𝛽: Beta of Unlevered firm

D: Market value of Debt

E: Market value of Equity

𝑇: Corporate Tax rate

Actual

Debt/Total Capital

CPK has no debt, hence its beta will be the unlevered beta outlined in Exhibit 7, that is 0.85 By applying the equation mentioned above, we can calculate the levered betas (L) for debt-equity ratios of 10%, 20%, and 30%, which result in the following levered betas: 0.87, 0.89, and 0.92

1.8 Cost of equity ( R S ):

𝑅 𝑟𝑠 𝑓 β × 𝑟𝑚− 𝑟𝑓

Where:

: Risk – free rate (Usually, the Risk-free rate will be equal to the interest rate of 10-year

𝑟𝑓

government bonds)

: Market risk premium

𝑟 − 𝑟𝑚 𝑓

Debt/Total Capital

Based on the assumption that the US government is highly unlikely to default on its commitments, we can use the rate on a 30-year US government bond (June 2007) as the risk-free rate (𝑟𝑓= 5.2 percent, retrieved from Exhibit 8) for calculating the costs of equity for an American firm like CPK

To compute the betas, we will use the calculations from prior analysis Additionally, theβ market risk premium (5%) is provided in Exhibit 9's notes section By using this data in the formula, we can obtain equity costs of 9.45%, 9.55%, 9.66%, and 9.8% for debt-equity ratios of 0%, 10%, 20%, and 30%, respectively

1.9 Weighted average cost of capital (WACC)

𝑊𝐴𝐶𝐶 = (𝐷+ 𝐸𝐸 × 𝑅𝐸) + (𝐷 + 𝐸𝐷 × 𝑅𝐷 × (1 − 𝑇𝑐 ))

Where:

: Cost of debt

𝑅𝐷

: Cost of equity

𝑅𝐸

𝑇: Tax rate

D: Market value of debt

E: Market value of equity

The model assumes the same cost of equity (RS) as determined by CAPM Exhibit 9 displays the debt cost (R = 6.16%) and corporate tax rate (TD C= 32.5%)

After substituting the given values into the calculation, the weighted average cost of capital (WACC) for debt-equity ratios of 0%, 10%, 20%, and 30% is 9.45%, 9.36%, 9.27%, and 9.2%, respectively

2 How does debt affect CPK:

Many companies see debt as an obligation they have to their creditors, and they are always concerned about making repayments However, taking on debt for a corporation has some benefits Because of the interest tax shield, companies can frequently increase their earnings per share (EPS) by repurchasing shares and dramatically raising their leverage Because of this, borrowing debt is frequently less expensive than issuing equity The interest tax shield reduces taxable income when debt is used to buy back outstanding shares, which raises EPS In the same way, CPK stands to benefit from taxes incurred during loan financing Debt has different tax effects than ownership Because less taxable income equates to less tax paid, utilizing CPK will enable them to achieve a lower tax rate Moreover, a tax shield raises market value by decreasing

a company's cash flow, therefore this will also show up in the market value of the business An additional benefit that CPK will see is a rise in ROE due to the increased debt to equity ratio

However, income won't be greatly impacted because of the tax benefit The ROE formula states that when net income/shareholders equity decreases more than net income, ROE increases Additionally, this adds value to the organization Loans may be used to repurchase CPK's stock because its stock price is dropping due to undervaluation As a result, CPK will have more control over the direction of their stock price and increase in value Not only would the debt inquiry help CPK, but its owners will also gain from it because of the tax shield, which will increase their earnings

III What should Collyns recommend?

With 30% debt, California Pizza Kitchen (CPK) gains from the use of financial leverage

by generating value for shareholders and raising the company's total worth Through a share repurchase program, this calculated move aims to strengthen the company's financial position, boost return on equity, and raise the stock price to $22.86 Even though CPK has never used debt before, choosing to use leverage seems less risky

The company's profits have been rising steadily over the last four years, which is compelling evidence in favor of debt buybacks Nonetheless, using debt excessively can raise risks, particularly in light of CPK's current $75 million credit limit and its $85 million growth plan

In short, debt financing can truly assist CPK in increasing shareholder capital and strengthening its financial position But with their expansion goals and existing debt, they must exercise caution in avoiding taking on too much debt Making well-informed decisions requires balancing these financial considerations With the recent strong performance and steady growth

of the major indexes over the past few years, it appears prudent to opt for a 30% debt setup as it reduces risk In this manner, they can reap the rewards of higher profits while retaining control

by making the necessary capital additions when needed

● Benefit of interest tax shield (Last updated Feb 15, 2024)- Step-by-Step Guide to

Understanding the Interest Tax Shield

https://www.wallstreetprep.com/knowledge/interest-tax-shield/#:~:text=The%20Interest% 20Tax%20Shield%20refers,having%20debt%20and%20interest%20expense.

● Process capital – What is CPK? (July 2021)

https://sixsigmastudyguide.com/process-capability-cp-cpk/

● Benefit of financial leverage – Linkedin

https://www.linkedin.com/pulse/power-financial-leverage-unlocking-growth-maximizing-returns/

● Advantages and Disadvantages of Debt Financing

https://www.lightspeedhq.com/blog/advantages-of-debt-financing/

● Benefit of debt buybacks

https://www.investopedia.com/ask/answers/040815/what-situations-does-it-benefit-compa ny-buy-back-outstanding-shares.asp

● Textbook Ross, S.A., Westerfield, R.W and Jaffe, J (2013) Corporate Finance 10th edition McGraw-Hill Irwin

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