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California Pizza Kitchen

Share Buyback and Financial Leverage
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California Pizza Kitchen has been growing consistently and ahead of competition by a large margin. Despite this,
the stock price of the company fell by 10% in June 2007. The company is currently debt free and has limited cash on
its balance sheet. It has an identified growth expansion plan of US$ 85 million. In order to arrest decline in share
price and reward its shareholders, the management is considering the plan to launch a share repurchase program.
Although co-CEO Rick Rosenfield is of the opinion of not using leverage on its balance sheet so to have a staying
power in time of crises and industry downturn, the CFO Susan Collyns is of the opinion how use of leverage can
provide benefits to company. The note represent Collyns case of how use of debt can boost return on equity of CPK,
increase overall value of the Firm, increases share prices and generates incremental economic value added and
hence boost shareholders wealth.

California Pizza Kitchen, headquartered in Los Angeles, California, is a restaurants service company that

operates casual dining chain. The company focuses on premium pizzas segment and had 213 locations in 28 states

and 6 foreign countries at end of second quarter of 2007. The company reported US$555 million revenues in 2006

which grew by 15.6% y-o-y. The restaurant chain derived its revenue from three sources: sales at company-owned

restaurants, royalties from franchisee restaurants, and royalties from a partnership with Kraft Foods to sell CPK

branded frozen pizzas in grocery stores. While the company does focus to diversify its business model by venturing

into with two other brands, the primary focus still continues to remain on operating company-owned full-service

CPK restaurants, of which were 182 units. Market estimates the potential of number of CPKs full-service self-

owned restaurant at 500. The management is also upbeat on the success and prospects with franchising full service

restaurants internationally. At the beginning of July 2007, the company had 15 franchised international locations

with more planned for opening in second half of 2017. With presence already in China (including Hongkong),

Indonesia, Japan, Malaysia, the Philippines, and Singapore, the company has plans to expand its foot prints to

Mexico and South Korea in the second half of 2007.

Financial Performance

In comparison to weakening sales and earnings growth among restaurants service provider companies,

CPKs revenues increased more than 16% to US$159 million for the second quarter of 2007. Royalties from Kraft

partnerships and international franchisee were notably up 37% and 21% respectively. Development plans for

opening 16 to 18 restaurants were on schedule for 2007. CPKs growth plans were anticipated to require US$ 85

million investment in capital expenditures. The cash profit in 2006 was reported at US$ 50 million. In the

environment of rising wage, fuel and food costs, CPK has been playing very smart by managing its costs. While

labor costs (as % of sales) declined to 36.3% in second quarter of 2007 vs, 36.6% in corresponding quarter of 2006,

the food, beverage and paper supply cost remained constant at 24.5% of sales during this period. As per

management much of the cost improvements have been achieved through increased efficiency at restaurant

operations. Besides rise in cost prices, restaurants were also grappling with issue of fall in gross margins that were

under pressure from the softening demand for dining out. However, CPKs past strong performance vs. its peers and

its performance in second quarter of 2007 affirm many analysts conclusions that CPK was a safe haven in casual
dining sector. Average weekly full service restaurant sales were growth at 3-Yr CAGR of 6.0%, whereas the growth

in second quarter of 2007 was at 4.7% both on y-o-y basis and compared to full year average of 2006. Sales at

company owned restaurants were growing in excess of 5% p.a which makes them few among the peers to grow at

such high rate on a consistent basis. Consensus forecast shows that CPKs was estimated to grow to US$ 650

million in 2007 and US$ 750 million by 2008 resulting in 17.1% and 5.4% y-o-y growth. This is much higher than

growth expected in overall restaurant industry in casual dining segment of full service sector which is estimated to

grow at 5-Yr CAGR of 6.5%.

Brand Loyalty

CPK spend barely 1% of its sales on advertisement in relative to as high as 3% to 4% of sales that competitors, such

as, Chilis, Red Lobster, Olive Garden, and Outback Steakhouse, spent annually. Well crafted execution of CPKs

model has resulted in invaluable word of mouth publicity resulting in increase in organic traffic. Further of total

advertisement spending nearly 50% was spend on inventive menu-development costs, while the other half gets

consumed by more typical marketing strategies, such as public relations efforts, direct mail offerings, outdoor

media, and online marketing. Demographics, in addition to endorsement of the chain, were another major reason for

consumer attraction towards the brand. CPKs core customer had an average annual household income of US$

75,000 and the bucket of these affluent societies sheltered them from any macroeconomic pressures, such as rising

gas prices or food cost that might lower sales at competition with fewer well-off patrons. In addition to crediting its

inventive menu, CPKs average check value at US$13.30 was below that of many of its upscale casual dining peers

and makes CPK a Price-Value-Experience leader in its sector.

The Big Question

Despite impressive performance, the stock price of CPK had decline 10% during June 2007 to a current value of

$22.10. Given the drop the Management Team was evaluating the option of rewarding its shareholders by

repurchasing company shares from open market at todays price. However, with little excess cash in the kitty (only

US$ 7.2 million as on July 1, 2007) a large share repurchase program would require debt financing. What also

needed to be borne in mind is that the cost of funding future growth and expansion plan is already estimated at US$

85 million dollar which needs to be financed either through issuing new equity or debt. The effect of using leverage
for financing share repurchase program needs to be evaluated in terms of boost it provide to RoE, EPS, Cost of

Capital, Share Price and economic value added.

Since going public in 2000, CPKs management had avoided putting any debt on the balance sheet. As per

company co-CEO Rick Rosenfield, the strategy was to have a staying power in event of any crises. The strong

balance sheet would maintain the borrowing ability needed to support CPKs expected growth trajectory. However,

Collyns was aware of the fact that use of borrowing or leverage will boost return on equity (RoE) of the company.

Despite the challenges of growth the number restaurants by 38% over last five years. CPK was successful in

generating strong operating returns. However, in absence of any borrowing, the companys was lagging behind in

delivering higher RoE. RoE in 2006 was at 10.1%. Because CPK used IPO proceeds of 2000 to completely retire its

debt, the company completely avoided debt financing and hence never took the benefit of leverage to improve its

RoE. The recent decline in share raised a question within Management Team of whether this was an ideal time to

launch large share repurchase program financed through debt. One immediate gain from borrowing would be to get

benefit from tax shield and hence reduce income-tax liability which had been nearly $10 million in 2006. While the

CFO Susan Collyns was confident of using debt to finance share repurchase program and take advantage of leverage

to boost RoE, the Management Team was apprehensive of the use of debt.

Hence, in order to preserve the firms ability to fund the expansion plan, CPKs management is open to any

type of financing to return capital to shareholders which is in line with the goals of growing business. Hence the big

question is what kind of capital structure policy the management should adopt which will be in sync with aim for

achieving growth and expansion.

Why debt adds value to CPKs financial and share price

Leverage is beneficial for companies as it provides interest paid on such debt is tax deductible and hence

provide tax shield and as a result boost EPS. Cost of raising debt is the least source of financing when compared to

equity and other securities. Hence when debt is used to finance the share repurchase program, it will provide dual

benefits. On one side, the tax shield on such debt will lower taxable income and hence will lower tax expense and on

the other side, the repurchase of shares will reduce the outstanding number of shares without impacting the net
income available for shareholder. This should substantially improve EPS and also will boost RoE. Increase in EPS

and RoE will increase the share price of the company and hence enhance shareholders wealth.

Effect of leverage on Cost of Capital

Given, the advantage of tax shield and debt being lost cost of financing, the leverage will lower the overall cost of

capital for CPK. In absence of debt on CPKs balance sheet, the cost of capital is same as cost of equity which is

7.67%. As per CAPM, cost of equity is: = + ( )

= 5.2% (10 ); 10 year is a fair estimate for risk-free rate of return.

= 8.11% (Based on last 57 years of annualized return up to June 2007)

Unlevered beta = 0.85

= . % + . (. % . %) = . %

In order to compute effect of debt on cost of capital, first we need to compute the levered beta by converting

unlevered beta at 0.85 (as per Exhibit 7 of the case study). To compute levered beta, the following formula has been

used: L= U[1+(1-T)D/E]; where U is the CPKs unlevered beta, T is CPKs income tax rate, D is the book value of

debt, and E is the book value of equity. As per the case, since CPK has no debt on its book, the market value of debt

is not available. As per case, the market value has been shown the same as book value which is not comparable to

market value of equity. Hence, book value of debt and equity has been considered for computing WACC.

Debt proportion (In US$ 000) ACTUAL 10% 20% 30%

u .85 .85 .85 .85
Tax rate 32.5% 32.5% 32.5% 32.5%
D=Book value of debt (Exhibit 9) 0 22589 45178 67766
E=Book value of equity (Exhibit 9) 225888 203299 180710 158122
L .85 0.87 0.89 0.92
Rf 5.2% 5.2% 5.2% 5.2%
Rm 8.1% 8.1% 8.1% 8.1%
Cost of Equity (R e) 7.67% 7.72% 7.78% 7.87%
Pre-tax Cost of Debt (Exhibit 9) 6.16% 6.16% 6.16% 6.16%
Post-tax Cost of Debt 4.16% 4.16% 4.16% 4.16%
Weight of Debt 0.00% 10.00% 20.00% 30.00%
Weight of Equity 100.00% 90.00% 80.00% 70.00%
WACC 7.67% 7.36% 7.06% 6.76%
Above data reveals two observation, first the use of debt has increased the cost of equity because of rise in risk

metric for the company due to use of leverage, but on the other hand the use of debt has lowered the overall cost of

capital significantly. Hence, it is clear that adding debt will add value to CPK from cost of capital perspective.

Effect of use of debt on CPKs Value

Current Value of Firm = Current Stock Price * Current Outstanding Share = US$ 22.10 * 29.13 million shares

Or, Current Value of Firm = US$ 643.773 million

Value of Levered Firm = Value of unlevered firm + Tax Rate * Debt Value (Tax Shield on Debt)

Debt proportion (in US$ 000) ACTUAL 10% 20% 30%

Tax rate 32.5% 32.5% 32.5% 32.5%
D=Market value of debt (Exhibit 9) 0 22.589 45178 67766
Value of Levered Firm 643,773 651,111 658,453 665,794

The above computation also reveals the fact that how the use of leverage enhances overall value of the firm. This is

largely in line with market values shown under Exhibit 9 of the case. Hence, this also proves the fact why leverage

boosts firms value.

How use of Debt boost RoE

Going by Exhibit 9 of the case study, we used the following information to compute return on equity.

Debt Proportion Actual 10% 20% 30%

Earnings after taxes 20,299 19,359 18,419 17,480
Book Value of Equity 225,888 203,299 180,710 158,122
Return on Equity (RoE) 8.99% 9.52% 10.19% 11.05%

One more evidence which should boost Collyns confidence is the rise in return on equity due to use of leverage.

Effect of Debt on Share Price

As per the case, CPK is considering repurchase of shares from open market at current price of US$ 22.10 per share.

Taking book value of debt from Exhibit 9, the different quantity of shares would be repurchased under different

assumption of leverage will result in substantial increase in share price of CPK as shown here under:
Debt Proportion 10% 20% 30%
Book Value of Debt for the purpose of share repurchase 22,589 45,178 67,766
Shares can be repurchased at US$ 22.10 per share (million) 1.02 2.04 3.07
Old outstanding shares (million) 29.13 29.13 29.13
New outstanding shares (million) 28.11 27.09 26.06
Market Value of Equity (US$ 000) 628,516 613,259 598,002
New share price of CPK 22.36 22.64 22.94

Finally, Collyns can also conclude that how use of debt can increase share price of CPK from current US$ 22.10.

Effect of Debt on Economic Value Added

Economic value added (EVA) measure the residual wealth generated by the company over and above its cost of

capital. It is calculated as:

EVA EBIT * (1 tax rate) WACC * Invested Capital

Debt Proportion (in US$ '000) Actual 10% 20% 30%

EBIT 30,054 30,054 30,054 30,054
Post-tax EBIT (EBIT * 67.5%) 20,286 20,286 20,286 20,286
D=Book value of debt - 22,589 45,178 67,766
E=Book value of equity 225,888 203,299 180,710 158,122
Invested Capital 225,888 225,888 225,888 225,888
WACC 7.67% 7.36% 7.06% 6.76%
EVA 2,961 3,661 4,339 5,016

Above output is very strong and can be a single point driver for using leverage as it may result in significant increase

in EVA for CPK.


Above analysis shows how use of leverage has substantial potential to increase California Pizza Kitchens return on

equity, value of overall firm and reduce overall cost of capital for the company. It also reveals the fact how use of

leverage can boost EVA and share price of CPK. Hence, Susan Collyns has a strong case to present to its

Management Team including co-CEO Rick Rosenfield and get their buy in on the decision of using debt financing

to reward its shareholders in the event of falling share price by launching a share repurchase program. However,

Collyns should be careful in deciding the capital structure with use of debt. This is because in addition to share

repurchase program CPK also has expansion plan of US$ 85 million and hence excess use of debt may also

increases the risk of bankruptcy. Hence prudent usage of debt has significant merit and has great chance of boosting

shareholder wealth.