How does debt affect CPK?

To answer this question, we involve the calculations on the following variables when CPK is
unlevered, and is levered at 10%, 20% and 30%:
 Return on equity (ROE)
 Price per share
 Shares repurchased (thousand shares)
 Shares outstanding (thousand shares)
 Earnings per share
 Price to earning ratio
 Beta
 Cost of equity
 WACC

3.1 CPK FINANCIAL ANALYSIS

 Exhibit 9
CALIFORNIA PIZZA KITCHEN
Pro Forma Tax Shield Effect of Recapitalization Scenarios
(Dollars in thousands, except share data; figures based on end of June 2007)

Debt/Total Capital
Actual 10% 20% 30%

(1)
Interest rate 6.16% 6.16% 6.16% 6.16%
Tax rate 32.5% 32.5% 32.5% 32.5%

(2)
Earnings before income taxes and interest 30,054 30,054 30,054 30,054
Interest expense 0 1,391 2,783 4,174
Earnings before taxes 30,054 28,663 27,271 25,880
Income taxes 9,755 9,303 8,852 8,400
Net income 20,299 19,359 18,419 17,480

Book value:
Debt 0 22,589 45,178 67,766
Equity 225,888 203,299 180,710 158,122
Total capital 225,888 225,888 225,888 225,888

Market value:
(3)
Debt 0 22,589 45,178 67,766
(4)
Equity 643,773 628,516 613,259 598,002
Market value of capital 643,773 651,105 658,437 665,769

ROE 8.99% 9.52% 10.19% 11.05%

Price per share 22.1 22.35 22.60 22.86

Shares repurchased (thousand shares) 0 1011 1999 2965
Shares outstanding (thousand shares) 29130 28119 27131 26165
Earnings per share 0.70 0.69 0.68 0.67
Price to earning ratio 31.7 32.5 33.29 34.21

Beta 0.85 0.87 0.89 0.92

Cost of equity 9.45% 9.55% 9.66% 10%
WACC 9.45% 9.37% 9.28% 9.20%

Notes:
(1)
Interest rate of CPK's credit facility with Bank of America: LIBOR + 0.80%.
(2)
EBIT includes interest income.
(3)
Market values of debt equal book values.
(4)
Actual market values of equity equals the share price ($22.10) multiplied by the current number of shares outstanding (29.13 million).
Case Study Assumptions:
1.     This case introduces the Modigiani-Miller capital structure irrelevance propositions and the concept of interest tax shield.
2.     To calculate CPK’s WACC, utilize the CAPM model to calculate cost of equity.
3.     CPK’s Beta can be modeled using the following formula:
beta L = beta U [1 + (1 − T)D/E]
i.       beta L = CPK’s Beta with leverage
ii.      beta U = CPK’s Beta without leverage
iii.    T = Corporate Tax Rate
iv.     D = Market value of Debt
v.     E = Market value of Equity
4.     Market risk premium = 5%

Source: Case writer analysis based on CPK financial data.

3.2. CALCULATIONS

 Return on equity (ROE)

Net income
ROE=
Book value of equity

 Price per share

 100% equity, no debt
Market value of equity
P 0=
Initial number of shares outstanding
 In the presence of debt, stock price then rises up by the added present value of
interest tax shield
TC × B
P=P 0+
Initial number of shares outstanding
 Shares repurchased
Market value of debt
Shares repurchased=
Share price
 Shares outstanding
Shares outstanding=Initial number of shares outstanding−Shares repurchased
 Earnings per share (EPS)
Net income
EPS=
Number of shares oustanding

 Price to earning ratio (P/E ratio)

Price per share
P/ E=
EPS
 Beta
Debt
β equity=β U (1+ ( Equity ) ( 1−T ))
c

 Cost of equity (using CAPM)

R S=R f + β equity ( Rm−R f )
 Cost of capital
S B
RWACC = × R S + × R S ×(1−T ¿¿ c )¿
V V

3.3 RECAPITALIZATION EFFECTS

 RETURN ON EQUITY
Return on equity (ROE) is a popular fundamental used in measuring the profitability of a
business as it compares the profit that a company generates in a fiscal year with the money
shareholders have invested. After all, the goal of every business is to maximize shareholder
wealth, and the ROE is the metric of return on shareholder's investment.
Using the information from Exhibit 9, the exhibit below demonstrates the effects of
increasing CPK’s debt by 10, 20, or 30 percent.
Debt/Total capital Actual  10% 20% 30%
Net income 20,299 19,359 18,419 17,480
Book value of equity 225,888 203,299 180,710 158,122

Return on Equity (ROE) 8.99% 9.52% 10.19% 11.05%

ROE
12.00%
11.05%
10.19%
10.00% 9.52%
8.99%

8.00%

6.00%

4.00%

2.00%

0.00%
0% debt 10% debt 20% debt 30% debt

Based on Modigliani and Miller’s capital structure theory, the required return on equity of a
levered firm increases linearly with its debt to equity ratio. CPK’s return on equity (ROE),
which was 10.1% for 2006, did not benefit from financial leverage. Currently, the company
pays about $10 million in taxes every year because CPK does not have any debt to claim
against their tax bill. Therefore, the unlevered return on equity is about 9%. However, adding
debt financing increases their return on equity by adding the present value of the tax shield.
This typically makes the cost of issuing debt cheaper than that of issuing equity. The interest
tax shield will reduce taxable income so that when debt is used to repurchase shares
outstanding, earnings are spread out over a reduced amount of equity. Thus, there will be a
subsequent increase in ROE.

RESULT: A recapitalization would increase the return on the CPK’s equity from 9% to
9.52%, 10.19% and 11.05% respectively.
  PRICE PER SHARE, SHARES REPURCHASED, SHARES OUTSTANDING

Despite the strong performance, industry difficulties were such that CPK’s share price had
declined 10% during the month of June to a current value of $22.10. Repurchasing shares
reduces the total number of shares outstanding. Since the market value of CPK increases due
to the present value of interest tax shield by issuing debt to repurchase shares, the reduction in
number of shares outstanding results in an increase of stock price. Moreover, when CPK
decides to repurchase shares, this signals to the investors that the stock is currently
undervalued. Thus, they may react to this by increasing the stock price. As a result, stock
price on the market goes up.

To find the price per share, we take the total market value of equity divided by the number of
shares outstanding. Actual market value of equity equals the share price ($22.10) multiplied
by the current number of shares outstanding is 29.13 million. When CPK is levered at 10%,
the market value of equity declines to 628,516 thousand. Meanwhile, the number of shares
outstanding will decline to 28.119 million as the company has already used debt financing to
repurchase shares at the price of $22.35. In the presence of debt, the stock price is added with
the present value of interest tax shield divided by the initial number of shares outstanding.

 CPK is levered at 10%

TC × B 32.5 % × 22589
P1=P0 + =$ 22.1+ =$ 22.35
Initial number of shares outstanding 29130
Market value of debt 22589
Shares repurchased= = =1011(thousand shares)
Share price 22.35
Shares outstanding=29130−1011=28119 thousand shares

 CPK is levered at 20%

TC × B 32.5 % × 45178
P2=P0 + =$ 22.1+ =$ 22.6
Initial number of shares outstanding 29130
Market value of debt 45178
Shares repurchased= = =1999(thousand shares)
Share price 22.6
Shares outstanding=29130−1999=27131thousand shares

 CPK is levered at 30%

TC × B 32.5 % × 67766
P3=P0 + =$ 22.1+ =$ 22.86
Initial number of shares outstanding 29130
Market value of debt 67766
Shares repurchased= = =2965(thousand shares)
Share price 22.86
Shares outstanding=29130−2965=26165 thousand shares
 10% 20% 30%
Actual
Leverage Leverage Leverage
Tax rate 32.5 % 32.5 % 32.5 % 32.5 %

Market value of debt 0 22,589 45,178 67,766

(dollars in thousands)
Share price $ 22.1 $ 22.35 $ 22.6 $ 22.86

Shares repurchased 0 1,011 1,999 2,965

(thousand shares)
Shares outstanding 29,310 28,119 27,131 26,165
(thousand shares)

RESULT: By adding debt to capital structure to repurchase shares, CPK increases its share
price as the number of shares outstanding in the market have decreased. The number of
shares outstanding after repurchasing decreases while the debt increases. The reason is that
the firm buys back shares with the money from issuing debt. When CPK becomes more
leverage, they add value to total market value of capital. The share price also increases. It
should be considered that as they increase their debt to equity ratio, they also increase their
risk of default.

Shares repurchased
(thousand shares)
3500
2965
3000

2500
1999
2000

1500
1011
1000

500
0
0
0% debt 10% debt 20% debt 30% debt
 Shares oustanding
(thousand shares)
29500 29130
29000
28500 28119
28000
27500 27131
27000
26500 26165
26000
25500
25000
24500
0% debt 10% debt 20% debt 30% debt

Price per share ($)

23
22.86
22.8
22.60
22.6

22.4 22.35

22.2 22.10

22

21.8

21.6
0% debt 10% debt 20% debt 30% debt

 EARNING PER SHARE

Earnings per share is one of the most important metrics employed in determining a firm's
profitability on an absolute basis. EPS is calculated by subtracting dividends paid out to
shareholders from a company's net income. The resulting value is divided by the company's
average outstanding shares. It is also a major component used to calculate the price-to-
earnings (P/E) valuation ratio, where the E in P/E refers to EPS. By dividing a company's
share price by its earnings per share, an investor can see the value of a stock in terms of how
much the market is willing to pay for each dollar of earnings.

 CPK is unlevered
Net income 20299
EPS ¿ N of shares outstanding = 29130 =$ 0.7/share
o

 CPK is levered at 10%

Net income 19359
EPS ¿ N of shares outstanding = 28119 =$ 0.69 /share
o

 CPK is levered at 20%

Net income 18419
EPS ¿ N of shares outstanding = 27131 =$ 0.68 /share
o

 CPK is levered at 30%

Net income 17480
EPS ¿ N of shares outstanding = 26165 =$ 0.67/share
o

10% 20% 30%

Actual
Leverage Leverage Leverage
Net income (dollars in thousand) 20,299 19,359 18,419 17,480
Number of shares outstanding 29,130 28,119 27,131 26,165
(thousand shares)
Net income 0.7 0.69 0.68 0.67
EPS ¿ Number of shares outstanding

Earning per share

0.70 0.70
0.70
0.69 0.69

0.69
0.68 0.68

0.68
0.67 0.67
0.67
0.66
0.66
0.65
0% debt 10% debt 20% debt 30% debt
RESULT: The EPS of CPK decreases from 0.7 to 0.69, 0.68, 0.67 as it increases its debt. By
adding debt to repurchase shares, CPK can benefit from the interest tax shield. However, the
number of shares outstanding after the repurchase is not enough to offset the additional
interest payments making for a reduction in EPS. Besides, to explain the change in EPS, we
can also use the break-even point in which the EBIT that makes EPS under current capital
structure with no debt equals to EPS under proposed capital structure with debt. If EBIT is
less than the break-even point, using debt will decrease EPS. Conversely, if EBIT is greater
than the break-even point, using debt will increase EPS.

 PRICE TO EARNING RATIO

The Price Earnings Ratio (P/E Ratio) is the relationship between a company’s stock price
and earnings per share (EPS). It is a popular ratio that gives investors a better sense of
the value of the company. The P/E ratio shows the expectations of the market and is the price
investor must pay per unit of current earnings (or future earnings, as the case may be). To
determine the P/E value, we divide the current stock price by EPS.

Actual 10% leverage 20% leverage 30% leverage

Stock price $ 22.1 $ 22.35 $ 22.6 $ 22.86
EPS 0.7 0.69 0.68 0.67
P/E ratio 31.7 32.5 33.29 34.21

P/E Ratio
34.5 34.2
34.0
33.5 33.3
33.0
32.5
32.5
32.0 31.7
31.5
31.0
30.5
30.0
0% debt 10% debt 20% debt 30% debt

RESULT: As can be seen, using additional leverage helps CPK to increase its P/E ratio as
the repurchase of shares outstanding leads to an increase in stock price and a decrease in EPS.
Besides, the use of leverage enhances the value of CPK by adding the present value of
interest tax shield. Thus, investors may have a better sense of CPK’s business performance
and higher expectations for future earnings growth as well. Therefore, they are willing to pay
more for the shares.

 BETA

When CPK has no debt in its capital structure, the stock’s risk premium consists solely of a
business risk premium. The stock’s beta therefore reflects the systematic risk inherent in its
basic business operations. With no financial leverage, this beta is its unlevered beta, β U . This
unlevered beta is the beta the CPK’s stock would have if the firm has no debt in its capital
structure. We use the unlevered beta of 0.85 stated in Exhibit 7 to determine the levered beta
β L when CPK is levered at 10%, 20% and 30% respectively. Because CPK must pay
corporate taxes, it is worthwhile to provide the relationship in a world with corporate taxes. It
can be shown that the relationship between the beta of the unlevered firm and the beta of the
levered equity is this:
D
β L =β U (1+ × ( 1−T c ) )
E

where β U is the CPK’s unlevered beta

T C is the CPK’s income tax rate

D is the market value of debt

E is the market value of equity

Actual 10% leverage 20% leverage 30% leverage

βU 0.85 0.85 0.85 0.85
Tax rate 32.5 % 32.5 % 32.5 % 32.5 %
D=¿ market value of debt 0 22,589 45,178 67,766
E¿ market value of equity 643,773 628,516 613,259 598,002
βL 0.85 0.87 0.89 0.92

RESULT: The firm’s beta leverage is 0.87, 0.89, 0.91 when debt is 10%, 20%, 30%
respectively as the firm becomes more leveraged which leads to increasing in the volatility, or
systematic risk of a security or a portfolio comparison to the market as a whole.
D
EFFECT: Because (1+ E × ( 1−T c ) ) must be more than 1 for a levered firm, it follows that
β Unlevered firm < β equity . Besides, the presence of debt in CPK’s capital structure results in additional
risk. The systematic risk inherent in the firm’s basic business operations is amplified by
financial leverage. With financial leverage, the beta on CPK’s stock reflects both business
and financial risk. Thus, the increase in beta reflects the additional systematic risk generated
by financial leverage. If a company increases its debt to the point where its levered beta is
greater than 1, the company's stock is more volatile than the market. If a company decreases
its debt to the point where its levered beta is less than 1, the company's stock is less volatile
than the market.

Beta
0.94

0.92 0.92

0.9 0.89

0.88 0.87

0.86 0.85

0.84

0.82

0.8
0% debt 10% debt 20% debt 30% debt

 COST OF EQUITY

Because equity capital typically comes from funds invested by shareholders, the cost of
equity capital is slightly more complex. While equity funds need not be repaid, there is a
level of return on investment that shareholders can reasonably expect based on the
performance of the market in general and the volatility of the stock in question. Companies
must be able to produce returns – in the form of healthy stock valuations and dividends – that
meet or exceed this level to retain shareholder investment. The capital asset pricing model
(CAPM) utilizes the risk-free rate, the risk premium of the wider market, and the beta value
of the company's stock to determine the expected rate of return or cost of equity. CAPM is
calculated according to the following formula:
Requity =R f + β equity ( R m−R f )

Actual 10% leverage 20% leverage 30% leverage

β equity 0.85 0.87 0.89 0.92
 Rf 5.2 % 5.2 % 5.2 % 5.2 %
Rm −Rf 5% 5% 5% 5%
Requity 9.45 % 9.55 % 9.66 % 10 %

The increase in cost of equity can be explained either by the increase in CPK’s beta or MM
Proposition II under corporate taxes. The presence of debt in CPK’s capital structure results
in additional risk which scales up the beta on CPK’s stock and increases the cost of equity.
Similarly, based on Modigliani and Miller’s capital structure theory, financial leverage adds
risk to the firm’s equity. Because equity (even unlevered equity) is risky, it should have an
expected return greater than that on the less risky debt. Thus, as compensation, the CPK’s
cost of equity rises when the firm takes more debt.

RESULT: When the debt is higher, it leads to the higher beta, which results in the cost of
equity from 9.45% (without debt) to 9.55%, 9.66%, 10% when CPK is levered at 10%, 20%
and 30%, respectively.

Cost of equity
9.90%

9.80% 9.78%

9.70% 9.66%

9.60% 9.55%

9.50% 9.45%

9.40%

9.30%

9.20%
0% debt 10% debt 20% debt 30% debt

 COST OF CAPITAL

The weighted average cost of capital (WACC) measures the total cost of capital to a firm.
Assuming that the cost of debt is not equal to the cost of equity capital, the WACC is altered
by a change in capital structure. The cost of equity is typically higher than the cost of debt, so
increasing equity financing usually increases WACC. We defined the weighted average cost
of capital (with corporate taxes) as follows:
 S B
RWACC = RS + R (1−T C )
VL VL B

Here
V L isthe present value of CPK after taking on debt

S isthe valueof levered equity

Bis the value of debt

R s is thereturn on equity

R B is theinterest rate ( cost of debt )

Actual 10% leverage 20% leverage 30% leverage

Market value of 643,773 628,516 613,259 598,002
equity
Market value of 0 22,589 45,178 67,766
debt
Market value of 643,773 651,105 658,437 665,769
capital
Cost of equity 9.45 % 9.55 % 9.66 % 10 %
Cost of debt 0% 6.16 % 6.16 % 6.16 %
Tax rate 32.5 % 32.5 % 32.5 % 32.5 %
Cost of capital 9.45 % 9.37 % 9.28 % 9.2 %

Cost of capital
9.50%
9.45%
9.45%
9.40%
9.37%
9.35%
9.30% 9.28%

9.25%
9.20%
9.20%
9.15%
9.10%
9.05%
0% debt 10% debt 20% debt 30% debt

Note that the cost of debt capital, R B , is multiplied by (1−T C ) because interest is tax
deductible at the corporate level. However, the cost of equity, R s, is not multiplied by this
factor because dividends are not deductible. In the no-tax case, RWACC is not affected by
leverage. However, because debt is tax-advantaged relative to equity, it can be shown that
RWACC declines with leverage in a world with corporate taxes. In the absence of debt, CPK’s
cost of capital equals to its cost of equity which is 9.45%. When CPK issues debt financial,
the cost of equity increases as financial leverage adds risk to the firm’s equity. Meanwhile,
interest payment is tax deductible. As some of the increase in equity risk and return is offset
by the interest tax shield, CPK’s cost of capital will thus decrease.

RESULT: When CPK is levered at 10%, 20% and 30%, the WACC of the firm decreases to
9.37%, 9.28% and 9.2%, respectively.

In conclusion, the financial leverage has affected several aspects, including ROE, Shares
outstanding, EPS, Price Earning Ratio, Beta, Cost of Equity and WACC. When
recapitalization, the increase of debt results in the increase of ROE, Price to Earning
Ratio, Beta and Cost of Equity. On the other hand, more debt added in the capital
structure also leads to the decline of the number of shares outstanding, EPS and
WACC.