CASE 33

CALIFORNIA PIZZA KITCHEN

Guidance Sheet

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 learning 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.

Questions

1. What is going on at CPK? What decisions does Susan Collyns face? In what ways can she
facilitate the success of CPK? What do you recommend?

2. Using the scenarios in case Exhibit 9, what role does leverage play in affecting the return
on equity (ROE) for CPK?

3. Is the capital structure decisions relevant for maximizing the shareholders’ value? What is
the ratio of debt-to-equity that maximizes the shareholder’s value? Why should the
stockholders care about maximizing firm value? Shouldn’t they be interested in strategies
that maximize shareholder value only?

What are the key drivers for increasing value of CPK how it affects its capital providers i.e.
shareholders and creditors.

4. How does debt add value to CPK?

5. What is the case for not doing the recapitalization?

6. What should Collyns recommend?

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Note: A spreadsheet is provided to assist students. Students however can create their own
analysis, financial model, spreadsheet, schedule or tables.

Please submit your case write up, presentation and spreadsheet. Please put you names on the
spreadsheets as well,

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