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California Pizza Kitchen (CPK) emerged on the culinary scene in 1985 in Beverly Hills, California, and rapidly expanded its presence, boasting 213 locations across 28 states and 6 countries by the year 2007. Despite its California-centric theme, the dining model successfully transcended regional boundaries, establishing itself as a prominent player in the restaurant industry. The year 2007 marked a significant juncture for CPK as it faced industry challenges, including heightened commodity, labor, and energy costs. Nonetheless, the company was on track to break quarterly records with an anticipated profit exceeding $6 million.
However, despite the positive performance, CPK encountered a 10% decline in its share price, which now stood at $22.10. This prompted Susan Collyns, Chief Financial Officer (CFO), and her financial team to contemplate a crucial decision – whether to implement a share repurchase program.
The challenge lay in the limited excess cash available, necessitating the exploration of debt financing for the repurchase agreement. This decision, if undertaken, had the potential to send a positive signal to the market, with future values expected to soar.
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Additionally, the finance team grappled with determining the optimal capital structure, given the prevailing low-interest rates.
Considering the financial landscape, CPK found itself at a crossroads in determining the appropriate capital structure. The availability of low-interest rates presented an opportunity to issue the required debt for a repurchase agreement at a minimal cost. Importantly, CPK had no prior debt, mitigating the risk associated with taking on additional financial obligations. The allure of increased value due to reduced taxes, facilitated by the tax shield, added complexity to the decision-making process.
Delving into the intricacies of leverage, as depicted in exhibit 9, varying debt/capital percentages exhibited discernible effects on return on equity (ROE) and the cost of capital.
The relationship between leverage and ROE proved direct, with an increase in leverage corresponding to an augmented ROE. At 10% debt/capital, ROE stood at 9.52%, rising to 10.19% at 20%, and further to 11.05% at 30%. Simultaneously, the cost of equity, derived from the beta equation, exhibited a parallel increase with higher leverage: 14.34% at 10%, 14.56% at 20%, and 14.84% at 30%. This escalation implied an inherent increase in risk due to the additional debt burden shouldered by the company.
An analysis of the Weighted Average Cost of Capital (WACC) equation unveiled an overall decrease in the cost of equity to the firm. This was attributed to the low cost of debt and the ensuing tax shield. The anticipated increase in share prices with each incremental debt/capital percentage further reinforced the attractiveness of a share repurchase program. At 10% debt/capital, the projected stock price was $22.35, reflecting a 1.13% increase and enabling the buyback of 1.01 million shares. Opting for a 20% debt/capital structure would yield a price of $22.60, a 2.26% increase, facilitating the repurchase of 1.99 million shares. A 30% debt/capital structure would elevate the price to $22.86, a 2.99% increase, allowing the buyback of 2.97 million shares.
Considering the multifaceted implications, the 20% debt/capital structure emerges as a strategic choice. This structure aligns with the company's objectives, facilitating a share repurchase program and enabling the buyback of approximately 1.99 million shares. The associated increase in share price not only addresses the declining trend but also appeases shareholders. Importantly, the 20% structure strikes a balance, leveraging the benefits of debt financing while maintaining a moderate level of risk. This approach ensures fiscal responsibility and leaves room for future expansion, positioning CPK for sustained growth.
In conclusion, the financial decision faced by California Pizza Kitchen is a pivotal moment in its trajectory. The careful analysis of varying debt/capital structures underscores the delicate balance required to maximize shareholder value while managing associated risks. Susan Collyns, as the CFO, plays a critical role in navigating this complex terrain. The recommended 20% debt/capital structure represents a strategic compromise, fostering growth while upholding fiscal prudence. As CPK stands at the intersection of financial strategy and market dynamics, the chosen path sets the stage for the company's future success.
California Pizza Kitchen: Financial Decision Analysis. (2016, Mar 12). Retrieved from https://studymoose.com/california-pizza-kitchen-case-study-essay
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