California Pizza Kitchen was first created in 1985 in Beverly Hills, California. By 2007 there were 213 locations throughout 28 states and 6 countries. Although 41% of the stores were based in California, keeping with the restaurants theme, the dining model flourished throughout the United States. For the second quarter of 2007, although they were faced with industry challenges such as raised commodity, labor and energy costs, they were still expected to break quarterly records with over $6 million in profits. Although they experienced good performance, the share price had declined 10% to a current value of $22.10. Susan Collyns, CFO, and her team were faced with the decision of a share repurchase program.
They had little money in excess cash though, so a repurchase agreement would mean debt financing. A share repurchase would send a positive signal to the market, with future values expected to be high. The financial team also needs to decide on the appropriate capital structure. Because of the low interest rates, CPK can issue the debt needed for a repurchase agreement at a low cost. Also because they have no previous debt, this would not be a large risk and it will in fact increase the value of CPK due to decreased taxes, which comes from the tax shield. The leverage from exhibit 9 has different effects for return on equity and cost of capital. For return on equity, as you increase leverage, the ROE increases as well. At 10% debt/capital, ROE is 9.52%, 20% debt/capital, ROE is 10.19%, and 30% debt/capital, ROE is 11.05%. Using the beta equation to find the effect on cost of equity, you can see that it increases as well when the leverage increases.
For 10% debt/capital, the beta of equity is .87 and cost of equity is 14.34%, 20% debt/capital, beta equity is .89 and cost of equity is 14.56%, lastly 30% debt/capital, beta equity is .915 and cost of equity is 14.84%. These increases also mean an increase in risk of the company because of the additional debt taken on. When taking into consideration the WACC equation, there will be an overall decrease in cost of equity to the firm because of the low cost of debt and the additional tax shield. When finding share prices, it is evident they will increase with each debt/capital percent. At 10% debt/capital, the price of stock will go up to $22.35, which is a 1.13% increase in price, and allows the buy back of 1.01 million shares. At 20% debt/capital structure, the price will move up to $22.60, a 2.26% increase and can buy back 1.99 million shares. Lastly, a 30% debt/capital, the price will move to $22.86, a 2.99% increase and allow the buy back of 2.97 million shares.
Again, the added value to the firm can be attributed to the present value of the tax shield that debt allows them to capture. So this allows for the buy back of shares at the new price. In my opinion, I think Susan Collyns should choose the 20% debt/capital structure. Under this structure, they should partake in a share repurchase program and buy back around 1.99 million shares. This will allow for an increase in share price that would please shareholders. There is not a huge level of risk involved in the 20% structure, it leaves room for future expansion but moderates how much debt taken on.