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Case #33 California Pizza Kitchen
Case #33 California Pizza Kitchen
This case examines the question of financial leverage at California Pizza Kitchen (CPK) in July
2007. With a highly profitable business and an aversion to debt, CPK management is considering a
debt-financed stock buyback program. The case is intended to provide an introduction to the
Modigliani-Miller capital structure irrelevance propositions and the concept of debt tax shields.
With the background of a pizza company, the case provides an engaging context to discuss the
“pizza graphs” that are commonly used in corporate finance curriculum to illustrate the wealth
effects of capital structure decisions.
Objectives:
Suggested Questions
We need to pay attention to the apparent appeal of leverage in increasing the expected ROE
of CPK. To illustrate the point that leverage comes with additional risk, let’s adjust the earnings
before interest and taxes (EBIT) line of case Exhibit 9 by a certain amount both up and down. In the
first round, the EBIT line can be multiplied by a factor of −1. In this case, the no-leverage ROE
drops to −18%, while the high-leverage ROE drops even more to −29%. Alternatively, if the EBIT
line is multiplied by a factor of 2, the no-leverage ROE rises to +22%, while the high-leverage ROE
increases even more to +30%. We should quickly see the magnifying effect of leverage on the risk
of equity returns.
So should equity investors be happy with the same level of return for a much higher risk?
Leverage is simply a way of slicing up the business risk. Since the weighted average cost of capital
(WACC) reflects the total risk, the WACC should not change with simply slicing up the risk across
various types of contracts. The total risk is unadjusted. To demonstrate this point with the case
example, we must alter the beta formula in the questions to remove the portion of risk that the
government bears in the tax shield. This revised formula is L = U[1 + D/E].
Over the month of July, CPK repurchased $16.8 million of company shares. The
repurchase was funded with the company’s line of credit such that the company’s outstanding
borrowings stood at $17 million by the end of the summer. In early 2008, the company
announced its intention to repurchase an additional $46.3 million shares. The company planned
to fund the new program with borrowings under an expanded credit line and available cash
balances. Co-CEOs Rosenfield and Flax remarked,
Management and our Board are confident about the strength and long-term
prospects of our Company. The [share repurchase agreement], in conjunction with
our expanded credit facility, is an effective way for us to return capital to
stockholders, leverage our balance sheet, and reduce our overall cost of capital.