California Pizza Kitchen

Jahlani Callender

California Pizza Kitchen

Decision:

        Our main decision that needs to be made is do we need to make changes to our company’s capital structure in order to implement a share buyback program.  

Steps for Analysis:

1. Analyze the 4 different debt ratios (what will be the outcome, and how will these ratios be achieved)
2. Determine what the company has to gain from adding leverage to its balance sheet for the purpose of buying back shares
3. Evaluate the affects of a repurchase program. Should the company used leverage to repurchase share and if so how much?
4. Final recommendation

Analysis:

         Step one is to analyze the 4 different debt ratios. We want to determine what effects these debt ratios will have on the company. On the surface we can see a couple of things. Adding debt will 1) decrease net income, 2) decrease income tax, 3) increase interest expense, 4) adjust the BV of debt and equity and 5) adjust the MV of debt and equity. Because we are adding debt for the purpose of financing and not to increase assets, our EBIT remains the same, but now we have the addition of interest expense. This decreases our EBT as well as out income taxes which can be seen in exhibit 9. But what does this mean for the company? I went ahead and worked out how the changes in debt would affect key rations such as ROE, EPS, P/E, Beta, Cost of Equity, WACC, and finally determined what it would do to the share price. ROE is a good determinant in how efficient the company is at generating profits without adding additional capital. In the case of CPK we can see a slight decline in ROE between fiscal year 2006 and 2007 (illustrated in exhibits 7 & 9 respectively). Although adding debt to the company will artificially raise the company ROE I believe at these levels it should be of no concern to shareholders. The next key ratio is EPS which may serve as an indicator of the company’s profitability. As calculated in exhibit 9 as we increase debt we see a steady decline in the company’s earning per share. This effect should be kept in mind as EPS is an important ration for investors. We can also observe that CPK P/E ration would increase. This is because share price, which will be discussed in a moment will increase faster than EPS will decrease. P/E is another ratio that investors will look to, so a increased P/E ratio will benefit the company. Additionally because of the addition of debt and lower level of equity and change in earning would prove to be more volatile, which is why you see a increase in Beta. Although there is an increase in the company’s Beta, if we compare the beta at the different debt ratio they all remain below the industry average of .95 as seen in exhibit 7. The last two rations we have are the Cost of Equity and the WACC. In exhibit 9 we can see that the Cost of Equity increases, while the company’s WACC decreases. Both of these ratios are crucial in valuing a company. Investor usually would like a company with a higher Cost of Equity and a lower WACC and we see this trend with at all three debt ratios. The final thing I want to mention is stock price. In exhibit 9 we price per share begins to increase as more debt is added to the company. We’ve see the affects debt will have on the company, not the question is how much debt.