Case 32

CALIFORNIA PIZZA KITCHEN

Synopsis and Objectives

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.

The case serves to motivate the following objectives:

• Introduce the Modigliani-Miller intuition of capital structure irrelevance;

• Establish how the cost of equity is affected by capital structure decisions by defining
financial risk and introducing the levered-beta capital asset pricing model (CAPM)
equation;
• Discuss interest tax deductibility and the valuation tax shields;
• Explore the importance of debt capacity in a growing business.

Suggested questions:

1. In what ways can Susan Collyns facilitate the success of CPK?

2. Using the scenarios in case Exhibit 9, what role does leverage play in affecting the
return on equity (ROE) for CPK? What about the cost of capital? In assessing the
effect of leverage on the cost of capital, you may assume that a firm’s CAPM beta can
be modeled in the following manner: β L = β U[1 + (1 − T)D/E], where β U is the firm’s
beta without leverage, T is the corporate income tax rate, D is the market value of
debt, and E is the market value of equity.
3. Based on the analysis in case Exhibit 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 of interest play in encouraging debt
financing at CPK?
4. What capital structure policy would you recommend for CPK?
5. What is the case for not doing the recapitalization?
6. What should Collyns recommend?