California Pizza Kitchen Case Study

Taylor Callaway

Mary Katherine Hall

John Hyland

Patrick Williford

California Pizza Kitchen Case Study

Susan Collyns, the California Pizza Kitchen (CPK) Chief Financial Officer, has been faced with many decisions to make in 2007, as the restaurant industry is facing much uncertainty.  Macroeconomic factors have resulted in increasing commodity prices, which has led to menu price increases, higher labor costs,  and a weakening demand for dining out as the average consumer has less to spend. Subsequently, the company’s stock price has taken a 10% hit despite their strong performance.  Management has viewed this as an opportunity to repurchase stock, as they believe that their stock price is currently undervalued.  In order to repurchase shares, CPK must take out a certain level of debt.

                Our financial analysis takes into account three possible debt structures: 10% Debt/Total Book Capital, 20% Debt/Total Book Capital, and 30% Debt/Total Book Capital.  The three debt financing options provide different alternatives to multiple metrics of CPK’s financial situation. Were CPK to adjust their debt/total book capital to 10%, their share price would increase to $22.35 allowing them to repurchase $1,010,602 worth of common stock. The EPS of CPK stock would drop to $.69 while the P/E ratio would increase to $32.47. The ROE of the stock would increase to 9.52% and the WACC would decrease to 9.37%. Under scenario two, the addition of 20% debt/total book capital would increase the share price to $22.60 and allow CPK to repurchase $1,998,669 worth of common stock. The EPS of CPK stock would drop to $.68 while the P/E ratio would increase to $33.29. The ROE of the stock would increase to 10.19% while the WACC would decrease to 9.28%. And lastly, under scenario 3 with the addition of 30% debt/total book capital, the share price of CPK would increase to $22.86 allowing the company to repurchase $2,964,903 worth of common stock. The EPS of the stock would decrease to $.67 while the P/E ratio would increase to $34.21. The ROE of the stock would increase to 11.05% and the WACC would decrease to 9.20%. As expected, the WACC for the firm decreased in accordance with higher levels of debt taken on to repurchase shares showing the advantage of tax deductibility of interest on the debt. the tax deductibility  While all of these debt financing options show positive outcomes for the firm, we decided to incorporate a 20% debt/total book capital for CPK.

Based on our analysis, we recommend that  CPK pursue 20% debt financing.  This form of financing provides an ROE of 10.19%, sitting right above the 10% hurdle rate. We calculated the cost of capital for the 20% debt financing structure to be 9.28%, which is cheaper than the 10% debt financing structure cost of capital and slightly more expensive than the 30% debt financing cost of capital . With the 20% debt financing structure, CPK will see a $0.50 share price increase, helping to create more value for its shareholders. The earnings per share for the 20% debt financing structure is slightly less than the earnings per share of the 10% debt financing structure, and slightly more than the earnings per share of the 30% debt financing structure. The earnings per share for the 20% debt financing structure is an appropriate and attractive measure as it falls in line with the repurchasing of shares through the issuance of debt.

        We feel that taking on 30% Debt/Total Book Capital is too risky at this time, given that zero debt is currently on the balance sheet. CPK has been very reluctant in the past to use debt as the nature of the restaurant business is cyclical and tends to move with the economy. History has shown that small changes in economic factors, such as gas prices or increasing labor wages for example, have an effect on the food industry and can disrupt many other realized costs and prices within the industry. This is one of the reasons the restaurant industry is not heavily levered at any point so financing decisions such as debt issuances play a large role in the long-term success of companies in this industry. The repurchase of shares with 20% debt financing will allow the company to stay well within the range of their existing $75 million line of credit allowing the company to use excess amounts of capital in other ventures such as strengthening their brand and incorporating new items to the menu. While comparing CPK to other companies in the industry, we wanted to take a conservative stance by not being on the low end or the high end in terms of debt capacity while taking other financial factors into consideration such as EPS, P/E Ratio, and ROE.

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