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Case #33 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. 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 firms CAPM beta can be modeled in the following manner: L = U[1 + (1 T)D/E], where U is the firms 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?

Financial leverage and financial risk We need to pay attention to the apparent appeal of leverage in increasing the expected ROE of CPK. To illustrate the point that leverage comes with additional risk, lets adjust the earnings before interest and taxes (EBIT) line of case Exhibit 9 by a certain amount both up and down. In the first round, the EBIT line can be multiplied by a factor of 1. In this case, the no-leverage ROE drops to 18%, while the high-leverage ROE drops even more to 29%. Alternatively, if the EBIT line is multiplied by a factor of 2, the no-leverage ROE rises to +22%, while the high-leverage ROE increases even more to +30%. We should quickly see the magnifying effect of leverage on the risk of equity returns. So should equity investors be happy with the same level of return for a much higher risk? Leverage is simply a way of slicing up the business risk. Since the weighted average cost of capital (WACC) reflects the total risk, the WACC should not change with simply slicing up the risk across various types of contracts. The total risk is unadjusted. To demonstrate this point with the case example, we must alter the beta formula in the questions to remove the portion of risk that the government bears in the tax shield. This revised formula is L = U[1 + D/E].

CALIFORNIA PIZZA KITCHEN

Over the month of July, CPK repurchased $16.8 million of company shares. The repurchase was funded with the companys line of credit such that the companys outstanding borrowings stood at $17 million by the end of the summer. In early 2008, the company announced its intention to repurchase an additional $46.3 million shares. The company planned to fund the new program with borrowings under an expanded credit line and available cash balances. Co-CEOs Rosenfield and Flax remarked, Management and our Board are confident about the strength and long-term prospects of our Company. The [share repurchase agreement], in conjunction with our expanded credit facility, is an effective way for us to return capital to stockholders, leverage our balance sheet, and reduce our overall cost of capital.