Professional Documents
Culture Documents
Kitchen
Section A
PGDM (GM)
Members:
Abhinav Sultania
(G16003)
Abinash Mishra
(G16005)
Amit Ashish (G16008)
Azhar Jalal Haider
(G16018)
Helen Nirmala N
(G16025)
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
companys 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. CPKs 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 CPKs 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 companys 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 managements 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, CPKs revenue
increased by 16% to $159 Million in the second quarter of 2007.
Royalties increased from partnerships and franchises by 37% and 21%
respectively. CPKs 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
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.
L = u 1+
( 1T )D
E
Where,
L = levered beta for equity in the firm
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.
Levered
0.85
0.91
1.09
1.42
0%
10%
20%
30%
8.42%
8.50%
8.58%
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,
WACC=
r d( 1T )D r eE
+
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.
Debt to Capital
ratio
0%
10%
20%
30%
WAC
C
(Mar
ket
value
)
8.42%
8.26%
8.10%
7.92%
Figure below shows that as CPK acquires debt its cost of capital
increases.
thousand USD)
Actual
Interest Rate
Tax rate
EBIT
Interest Expense
EBT
Income Tax
Net Income
32.50%
30054
1391
32.50%
30054
2783
32.50%
30054
4174
30054
9768
20286
28663
9315
19347
27271
8863
18408
25880
8411
17469
0
225888
225888
22589
203299
225888
45178
180710
225888
67766
158122
225888
0
643773
22589
628516
0.036
45178
613259
0.074
67766
598002
0.113
643773
22.1
651105
22.36
658437
22.64
665768
22.94
1022118
2044235
3066353
29130000
0.70
8.98%
8.42%
28107882
0.69
9.52%
8.26%
27085765
0.68
10.19%
8.10%
26063647
0.67
11.05%
7.92%
Book Value
Debt
Owner Equity
Total Capital
Market Value
Debt
Equity
D/E Ratio
Market Value of
Capital
Share Price Unit
No. of Shares
Purchased
Common Shares
Outstanding
Earnings Per share
Return on Equity
WACC
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.