CASE STUDY ANALYSIS: CALIFORNIA PIZZA KITCHEN 1

Case study analysis: 33

California Pizza Kitchen

Managing for Corporate Value Creation FIN3CSFS2 2015

CASE STUDY ANALYSIS: CALIFORNIA PIZZA KITCHEN 2

Abstract:

This case analysis studies the financial performance and position of California Pizza

Kitchen (KPC) including available sources of finance with optimal weightage to cost of capital

minimal by share repurchase and their effect on share price and return.

Question No. 1

As the history of California Pizza Kitchen (KPC) is concerned, it was incorporated in

1985 In Baverlly Hills, California. By mid of 2007, it was expanded with 213 retail outlets round

the US and outside the country as well. Currently, CPK is operating fully owned outlets; some

with partnerships and rest are operating as franchises. Also these are the main source of income.

At the start of he July 2007, CPK observed profit over $6 million with revenue growth up to 5%,

performed far better than its competitors however, slump in share price is observed by 10% to

$22.10. Although the market is depressed but CPK’s performance seems marginally better in the

industry but appears to be undervalued.

As CPK is considering to open 16-18 new branches with closure of one branch therefore,

to finance such expansion Collyns is concerned about with most appropriate capital structure. As

the share price is depressed so change of capital structure is being considered by repurchase of

share at current market price of $22.10. The effect of share repurchase will be observed by

signals to market, can expect higher value in future by increased return on equity, reduced cost of

capital and also increase in stock price can be expected.

CASE STUDY ANALYSIS: CALIFORNIA PIZZA KITCHEN 3

Question No. 2

Return on book value of capital:

Return on Capital is 13.37% at actual leverage, 13.58% at leverage of 10% with increase

of 21bps, 13.80% at 20% with increase of 43bps and 14.04% at 30% leverage with 67bps

increase. Such increase basis points represents the rise in expectation of return rate of investor.

Return on book value of equity:

Based on Book value Return on Equity (ROE) is approximately 9% with actual results.

Such return is 9.52% at 10% leverage, 10.19% at 20% leverage and 11.05% at 30% leverage.

Actual 10% Leverage 20% Leverage 30% Leverage

Net Income: 20,299 19,3599 18,419 17,480

Total Capital 225,888 203,299 180,710 158,122

Return on Equity: 8.99% 9.52% 10.19% 11.05%

Question No. 3

The cost of Equity Capital represents the expected return of equity investors.

The WACC is measured by taking the weight of debt outstanding and multiplying it by the cost

of debt and the tax shield, then adding to that the weight of equity and multiplying that by the

cost of equity, as shown in the following equation:

Equation 1: [D/V*(Rd)*(1-T)+E/B*(Rd)]
CASE STUDY ANALYSIS: CALIFORNIA PIZZA KITCHEN 4

As the WACC holds true, the increased weight in the lower cost of debt along with the additional

tax shield and the decrease in weight in the higher cost of equity will result in a decrease in the

overall cost of equity to the firm. In theory the more debt you add to the capital structure the

lower your WACC will be

Cost of Equity:

Using the formula given, cost of equity can be calculated as:

At actual:

Leveraged beta is computed as:

0.85 * [1+(1-32.5%)0/643,773 = 0.85

Using Capital Asset Pricing Model (CAMP) Cos of Equity is: 0.052 + 0.85(0.05) = 9.45%

At 10% Leverage:

Leverage beta is:

0.85 * [1+(1-32.5%)22,589/628,516 = 0.87

Therefore, using CAPM Cost of Equity is : 0.052 + 0.87(0.05) = 9.55%

At20% Leverage:

Leverage beta is:

0.85 * [1+(1-32.5%)45,178/613,259 = 0.89

Therefore, using CAPM Cost of Equity is : 0.052 + 0.89(0.05) = 9.65%

At 30% Leverage:

Leverage beta is:

0.85 * [1+(1-32.5%)67,766/659,002 = 0.15

Therefore, using CAPM Cost of Equity is : 0.052 + 0.915(0.05) = 9.78%

CASE STUDY ANALYSIS: CALIFORNIA PIZZA KITCHEN 5

WACC:

At zero debt

9.45% = 9.45 (100%) + 6.16%(0%)

At 10% debt

9.2% = 9.55% (90%) + 6.16%(10%)

At 20% debt

8.95% = 9.65% (80%) + 6.16%(20%)

At 30% debt

8.69% = 9.78% (70%) + 6.16%(30%)

Question Number 4

With this computation we compute the market price per share at different level of

shares and effect on number of shares at 10%, 20% and 30% level of leverage after making

repurchase.

Actual 10% 20% Leverage 30% Leverage

Leverage

Market Value of Capital 643,773 651,105 658,437 665,769

Number of Shares: 29.13 m 29.13 m 29.13 m 29.13 m

Market Value Per Share 22.10 22.35 22.60 22.85

Debt 0 22.589 M 45.178 M 67.766 M

Shares to be 0 1.010 M 1.999 M 2.965 M

repurchased
CASE STUDY ANALYSIS: CALIFORNIA PIZZA KITCHEN 6

Using a 10% debt to total capital structure will drive the price of our stock up to $22.35, a

1.13% increase and will allow us to buy back 1,011,000 shares, a 3.47% decrease in shares. A

20% debt to total capital structure will move our price to $22.60, a 2.26% increase and 1,999,000

shares to be bought back, a 6.68% decrease. Finally, a 30% debt to total capital structure will

jump our stock price to $22.86, a 2.99% increase and allow us to repurchase 2,965,000 shares, a

10.18% decrease in shares.

Question Number 5

As debt is used to finance the repurchase of equity therefore, as the number of shares

reduces, debt is issued more. Because issuing debt is cheaper than equity and also the interest is

tax deductible expense, for that reason return would increased and such return would be spread

out reduced number of shares resulting increase of Return on Equity (ROC). Similar effect

would be on Earning per share as because tax shield available to tax expense. Such indicators

will ultimately increase the value of firma and reduce cost of capital.

Conclusion:

In conclusion, California Pizza Kitchen in considering to change its capital structure by

repurchasing its shares which are financed by issuing debt. This incorporates the tax shield ,

which increase tax deductible expense, increase return, reduce cost of capital, increase share

price and EPS and the value of company.