California Pizza Kitchen

Advanced Corporate Finance

CASE 1 – California Pizza Kitchen

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1) What is going on at California Pizza Kitchen (henceforth, CPK)? What decisions does Susan Collyns face? What do you recommend?

California Pizza Kitchen is a casual but high quality diner restaurant that was founded in 1985. It offers high quality food for relatively low prices. With mainly strong word-of-mouth advertising, CPK has managed to attract customers that have an average income of above $75.000, even though its prices are low.  In July 2007, it had 213 locations in six countries. When macro-economic conditions for the industry changed, including higher labour costs, higher gas prices and increasing commodity prices, this led to higher costs of business for the restaurant industry. However, where competitors struggled and suffered losses due to these higher prices, CPK managed a growth in revenues and growth, mainly because its high-income customers are relatively insensitive to the macro-economic changes such as higher gas prices.

At the moment of the case study, California Pizza Kitchen is about to release the results for the second quarter of 2007. CPK outperformed its competitors with profits over six million. However, despite the growth of profits, the stock price had declined by 10% due to aforementioned difficulties within the industry. This leads Susan Collyns, the CFO of CPK, to believe that the stock is undervalued. To combat this low stock price, she could repurchase outstanding shares and reissue them as soon as their stock price more accurately reflects the value of its equity, which would lead to a profit for the company.

Susan Collyns is considering to repurchase outstanding shares using debt financing. As of date, CPK is an unlevered company but leveraging the company would have its benefits. First of all it would signal to the market that the company is expecting higher revenues in the future. Repurchasing stock signals that management thinks the stock is underrated and is expecting it to go up in the future. As management has inside information about the performance of the firm, repurchasing stock is a credible signal to the market that the stock is actually undervalued which will likely lead to an increase in the stock price. Furthermore, the company could reissue the shares as soon as the stock price has gone up and more accurately reflects its intrinsic value for a profit. The downside of repurchasing using debt is that it leaves the company leveraged which would leave less borrowing capacity to support CPK’s expected growth trajectory. Alternatively, CPK could issue more dividends which would make the stock a more attractive investment for future shareholders. However, paying out more dividends lowers the amount of funds available for investments in growth opportunities. Similar to repurchasing shares, this would limit what Co-CEO Rick Rosenfield refers to as financial staying power. Furthermore, individual investors pay personal income taxes on dividend, thus providing a lower payout to investors than repurchasing shares would.

Because CPK is a high-growth company, we do not recommend paying out higher dividends, as it would be better to retain the earnings as investment in the growth of the company. However, because of the low stock price, repurchasing shares using debt is an option to consider. According to Modigliani and Miller the capital structure of a firm does not matter when the market is efficient. However in this case, there are market inefficiencies at place. First of all, there are corporate taxes. Debt financing would provide a tax shield that lowers the total amount of taxes to be paid, thus increasing the value of the firm. A second assumption of efficient markets is perfect information. In this case, we believe that there is imperfect information, namely Susan Collyns, the CFO of CPK knows more about the firm than the market. She knows the demographics of CPK’s customers and that they are relatively insensitive to the higher prices due to macro-economic issues.  Furthermore, she knows the results of the second quarter of 2007 in which CPK manages to maintain high revenues and profits. However, this knowledge is not reflected in the stock price as it has gone down. Susan Collyns could use this knowledge to her advantage and repurchase some of the underpriced stock, then reissue it when the market has caught up to this information and adequately reflects its intrinsic value.

Although this seems the perfect moment to repurchase shares, there is an important factor that has to be considered, namely that CPK has a high expected growth trajectory. Borrowing to repurchase shares, lowers the amount of borrowing power for growth projects, which could limit CPK’s opportunities to grow.  Concluding from these considerations, we recommend that the company should leverage the firm to repurchase shares because it creates value. However, it should keep enough debt capacity so they will have enough financial resources available for expansion opportunities

2) How does debt add value to CPK?        

There are a few benefits of debt for CPK. First of all, as debt is taxed differently than equity, there are certain tax benefits to debt financing. By leveraging the company, the taxable income will decrease which leads to lower taxes paid for the firm. This tax shield positively influences the company’s market value. Secondly, the ROE will likely increase, namely: as the proportion of debt increases, the proportion of equity decreases while the net income will decrease by a smaller amount because of benefits of the tax shield. Looking at the formula of ROE:

ROE = Net Income / Shareholders Equity

When the denominator decreases more than the nominator, this results in an increase in ROE. Furthermore, an increase in the ROE will lead to a higher valuation of the firm by analysts. Moreover, issuing debt to repurchase shares includes additional benefits as mentioned in question 1; it sends a credible signal that the stock is undervalued which will generally have a positive effect on share price.

Different from dividends payments, investors themselves can decide whether to tender their shares for repurchase. According to the Modigliani Miller theorem, the financial structure of the firm does not matter for individual shareholders. They have the ability to undo any changes in the capital structure of the firm by borrowing and lending on their own account. However, with the inclusion of corporate taxes, debt is actually beneficial for shareholders, because the tax shield will provide them with higher returns.