California Pizza Kitchen

Section – A
PGDM (GM)

Members:
Abhinav Sultania (G16003)
Abinash Mishra (G16005)
Amit Ashish (G16008)
Azhar Jalal Haider (G16018)
Helen Nirmala N (G16025)
Sumit Saxena (G16054)
Executive Summary:

California Pizza Kitchen (CPK) based out of Beverly Hills, California is a well-known chain of
restaurants. In 2007, CPK was about to announce a second-quarter profit of over $6
Million. The profit expansion in the quarter may have been due to the strong revenue
growth with comparable restaurant sales up over 5%. The results were as per the
company’s forecast figures. Despite the strong performance showed by the company, due
to the market conditions, its share price declined by 10% to the current value of $22.10
per share. This price drop prompted the management to discuss the re-purchase of
shares. As the company little excess cash with them, they were planning to move with
debt financing. Prior to this, the company had never taken any substantial debt. Financial
policy was conservative. CPK’s book equity was expected to be around $226 Million at the
second quarter. With the current share price, market capitalization stood at $644 Million.
The company had recently issued a 50% stock dividend, which ultimately split CPK’s shares
on a 3-for-2 basis. CPK had serviced all of its debt with the returns from the IPO in 2000.
CPK maintained borrowing capacity available under an existing $75 Million. The recent
decline in the share prices made the company to consider leveraging the company’s
balance sheet with debt on its existing line of credit. Reduction in the income –tax liability
was one of the arguments in favor of the debt financing. But company needed to preserve
its capacity to grow. A decision had to be taken while balancing the management’s goal of
growth and the return of capital to shareholders.

Case Details:
California Pizza Kitchen has been operating since 1985 predominantly in California. As of
June 2007, they had 213 retail locations in the US and abroad. Analysts have put estimates
on the potential of 500 full service locations. CPK's strategy includes the opening of 16 to
18 new locations this year including the closing of one location. CPK derived its revenue
from three major sources: sales at company owned restaurants, royalties from franchised
restaurants, and royalties from the partnerships. While the company had expanded from
its original concept with two other brands, the main focus remained on operating the 170
units of company-owned full-service restaurants. In 1996 the company came up with the
concept of ASAP outlets at airports. Sales and operation from these outlets were not
satisfactory as per the management. In 2007, the management indefinitely halted the
development of all of its ASAP centers and planned to record a consolidated expense of
$770000 in the coming quarter. At the beginning of 2007, the company had 15
international franchised locations with more openings planned. Franchising agreements
typically generated a revenue of $50000 to $65000 for each location and 5% of sales
growth. While other businesses of the sector saw weakening sales and earnings growth,
CPK’s revenue increased by 16% to $159 Million in the second quarter of 2007. Royalties
increased from partnerships and franchises by 37% and 21% respectively. CPK’s growth
plans required a capital expenditure of $85 Million. The company had successfully
managed the rising labor costs and food costs. Labor costs were kept in control from
36.6% to 36.3% of total revenues in the second quarter of 2007. The company had
implemented many initiatives to deal with the commodity price pressures.

Performing comparatively well against its competitors, CPK's stock has been depressed
recently falling to $22.10 in June making their P/E equal to 31.9 time current earnings. In
comparison with BJ's Restaurants with a P/E of 48.9, CPK appears undervalued. CPK's
direct competitor, BJ's pays no dividend and has a similar beta and therefore it makes for
a good comparative company. Despite uncertainty in the industry and general poor
performance among competitors, CPK is performing marginally better than the overall
industry.

Calculation of Cost of Debt:

Cost of debt is estimated based on following expression,

r d =LIBOR +0.80 %

Where,

LIBOR=5.36 %, so r d =6.16 %

Calculation of Levered Beta (β) for Recapitalization Scenarios Market Value Weight:

CPK unlevered beta for 0% debt to capital ratio is given as 0.85. Levered beta for the three
recapitalization scenarios of 10% debt-to-capital ratio, 20% debt-to-capital ratio, and 30%
debt-to-capital ratio is calculated based on financial leveraging of capital. Financial
leveraging equation to compute levered beta is given below.

( 1−T )∗D
[
β L =β u∗ 1+
E ]
Where,
β L = levered beta for equity in the firm
β u = unlevered beta of the firm
T = Marginal Tax rate for the firm = 32.5%
D
= Debt/Equity ratio
E

Table below shows the final estimates of levered beta.

Debt to Capital ratio Levered β

0% 0.85
10% 0.91
20% 1.09
30% 1.42

Calculation of Cost of Equity:

Cost of equity was calculated based on Capital Asset Pricing Model (CAPM). As per CAPM
model following equation was used to estimate cost of equity:

r e =r f + β∗(r m −r f )
Where,
r m = expected market rate
r f = risk-free rate or US Treasury YTM rate
β = levered risk coefficient

Tabulated data on US treasury yield to maturity (YTM) for different maturity period is
provided in Exhibit 8. To estimate cost of equity YTM for appropriate maturity year is
chosen. Risk free rate (r f ) of 10 year is used in estimating cost of equity for firm i.e. 5.1%.

In order to calculate the market premium rate, one needs to look at Exhibit 6. Using
Exhibit 6, one can see that the value of $100 invested on 7/3/2006 in the S&P Small Cap
600 Restaurants index is around worth $109 on 6/3/2007. As a result, one can conclude
that the market return is 9% ($109/$100− 1).

Table below shows the final estimates of cost of equity based on market value weights.
 Debt to Capital ratio Cost of Equity (re) (Market value)

0% 8.42%
10% 8.50%
20% 8.58%
30% 8.67%

Calculation of WACC

To estimate cost of capital for CPK and each of its three recapitalization scenarios, formula
for weighted average cost of capital (WACC) is utilized as shown below,

r d∗( 1−T )∗D r e∗E

WACC= +
V V

rd = Cost of debt
re = Cost of equity
D = Market value of debt
E = Market value of equity
V = D + E = Value of the company (or division)
T = Tax rate

Table below shows the final estimates of cost of capital based market value weights.

WACC
Debt to Capital ratio (Marke
t value)
0% 8.42%
10% 8.26%
20% 8.10%
30% 7.92%

Figure below shows that as CPK acquires debt its cost of capital increases.
Optimal Capital Structure

Based on the details and assumptions of pro forma recapitalization estimates of EPS, RoE,
and WACC was calculated. While issuing debt and adding capital by repurchasing common
stock some assumptions was made.

Table below demonstrates, pro forma of alternative capital structures along with key
performance indicators of concern for investors. A decrease in earnings per share and
increase in return on equity was seen with increasing debt-to-capital ratio; and as CPK
acquires debt its cost of capital increases. So it does not make sense for CPK to take debt.

Moreover, the cost of debt is higher than the firm’s cost of equity, adding debt to the
business does not add value to CPK from a financial risk perspective.

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.

Proforma Tax shield effect of recapitalization scenarios (End of june 2007) (in thousand USD)
10% Debt-to 20% Debt-to 30% Debt-to
  Actual Capital Capital Capital
Interest Rate 6.16% 6.16% 6.16% 6.16%
Tax rate 32.50% 32.50% 32.50% 32.50%
EBIT 30054 30054 30054 30054
Interest Expense 0 1391 2783 4174

EBT 30054 28663 27271 25880

Income Tax 9768 9315 8863 8411
Net Income 20286 19347 18408 17469

Book Value  
Debt 0 22589 45178 67766
Owner Equity 225888 203299 180710 158122
Total Capital 225888 225888 225888 225888

Market Value        
Debt 0 22589 45178 67766
Equity 643773 628516 613259 598002
D/E Ratio   0.036 0.074 0.113
Market Value of Capital 643773 651105 658437 665768
Share Price Unit 22.1 22.36 22.64 22.94
No. of Shares Purchased 0 1022118 2044235 3066353
 Common Shares
Outstanding 29130000 28107882 27085765 26063647
Earnings Per share 0.70 0.69 0.68 0.67
Return on Equity 8.98% 9.52% 10.19% 11.05%
WACC 8.42% 8.26% 8.10% 7.92%

Conclusion:

As per the calculations, if the company goes for any repurchase of shares by taking debt of
10%,20% and 30% respectively their WACC will reduce to 8.26%, 8.1% and 7.92%
respectively although EPS will reduce from 0.7 to 0.67. But, there is no significant change
in the share price of the company.
Hence the company can take debt for expansion plans, as the growth rate positive. But it
is not advisable to repurchase shares by debt financing.