VIETNAM NATIONAL UNIVERSITY – HO CHI MINH CITY

INTERNATIONAL UNIVERSITY
SCHOOL OF BUSINESS

Group Assignment – California Pizza Kitchen

Vũ Thụy Hải Đăng – BABAIU18031
Nguyễn Xuân Huy – BABAIU18065
Nguyễn Thị Mỹ Duyên – BAFNIU18290
Lê Gia Khánh – BABAIU18076
BA054IU
CORPORATE FINANCE
Trinh Thu Nga
May 31, 2021
 I. The situation of California Pizza Kitchen and Susan Collyns’s decisions.

California Pizza Kitchen started its first restaurant in 1985 in Beverly Hills, California. Until
the end of the second quarter of 2007, the company had expanded its operation to 213 locations
in 28 states and 6 foreign countries while still being very California-centric. Management
believed its success in growing both domestically and internationally was due in large part to its
“dedication to guest satisfaction, menu innovation and sustainable culture of service. Moreover,
it was also pointed out that its average check of $13.30 was below that of many of its upscale
dining casual peers.

The company derived its revenues from three sources: sales at company-owned restaurants,
royalties from franchised restaurants, and royalties from a partnership with Kraft Foods to sell
CPK-branded frozen pizzas in grocery stores. In recent years, the restaurant industry had to
face several challenges of increasing commodity prices, higher labor costs, softening demand
due to high gas prices, deteriorating housing wealth, and intense interest in the industry by
activist shareholders. Despite all these difficulties, CPK’s performance was remarkably
impressive compared with many other casual dining firms with sharp declines in customer
traffic and sales and earnings growth. For the second quarter of 2007, CPK’s revenues
increased more than 16% to $159 million, royalties from the Kraft partnership and international
franchises were up 37% and 21% respectively. Enhancements in restaurant operations also
helped the company achieve cost improvements. In July 2007, CPK announced its near-record
quarterly profits of over $6 million, which was explained by strong revenue growth with
comparable restaurant sales up over 5%.

However, CPK was dealing with a drop of 10% in share price to a value of $22.10, making the
company’s market capitalization stood at $644 million. As the stock price reflected the
company’s financial health, under this scenario, Susan Collyns and the management team had
to face the capital structure decisions of whether this was an ideal time to repurchase shares and
potentially leverage the company’s balance sheet with ample borrowings available on its
existing line of credit. As CPK has little money in excess cash, repurchasing a large amount of
shares would require the company to use debt financing (or leverage). On one hand, leverage
would help the company benefit from reducing the corporate income-tax liability, which had

2
been almost $ million in 2006, increasing the firm value, and if it is successful, expanding
earning per share and return on equity. On the other hand, because CPK used the proceeds from
its 2000 initial public offering to pay off its outstanding debt, the company completely avoided
debt financing. CPK’s financial policy was conservative to take on debt as a strong balance
sheet would maintain the borrowing ability to support its expected expansion. Moderately
levering up equity would help CPK, especially when the interest rate had been on the rise from
historical lows. Collyns and the management team were aware of the tradeoff and that any use
of financing to return capital to shareholders needed to be balanced with management’s goal of
growing the business.

II. The effects of debt on California Pizza Kitchen.

Debt/Total Capital

Actual 10% 20% 30%

Interest rate (1) 6,16% 6,16% 6,16% 6,16%

Tax rate 32,5% 32,5% 32,5% 32,5%

Earnings before income taxes and 30.054 30.054 30.054 30.054

interest(2)

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

3
   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:

Debt(3) 0 22.589 45.178 67.766

Equity(4) 643.773 628.516 613.259 598.002

  Market value of capital 643.773 651.105 658.437 665.769

1. Return on equity
Net Income
ROE=
Equity

Debt/Total Capital

Actual 10% 20% 30%

  Net income 20.299 19.359 18.419 17.480

Equity 225.888 203.299 180.710 158.122

4
 Return on 8,99% 9,52% 10,19% 11,05%
equity

Return on equity ratio measures the rate of return that the stock owners receive on their
shareholdings. The original ROE was 8,99%, which means for every $1 invested, the
shareholders will receive $0.0899. When CPK uses 10% debt to capital ratio refinancing, there
is an increase in interest expense that leads to a 4.63% drop in net income (from $20299 to
$19359) and a decrease of 10% in equity. Therefore, ROE ratio increases to 9.52%. Similarly,
when Debt/Capital is 20% and 30%, ROE are 10.19% and 11.05% respectively.

2. Price per share

Market value
Price per share=
Share Outstanding

Debt/Total Capital

Actual 10% 20% 30%

Market value of capital 643.773 651.105 658.437 665.769

Current number of shares outstanding 29.130 29.130 29.130 29.130

(thousand shares)

Price per share $22,10 $22,35 $22,60 $22,86

As the market value of the firm increases when the company uses more debt financing while
the current number of shares outstanding remains unchanged, price per share increases. The
price per share of 10%, 20%, and 30% debt to capital ratio financing are $22.35, $22.60, and
$22.86 respectively.
3. Shares repurchased and Share outstanding
Debt
Shares repurchased=
Share price
Shares outstanding=Initial share outstanding−Shares repurchased

5
 Debt/Total Capital

Actual 10% 20% 30%

Debt(3) 0 22.589 45.178 67.766

Price per share $22,10 $22,35 $22,60 $22,86

Shares repurchased (thousand 0 1.011 1.999 2.965

shares)

Shares outstanding (thousand shares) 29.130 28.119 27.131 26.165

Number of shares repurchased is determined by dividing debt by the share price. The more debt
is used, the more shares the company repurchases.
4. Earnings per share
Net Income
Earnings per share=
Shares Outstanding

Debt/Total Capital

Actual 10% 20% 30%

  Net income 20.299 19.359 18.419 17.480

Shares outstanding (thousand shares) 29.130 28.119 27.131 26.165

Earnings per share 0,70 0,69 0,68 0,67

Earnings per share is an important financial measure, which indicates the profitability of a
company. As CPK used more debt, EPS slightly decreases.
5. Price to earnings ratio

6
 Price per share
Price ¿ earnings ratio=
Earnings per share

Debt/Total Capital

Actual 10% 20% 30%

Price per share $22,10 $22,35 $22,60 $22,86

Earnings per share 0,70 0,69 0,68 0,67

Price to earnings ratio $31,71 $32,47 $33,29 $34,21

The actual P/E ratio of the company was $31.71, which means shareholders are willing to
invest $31.71 for $1 earning from the company. When CPK uses 10% debt to capital ratio,
price per share increased by $0.25 and earnings per share decreases by $0.01. Therefore, P/E
ratio grows to $32.47. Similarly, P/E ratios for 20% and 30% debt/capital financing are $33.29
and $34.21 respectively.
6. Beta (in a world with corporate taxes and riskless debt)
D
β L =[1+ ( 1−T ) × ]× βU
E

Debt/Total Capital

Actual 10% 20% 30%

Tax rate 32,5% 32,5% 32,5% 32,5%

Debt 0 22.589 45.178 67.766

Equity 225.888 203.299 180.710 158.122

Debt/Equity 0,00 0,04 0,07 0,11

Beta without 0,85 0,85 0,85 0,85

7
 leverage

Beta with leverage 0,85 0,87 0,89 0,92

Beta measures the risk of a firm with debt and equity in its capital structure to the volatility of
the market. The higher beta, the more risk the firm has to bear. When using no debt, the firm’s
beta is 0.85. However, as the firm use more debt, the beta increases (to 0.87, 0.89 and 0.92
respectively), and CPK deals with more risk.
7. Cost of equity
R E=R F + Market risk premium× β

Debt/Total Capital

Actual 10% 20% 30%

R F (long-term government bond yield – 30

years) 5,20% 5,20% 5,20% 5,20%

Market risk premium 5% 5% 5% 5%

Beta with leverage (β) 0,85 0,87 0,89 0,92

Cost of equity ( R E) 9,45% 9,55% 9,66% 9,78%

Risk-free rate is determined by the long-term government bond-yield of 30 years.

Cost of equity indicates the compensation the market demands in exchange for owing the asset
and bearing the risk of ownership. Initially, as the company chooses to use all-equity financing
and bear less risk, the cost of equity is only 9.45%. When the company uses more debt, the
beta, which measures the risk, increases. This results in a rise in cost of equity. Then
debt/capital ratio is 10%, 20%, and 30%, the cost of equity is 9.55%, 9.66%, 9.78%
respectively.
8. Weighted average cost of capital (WACC)

8
 E D
WACC= × RE+ × R D ×(1−T )
E+ D E +D

Actual 10% 20% 30%

Tax rate (T) 32,5% 32,5% 32,5% 32,5%

Debt (D) 0 22.589 45.178 67.766

Equity (E) 225.888 203.299 180.710 158.122

E
E+ D 1,00 0,90 0,80 0,70

D
E+ D 0,00 0,10 0,20 0,30

Cost of equity (
RE ¿ 9,45% 9,55% 9,66% 9,78%

Cost of debt ( R D ) 6,16% 6,16% 6,16% 6,16%

WACC 9,45% 9,37% 9,28% 9,20%

WACC is the average after-tax cost of a company’s various capital sources. It is the average
rate a company expects to pay to finance its assets and it gives insight into how much interest a
company owes for each dollar it finances. The original WACC equals to its cost of equity since
the company does not use any debt. For $1 it finances, it has to pay $0.0945 interest. However,
when the company uses debt, the WACC decreases because cost of debt is lower than cost of
equity. When Debt/Capital is 10%, for every $1 invested, the company pays $0.0937 interest.
Similarly, the interests CPK pays for 20% and 30% debt/capital financing are $0.0928 and
$0.0920. The more debt is used, the higher the value of the company.
Conclusion:

9
For many companies, debt is considered a liability that they owe to their creditors and there is
always an ongoing concern to repay it. But yet there are certain advantages carried by acquiring
debt for a company. The same is applicable for CPK, as they will be able to benefit from the
taxation that occurs when financing a debt. Taxation implication on debt differs from the one
on equity. Leveraging CPK will allow them to achieve lower tax rate, since the lower taxable
income; lower the tax paid. Moreover, this will be reflected on the company's market value as
the tax shield raises market value by saving a company's cash flow. Another benefit for CPK
will be the rise in ROE that would occur due to the greater proportion of debt compared to
equity. But due to the tax shield, income will not be affected greatly. According to the ROE
formula; net income/shareholders equity, when equity decreases in a greater proportion to the
net income, ROE tends to rise. This also adds value to the company. Since CPK is facing a
decline in their stock price due to undervaluation of its stocks, they could repurchase it via the
debt. By this CPK will be able to affect the impact of their stocks price and can raise their value
again. Debt inquiry will not only benefit CPK, but their shareholders as well, as they will be
able to attain greater income due to the tax shield. 

III. Recommended measurements for CPK

As an aim to improve the company value, CPK should apply financial leverage to smoothen its
operations. According to the available financial information, it is most suitable for CPK to
either finance their debt at 20% or 30%. Since CPK did not acquire debt earlier, it is considered
risky for them, but the benefits that will arise from it are greater than not having debt at all.
Greater returns are forecasted when obtaining debt. Moreover, this time is considered ideal for
CPK debt acquisition, as positive prospects are assured from the outperformed benchmarking
and the steady growth rate the past 4 years in sales, net operating income and net income.
Although we mentioned earlier that there is a slight benefit of repurchasing their stock; as it
will raise its value, it is not considered an investment to the firm. However, 30% debt financing
is not the best possible option. Since there is a limit to debt capacity, the firm should save up
debt for future expansions by lowering the amount of debt to less than 30%.

In case of a repurchase of stocks, the company will only need to refinance with 20% of the
debt, in order to not exceed their credit line of 75 million dollars. The rest of the money could

10
be used in other aspects of the company to improve and innovate their products. As mentioned
above, moderately levelling up equity would be more beneficial for CPK when the interest rate
had been on the rise from historical lows. What makes CPK so different from other restaurants
and keep the business doing so well are: the dedication to guest satisfaction, menu innovation
and sustainable culture of service. These are listed as intangible assets that CPK is currently
holding. We know that Debt–equity ratios vary across industries; specifically, Firms with a
high percentage of intangible assets such as research and development should have low debt.
Firms with primarily tangible assets should have higher debt. This is not to say that the
company heavily relies on intangibles, CPK currently has 213 locations which translate to a
pool of tangible assets like lands, buildings, computers, equipment and many more. This shows
that the company should put the above-mentioned intangible assets into consideration when
determining the amount of debt the company is financing. A 10% debt financing is too low of
leverage. Referring to signaling theory, profitable firms are likely to increase their leverage
because the extra interest payments will offset some of the pretax profits. Similarly, investors
will associate a low level of debt with firms that have low anticipated profits. So while leverage
enhances the company value, low level of debt (10% in this case) will instead lower the
company value. The company would be better off debt financing 20% as it is the most suitable
approach.

11