Case 33 Essay
1. In what ways can Susan Collyns facilitate the success of CPK? – repurshasing company shares through debt financing, since the price of the shares declined by 10%. The view is that a strong balance sheet would maintain the borrowing ability needed to support CPK’s expected growth. – increasing international franchises and expand the agreement with Kraft Foods throught a strong partnership. Kraft Foods| International Franchises|
* 95% pretax margin * obliged to spend 5% of gross sales on marketing the CPK frozen pizza brand (more than the company often spent on its own marketing)| * 50 to 65K initial payment for each locationa + 5% gross sales * royalties from gross sales benefited from any pricing increase that were made to address higher costs.|
* creative menu with high-quality ingredients + specific menu depending on country to support sales growth. * Average check of $13.30 was below that of many of its upscale dining casual peers, labeling the chain as “Price-Value-Experience” leader in its sector. * Management created devoted patrons who created free, but far more-valuable word-of-mouth marketing for the company. CPK spent 1% of its sales on advertising, far less than the 3% to 4% of its competitors. * 50% of advertising were spent on menu-development costs, with the other half spent on advertising strategies, such as public relations effort, direct mail offerings, outdoor media, and online marketing. * Clients’s average household income of more than 75K, which sheltered the company from macroeconomic pressures, such as high gas prices. 2. Using the scenarios in case Exhibit 9, what role does leverage play in affecting the return on equity (ROE) for CPK? What about the cost of capital? In assessing the effect of leverage on the cost of capital, you may assume that a firm’s CAPM beta can be modeled in the following manner: L = U[1 + (1 − T)D/E], where U is the firm’s beta without leverage, T is the corporate income tax rate, D is the market value of debt, and E is the market value of equity.
| Actual| 10%| 20%| 30%|
ROE| 0.089863118| 0.095224276| 0.101925737| 0.110547552| CAPM| 0.85|
0.870620698| 0.892267423| 0.915017747|
The leverage increases the ROE.
So if the Net Income goes up, CPK will have a better ROE when leveraging more. But at the same time, if the Net Income goes down, CPK will have a better ROE when leveraging less. So leveraging is a successful strategy but risky, and the cost of capital confirms it. The more CPK borrows, the higher its ROE will be, and the higher the risk will be.