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California Kitchen Case Study
California Kitchen Case Study
WACC
WACC=WeRe+Wdrd
CPK's WACC
5.55
5.5
5.45
5.4
5.35
5.3
5.25
5.2
5.15
5.1
5.05
WACC %
10%
30%
Because the cost of debt is higher than the firms unlevered cost of capital and
their cost of equity, adding debt to the business does not add value to California Pizza
from a cost of capital perspective.
Return on Equity
The Return on Equity is rising as the firm takes on more debt, becoming more
leveraged. This is true as interest payments to creditors are tax deductible and therefore
the company is able to generate a higher return on fewer shares outstanding because of
the repurchase. The result is that a higher proportion of debt in the firm's capital structure
leads to higher ROE as earnings are spread over a reduced amount of equity.
Share Price
Share Price=
Equity
Shares Outsanding
PV =
V L =V U +TD
0% Debt
Share Price = E/CSO
Share Price = 643 773 000/29 130 000
Share Price = 22.10$
10% Debt
Share Price = E/CSO
Share Price = 628 516 000/28 108 000
Share Price = 22.36$
20% Debt
Share Price = E/CSO
Share Price = 613 259 000/27 086 000
Share Price = 22.64$
30% Debt
Share Price = E/CSO
Share Price = 598 002 000/26 064 000
Share Price = 22.94$
The share price of the firms stock rises as it increases its debt. Share price being
determined by the Total Market Value of Equity divided by the current number of shares
outstanding. As the firm increases its leverage, it buys back shares, as well as reduces its
equity. The rate that equity decreases is smaller than that of shares being bought back,
thus causing an increase in share price.
Shares Outstanding
Shares outstanding decrease as the firm takes on more debt. The reason being is
that the firm buys back shares with the newly acquired cash from issuing debt.
By leveraging their company, California Pizza Kitchen adds value to their Total
Market Value of Capital. They also increase their share price. It should be considered that
as they increase their debt to equity ratio, they also increase their risk of default.
Breakeven levels of EBIT for each scenario
No Leverage
Debt
Equity
Total Capital
Interest on Debt
0
225888
225888
0
CSO
CSOU/CSOL
Breakeven EBIT
29130
n/a
n/a
10%
EBIT/CSOU=(EBIT-i)/CSOL
EBIT=(CSOU/CSOL)(EBIT-i)
EBIT=1.036(EBIT-i)
EBIT=1.036(EBIT-1391)
-.036EBIT= -1446
10%
22589
203299
225888
1391
20%
45178
180710
225888
2783
30%
67766
158122
225888
4174
28108
1.036
$40,166.67
27086
1.075
$37,106.67
26064
1.118
$35,373.00
20%
EBIT/CSOU=(EBIT-i)/CSOL
EBIT=(CSOU/CSOL)
(EBIT-i)
EBIT=(1.075)(EBIT-i)
EBIT=1.075(EBIT-2783)
-.075EBIT=-2783
$40,166.67
$37,106.67
30%
EBIT/CSOU=(EBIT-i)/CSOL
EBIT=(CSOU/CSOL)(EBIT-i)
EBIT=(1.118)(EBIT-i)
EBIT=1.118(EBIT-4174)
-.118=-4174
$35,373.00
The results from the breakeven EBIT analysis are calculated to current market
conditions. The market has equities; in particular, California Pizza priced its prices at
very high valuations. This is exhibited by California Pizzas price/earnings ratio of 31.9.
Because of this lofty valuation, if California Pizza is going to repurchase shares at the
current market price of $22.10, it will be costly to investors. It will be especially
expensive to investors to buy back shares if California Pizza using debt because their cost
of debt is higher than their cost of equity.
California Pizza has decreasing break even EBITs because the numerator (interest
expense) is expanding with each scenario of debt financed stock repurchases. Because the
cost of debt is higher than the cost of equity, the breakeven EBIT is decreasing with each
increased debt scenario.
What happens to ROE and EPS if?
As the company changes their capital structure to incorporate varying levels of
debt, they are reducing their common shares outstanding and equity within the company.
In all three cases, ROE continues to rise as more debt is added in. When EBIT is at a
point that is above the Break-even point, ROE increases at a much larger rate, compared
to if EBIT is below the Break-even point. As seen under the 100% EBIT chart, ROE
increases at a much higher rate than compared to the 50% reduced EBIT tables, which is
below the break-even EBIT.
Current EBIT
EBIT
Interest
Actual
30,054
0
10%
30,054
1,391
20%
30,054
2,783
30%
30,054
4,174
Taxes
9,755
9,303
8,852
8,400
NI
ROE
EPS
Because the repurchase cost of shares is so high, the number
20,229
8.99%
$0.69
19,360
9.52%
$0.69
18,419 17,480
10.19% 11.05%
$0.68
$0.67
Actual
15,027
10%
15,027
20%
15,027
30%
15,027
1,391
2,783
4,174
Taxes
4,877
4,426
3,974
3,523
NI
ROE
10,150
4.49%
9,210
4.53%
8,270
4.58%
7,330
4.64%
EBIT
Interest
EPS
$0.35
$0.33
$0.31
$0.28
Actual
10%
20%
30%
60,108
60,108
60,108
60,108
1,391
2,783
4,174
Taxes
19,510
19,058
18,607
18,155
NI
39,658
38,718
37,779
ROE
40,598
17.97
%
EPS
$1.39
100% EBIT
EBIT
Interest
When EBIT is increased by 100%, EPS shows an increasing trend from $1.39 $1.45. EPS increases as more debt is added because it is above the break-even EBIT
point. Because we are above the EBIT breakeven point, the firm benefits from the
increased leverage which raises the EPS as more debt is added.
Conclusion & Recommendations
$1.43
$1.45
In conclusion, it is the analysts recommendation that California Pizza Kitchen change its
capital structure by issuing debt and repurchasing shares. This instates a tax shield, which
reduces taxable income, increases the value of the company, and in turn increases the
return to shareholders. Subsequently allowing earnings to be spread out over fewer shares
and as the market increases, shareholders will have greater ROE and EPS.