Case #33

California Pizza Kitchen


Synopsis and Objectives

This case examines the question oI Iinancial leverage at CaliIornia Pizza Kitchen (CPK) in July
2007. With a highly proIitable business and an aversion to debt, CPK management is considering a
debt-Iinanced stock buyback program. The case is intended to provide an introduction to the
Modigliani-Miller capital structure irrelevance propositions and the concept oI debt tax shields.
With the background oI a pizza company, the case provides an engaging context to discuss the
'pizza graphs¨ that are commonly used in corporate Iinance curriculum to illustrate the wealth
eIIects oI capital structure decisions.

Objectives:

O ntroduce the Modigliani-Miller intuition oI capital structure irrelevance;
O stablish how the cost oI equity is aIIected by capital structure decisions by deIining
Iinancial risk and introducing the levered-beta capital asset pricing model (CAPM) equation;
O iscuss interest tax deductibility and the valuation tax shields;
O xplore the importance oI debt capacity in a growing business.

Suggested Questions

1. n what ways can Susan Collyns Iacilitate the success oI CPK?
2. Using the scenarios in case xhibit 9, what role does leverage play in aIIecting the return
on equity (RO) Ior CPK? What about the cost oI capital? n assessing the eIIect oI
leverage on the cost oI capital, you may assume that a Iirm`s CAPM beta can be modeled
in the Iollowing manner: .

÷ .
&
1 ¹ (1 %)/|, where .
&
is the Iirm`s beta without
leverage, % is the corporate income tax rate, is the market value oI debt, and is the
market value oI equity.
3. ased on the analysis in case xhibit 9, what is the anticipated CPK share price under
each scenario? How many shares will CPK be likely to repurchase under each scenario?
What role does the tax deductibility oI interest play in encouraging debt Iinancing at
CPK?
4. What capital structure policy would you recommend Ior CPK?


inancial leverage and financial risk

We need to pay attention to the apparent appeal oI leverage in increasing the expected RO
oI CPK. To illustrate the point that leverage comes with additional risk, let`s adjust the earnings
beIore interest and taxes (T) line oI case xhibit 9 by a certain amount both up and down. n the
Iirst round, the T line can be multiplied by a Iactor oI 1. n this case, the no-leverage RO
drops to 18°, while the high-leverage RO drops even more to 29°. Alternatively, iI the T
line is multiplied by a Iactor oI 2, the no-leverage RO rises to ¹22°, while the high-leverage RO
increases even more to ¹30°. We should quickly see the magniIying eIIect oI leverage on the risk
oI equity returns.

So should equity investors be happy with the same level oI return Ior a much higher risk?
Leverage is simply a way oI slicing up the business risk. Since the weighted average cost oI capital
(WACC) reIlects the total risk, the WACC should not change with simply slicing up the risk across
various types oI contracts. The total risk is unadjusted. To demonstrate this point with the case
example, we must alter the beta Iormula in the questions to remove the portion oI risk that the
government bears in the tax shield. This revised Iormula is .

÷ .
&
1 ¹ /|.





CALIORNIA PIZZA KITCHEN
pilogue


Over the month oI July, CPK repurchased $16.8 million oI company shares. The
repurchase was Iunded with the company`s line oI credit such that the company`s outstanding
borrowings stood at $17 million by the end oI the summer. n early 2008, the company
announced its intention to repurchase an additional $46.3 million shares. The company planned
to Iund the new program with borrowings under an expanded credit line and available cash
balances. Co-COs RosenIield and Flax remarked,

Management and our oard are conIident about the strength and long-term
prospects oI our Company. The share repurchase agreement|, in conjunction with
our expanded credit Iacility, is an eIIective way Ior us to return capital to
stockholders, leverage our balance sheet, and reduce our overall cost oI capital.


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