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Introduction
In July of 2007, California Pizza Kitchen (CPK), a casual dining pizzeria started in California by co-owners Rick Rosenfield and Larry Flax, was faced with the decision to invest in a stock repurchase program. Led by Chief Financial Officer Susan Collyns, the financial team of CPK was reviewing the preliminary results for the second quarter to determine if the stock repurchase program would provide a significant financial leverage for the company. The goal was to determine if the company can maintain the necessary financial stability to meet the expected growth trajectory for 2008 while utilizing debt financing for the buyback program.
Having started the company using the original funding from the initial public offering in 2000, the co-owners were able to have zero debt financing on the balance sheets while maintaining a substantial borrowing capacity of $75 million with an interest rate of 6.16%.
With the recent 10% stock decline, the timing to roll out a stock buyback program would be questionable, however it would reduce the corporate income-tax liability, which was previously $10 million in 2006, and would allow for a debt tax shield.
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Utilizing the CPK financial statements from 2003-2007, recommendations will be provided to determine the best recapitalization approach for the buyback program.
SWOT Analysis
Before indulging in the financials of CPK, a SWOT analysis will give an understanding of the internal and external factors that are influencing the current business and industry. Based upon information provided in the case, it appears that CPK has an abundance of strengths, with minimal weaknesses, that are currently affecting the company.
There are several opportunities that the company could utilize to potentially increase revenues and help maintain a competitive advantage in the market. With the current threats of the economy and competitors, some of the opportunities may provide additional ways for CPK to boost their sustainability while investing in the stock repurchase program. The SWOT analysis can be found in Table 1, below, and provides additional factors that could affect the company in the near future. Table 1. SWOT Analysis of CPK Strengths > Inventive products > Consumer loyalty > Kraft partnership for frozen goods > Projection of increased consumer spending on dining out > Experienced minimal impact of rising labor & food costs > Recent revenue and royalties increase in 2007
Weaknesses
> Loss of ASAP development > Below industry advertising expenses > Balancing stock repurchase while expanding operations
Opportunities
> Online marketing > International expansion > Consistent new products > Increase advertising funding > Growth from acquisition of LA Food Show > Stock repurchase > Continued enhancements in restaurant operations
Threats
> Economic decline > Increased competitors in market > Activist investors affecting major food companies > Rising commodity, labor, and energy costs
Although there appears to be minimal weaknesses and threats, it is important for CPK to address these with caution considering the amount of risk with a debt-financed approach for the stock buyback program. If an economic decline impacts the company in the upcoming years, an investment of 30% could result in a potential loss much greater than the amount originally financed.
Financial Leverage and ROE
The primary goal of CPK in 2007 was to increase its financial leverage utilizing the stock buyback program while ensuring the company will have enough funding for future growth. Using the Pro Forma Tax Shield Effect of Recapitalization Scenarios, the different debt to capital ratios were analyzed at 10%, 20%, and 30% respectively. (See Appendix A) According to the calculated values, it appears that the higher the debt to capital ratio, the higher the return on equity (ROE) will be for CPK. With rates of 20% and 30%, the ROE’s are 10.2% and 11.1% which would put the company at a greater advantage than the 10.1% ROE from 2006. Not only would this benefit the company, but would also benefit the stakeholders who just received the additional 50% stock dividend that CPK issued.
Financial Leverage on WACC
When analyzing which debt financing option CPK should choose, the weight average cost of capital (WACC) will provide an approximation on how much CPK must earn in order to satisfy the amount financed. The values of WACC for the actual, 10%, 20%, and 30% options can be found in Appendix A. It appears that the higher the financial leverage, the lower the WACC will be. Take for instance if CPK chooses a 30% debt to capital situation, the ROE will be 11.1 % with a 9.2% WACC. In contrast, at the actual value, the ROE is 9% with the WACC being 9.5% and could pose badly for CPK. As long as CPK is comfortable with the high risk of a 30% debt to capital ratio, then it would be the most beneficial in terms of adding economic value to the company, and for the shareholders, while providing a high financial leverage.
Financial Leverage and Cost of Equity
The effect of financial leverage on the cost of equity is prevalent in the Modigliani-Miller capital structure theory. Since the financial leverage increases the cost of equity, it can be considered one of the disadvantages of borrowing. As shown in Appendix A, the cost of equity, at each debt to capital ratio, increases by 0.1% as the financial leverage increases by 10%. With a higher financial leverage, CPK will need to address the higher cost of equity from the viewpoint of the stockholders and the returns they expect to receive from the increased risk that comes with the debt-financed buyback.
Financial Leverage and Risk of Equity Returns
Analyzing the effect of financial leverage on the risk of equity returns will be a good way for CPK to illustrate a form of risk analysis should there be an economic decline in the near future. If CPK chooses to finance the stock buyback program utilizing current debt, there will be a lot of risk associated with future income and analysis of the risk should be a crucial step in determining if the company should go forward with the program. In order to address the effects of the financial leverage on the risk of equity returns, the earnings before interest and taxes (EBIT) will be adjusted to illustrate potential increases and decreases in operating income in the near future. The EBIT will also be multiplied by a factor of -1 and 2 to help illustrate the relationship between the different debt levels and the risks associated with each scenario. (See Appendix B)
The first effect will be with an increase of earnings by $1 million, to suggest additional income, and shows that the ROE increases more based upon the higher amount of leverage. For example, at debt/capital ratios of 10% and 20%, the ROE increased approximately 0.5% while at 30%, the ROE increased 0.6%. Similarly with a decrease of $1 million, the ROE decreased by the same values as expected. With these preliminary calculations, it appears that with greater leverage (debt) from financing, the greater the ROE will become.
The second effect will illustrate the difference of ROE for each leverage possibility with the EBIT multiplied by a factor of -1. By multiplying the EBIT by -1, the relationship between the increasing leverage and effect on ROE can be examined. As the table in Appendix B illustrates, the difference between the 10% debt/capital option and 30% option is an astounding 13.3%. It appears that the higher the leverage, the higher the rate of increase of the ROE. In terms of risk, if CPK were to invest in the 30% debt/capital option, the amount of risk drastically increases when compared to the 10% or 20% options. Keeping in mind that this illustration deals with impacts from the weaknesses or threats that CPK currently faces, these are important factors that should be considered if there were an economic decline or significant loss of operating income.
In contrast to the previous analysis, the next portion will address the potential earnings that the company could experience if there were an increase in operating income and the company was to operate as forecasted. By multiplying the EBIT by a factor of 2, it will illustrate the projected expansion of the company along with the influence of increased income with the stock buyback program. As shown in Appendix B, the ROE for each option increases as the leverage increases. For example, the difference between the 10% and 20% options is 1.8% compared to the 2.3% increase in ROE from 20% to 30%. So what does this say about the effect of leverage on the risk of equity returns and how it affects the decision CPK is faced with?
Based upon the analysis, using the different factors and adjustments to operating income, the increase in leverage would result in an increase in the risk of equity returns. If the company experiences a decrease in operating income, it could very well reduce the returns on equity by more than the original amount that was invested. For example, if the company invests in a 30% debt-financing option, it could result in a loss of over 40% in ROE. However, if the company were to increase operations and increase its revenue, it would only see tapering increases in ROE based upon the more debt that is financed. Utilizing the risk analysis of each option, CPK will need to determine a capital structure policy that will meet the amount of risk that the financial team is comfortable with while considering the SWOT analysis of the project and company.
Recommendations
Considering the options of financial leverage that CPK has provided, it is important to address the potential risks of the current industry while utilizing the effects that leveraging will have on the company’s ROE. Based upon the previous analysis of the tax shield options, CPK should opt for debt/capital ratio of 20%. Utilizing the tax shield will allow the company to increase the cash flow because as the amount of debt increase, the amount of tax reduces, resulting in an increase of cash flow to CPK. The end result would be investing approximately $45 million, of the current $75 million credit line, into the buyback program which would result in an ROE of approximately 10.2%, or roughly 0.1% greater than in 2006.
Although there is not a tremendous increase in the ROE from the previous year, the company ensures a debt-to-equity (market value of debt/market value of capital) ratio of only 7%. By choosing the 20% option, it reduces the amount of risk that could be associated with higher ratios. It has a 0.9% difference over the WACC, in terms of ROE, which adds economic value to both the shareholders and the company while providing substantial financial leverage for CPK. If CPK chooses to invest into the stock repurchase program, it has the opportunity to gain financial leverage from issuing the new debt. Since the current share price is lower than the market share price, buying up a substantial amount of shares will signal to investors that the company believes the stock is undervalued.
Once CPK invests in the stock, the supply will drop and most likely result in an increased price per share. For Susan Collyns and the financial team at CPK, utilizing the aforementioned capital structure policy will not only provide a substantial amount of financial leverage for CPK, but it will also increase the economic value of CPK for both the owners and investors. By investing at a 20% ratio, the company will gain leverage while experiencing less of a risk and still have additional credit. With the stock buyback option, the company will take advantage of the undervalued stock at the current price and seek additional rewards from using debt to finance the investment while also taking advantage of the tax shield.
Future Outlook
Upon completion of the case analysis, further research into the CPK situation provides insight on what the company chose to do in July of 2007 up until the present date. On August 9, 2007, the CPK Board of Directors authorized a stock repurchase of $50 million. Based on a conference call from February of 2008, the company decided to go with an investment of $50 million for the stock buyback program. As stated by Susan Collyns on February 14, 2008, “We didn’t repurchase any of our own shares during the fourth quarter under our $50 million buyback authorization but as you probably remember we did announce an accelerated share repurchase totaling $43.6 million with Bank of America on February the 1 st.”
It appears that CPK decided to invest slightly more than the 20% option and also amended their existing credit line with Bank of America with expectations to increase the line of credit to upwards of $150 million. Following the accelerated share repurchase program announcement, the company experienced increased earnings per share and by August 8, 2008, the company announced an increase of 24% increase in earnings per share. Not only did the financial leverage help increase the economic value for the company and shareholders, but it helped fulfill the goals that CPK originally set out in July of 2007 while increasing sales and expanding the company as planned.
California Pizza Kitchen. (2016, Oct 17). Retrieved from https://studymoose.com/california-pizza-kitchen-essay
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