CALIFORNIA PIZZA KITCHEN

Teaching Note

Synopsis and Objectives

This case examines the question of financial leverage at California Pizza Kitchen (CPK) in July 2007. With a highly profitable business and an aversion to debt, CPK management is considering a debt-financed stock buyback program. The case is intended to provide an introduction to the Modigliani-Miller capital structure irrelevance propositions and the concept of debt tax shields. With the background of a pizza company, the case provides an engaging context to discuss the “pizza graphs” that are commonly used in corporate finance curriculum to illustrate the wealth effects of capital structure decisions.

The case serves to motivate the following teaching objectives:

• Introduce the Modigliani-Miller intuition of capital structure irrelevance;

• Establish how the cost of equity is affected by capital structure decisions by defining financial risk and introducing the levered-beta capital asset pricing model (CAPM) equation;

• Discuss interest tax deductibility and the valuation tax shields;

• Explore the importance of debt capacity in a growing business.

Suggestion for Advance Assignment to Students

Students may consider the following study questions:

1. In what ways can Susan Collyns facilitate the success of CPK?

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: βL = βU[1 + (1 − T)D/E], where βU 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.

3. Based on the analysis in case Exhibit 9, what is the anticipated CPK share price under each scenario? How many shares will CPK be likely to repurchase under each scenario? What role does the tax deductibility of interest play in encouraging debt financing at CPK?

4. What capital structure policy would you recommend for CPK?

Supplementary Material

A spreadsheet (Case_33.xls) is available for students. The technical note, “The Effects of Debt Equity Policy on Shareholder Return Requirements and Beta,” (UVA-F-1168) is available as a review of the theory and application of the issues surrounding financial risk. A spreadsheet (TN_33.xls) is also available for instructors.

Teaching Plan

1. What is going on at CPK? What decisions does Susan Collyns face? What do you recommend?

This question affords an outline of the issues regarding the capital structure decision at CPK. End with a class vote on the alternatives.

2. Maybe we can all be right. Is there a case for that?

This question is designed to introduce a discussion of the Modigliani-Miller value irrelevance of capital structure decisions.

3. How does debt add value to CPK?

This question allows the class to go through the concepts and mechanics of leverage and debt tax shields. Using case Exhibit 9, the class can discuss ROE, levered betas, and the concept of risk-sharing.

4. What is the case for not doing the recapitalization?

This question affords a discussion of the counterpoint that completing the recapitalization diverts the current borrowing capacity away from funding CPK’s growth trajectory.

5. What should Collyns recommend?

This question invites a wrap-up of the case discussion.

Case Analysis

1. What is going on at CPK? What decisions does Susan Collyns face? What do you recommend?

The instructor should allow the students to develop the lay of the land for the case. Of particular importance are the following points.

• CPK has shown strong operating performance recently despite industry challenges of increasing labor, food input, and energy costs.

• Its management has an agenda of expanding the company with 2007 growth requiring $85 million in capital expenditures. “Staying power” requires a strong balance sheet.

• CPK’s stock price is down 10% to $22.10. Management is considering the benefits of borrowing to repurchase shares

The four alternatives considered explicitly in the case are

1. Maintain existing financial policy with no debt;

2. Borrow $23 million (10% debt to total book capital);

3. Borrow $45 million (20% debt to total book capital);

4. Borrow $68 million (30% debt to total book capital).

This discussion can end with the instructor inviting each student to vote on the alternatives at hand. Representative student “champions” can be recorded to facilitate subsequent discussion.

2. Maybe we can all be right, is there a case for that?

This question is designed to introduce a discussion of the Modigliani-Miller value irrelevance of capital structure decisions. Since this is a “pizza case,” an engaging way to stimulate this discussion is with the traditional pizza example of capital structure theory. In this case, I like to do this example with a couple of real pizzas.[1] The instructor can alternatively draw two pizzas on the board. The pizzas should be identical except that one pizza might be cut into four slices and the other cut into eight slices. The instructor can ask if anyone is willing to pay $5 for the four-slice pizza. Then the instructor can ask if the person would rather pay $10 for the eight-slice pizza. The instructor can use this discussion to solicit the observation that the value of the pizza depends more on the size of the pizza—not on how it is sliced.

Once the class is convinced, the instructor can ask the class to draw comparisons with CPK. The students will quickly recognize that the value of CPK depends on the total size of the profits and not on how the profits are divided up. One can also discuss homemade leverage in the same spirit as the low cost of self-cutting the pizza and creating an eight-slice pizza. The pizza experience becomes a striking example that can easily be hearkened back to in subsequent class sessions.

3. How does debt add value to CPK?

Conceptually, the instructor can proceed from the previous discussion by highlighting the large piece of pizza consumed by the government in the form of corporate income taxes. A tax policy that allows for interest payments to be tax deductible allows firms to create wealth for investors by reducing the government’s share of the pie.

The mechanics of debt tax shields can be facilitated through a discussion of case Exhibit 9. This exhibit provides a simple pro forma estimate of the value of debt tax shields for three recapitalization scenarios (10%, 20%, and 30%). In the suggested study questions, students are invited to complete a variety of different tasks with respect to case Exhibit 9. These tasks include calculating the implied ROE, costs of capital, stock price, and number of shares outstanding for each scenario. Exhibit TN1 provides instructor solutions to that exercise. The instructor can invite students to explain the exhibit and then present their analyses regarding each of those tasks. The exercise provides two main learning points:

• Comprehending the effect of financial leverage and financial risk on firm returns;

• Understanding the effect of tax shields on value and the cost of capital.

Financial leverage and financial risk

The instructor can draw attention to the apparent appeal of leverage in increasing the expected ROE of CPK. When pushed, students will appreciate that leverage comes with additional risk. To illustrate the point, the instructor can ask students to adjust the earnings before interest and taxes (EBIT) line of case Exhibit 9 by a certain amount both up and down. In the first round, the EBIT line can be multiplied by a factor of −1. In this case, the no-leverage ROE drops to −18%, while the high-leverage ROE drops even more to −29%. Alternatively, if the EBIT line is multiplied by a factor of 2, the no-leverage ROE rises to +22%, while the high-leverage ROE increases even more to +30%. The students should quickly see the magnifying effect of leverage on the risk of equity returns.

The instructor can ask whether equity investors should be happy with the same level of return for a much higher risk. The instructor can use this discussion to motivate and discuss the levered-beta formula provided in the study questions and how it captures the effect of financial risk in concentrating the business risk within a smaller amount of equity capital. The instructor can refer back to the pizza argument with respect to risk. Leverage is simply a way of slicing up the business risk. Since the weighted average cost of capital (WACC) reflects the total risk, the WACC should not change with simply slicing up the risk across various types of contracts. The total risk is unadjusted. To demonstrate this point with the case example, the instructor must alter the beta formula in the study questions to remove the portion of risk that the government bears in the tax shield. This revised formula is βL = βU[1 + D/E]. The instructor can review the students’ cost of capital estimates and discuss how the tax shield allows leverage to reduce the WACC.

The effects of tax shields on value and the cost of capital

The suggested study questions have the students estimating the cost of capital and implied stock price effects of the tax shield. Exhibit TN1 provides the analysis for that exercise. The instructor can have the students present and discuss their analyses. The instructor can encourage consensus on the motivation and mechanics for how the tax shield enters into the weighted-average costs of capital. An illustration of each component of the cost of capital at each scenario may be helpful.

Students frequently struggle with estimating the effect of the tax shield on the stock-price effect and estimating the number of repurchased shares. To help students understand the mechanics, it is helpful to break the task down by event time. At the time of the announcement of the recapitalization, the stock price will change to reflect the anticipated tax shield but the number of shares remains constant. The stock price rises by the value of the tax shield:

Present value of tax shield using perpetuity formula = (kd × D × t)/kd = D × t.

Post-announcement share price = PN = $22.10 + D × t/29.129 million shares outstanding.

Later, at the recapitalization, shares are repurchased in the amount of the debt raised. In expectations, the repurchase occurs at the new share price, PN.

Number of shares repurchased = D/PN.

The new shares-outstanding number is equal to the original number of shares outstanding less the number of shares repurchased.

4. What is the case for not doing the recapitalization?

CPK has a tradition of conservative financial policy based on its concern for maintaining staying power. Senior management may be leery of the benefits of leverage and tax-shield gains when contrasted with the cost of using up borrowing capacity for the future.

Since CPK management has an important growth trajectory for the business, one might question whether the growth path exceeds the firm’s ability to sustain such growth. One way to explore that issue is through an analysis of the sustainable growth rate. To motivate the sustainable growth rate, the instructor can start with the sources and uses of cash. The definition below excludes the possibility of new equity financing.

Sources of cash = NOPAT + Net new debt. Uses of cash = ΔNWC + ΔPPE + Dividends and repurchases + Interest payments.
Setting those equations equal to each other and rearranging terms, we get:

ΔNWC + ΔPPE = NOPAT + Net new debt − Dividends and repurchases − Interest payments.

Dividing both sides of the equation by total capital (TC) gives the following equation:

Growth in total capital = ROC + ΔD/TC – Payments/TC,

where growth in total capital is equal to ΔTC/TC, ROC is equal to NOPAT/TC, and payments are equal to dividends plus repurchases plus interest payments.

By using debt capacity to repurchase shares, management restricts the funding of business growth to the level generated by the operations of the business, ROC. With ROC for CPK running at approximately 10%, CPK’s growth rate should be at about that level. The growth in new stores for 2007 was estimated at 16 to 18 on a base of 213 stores, representing a 7.5% to 8.5% expected growth rate. The 2007 capital expenditure was expected to be $85 million; depreciation was likely to be $35 million based on historical values and the first six months of 2007. A $50 million increase ($85 million − $35 million) in net property and equipment (NPE) on a book capital base of $226 million represents a 22% growth rate in total capital, not including any increases in new working capital (NWC). The internally generated funding for growth will be adversely affected if the industry’s economics deteriorate further and reduce business’s ROC.

5. What should Collyns recommend?

The class can close with a discussion on the recommendation. An epilogue for the case is included in Exhibit TN2.
Exhibit TN1

CALIFORNIA PIZZA KITCHEN

Pro Forma Tax Shield Effect of Recapitalization Scenarios
(dollars in thousands, except share data; figures based on end of June 2007)

[pic]
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Notes: (1) Interest rate of CPK’s credit facility with Bank of America: LIBOR + 0.80%. (2) EBIT includes interest income. (3) No earnings per share calculated on treasury stock. (4) Market values of debt equal book values.

Source: Case writer analysis based on CPK financial data.

Exhibit TN2

CALIFORNIA PIZZA KITCHEN

Epilogue

Over the month of July, CPK repurchased $16.8 million of company shares. The repurchase was funded with the company’s line of credit such that the company’s outstanding borrowings stood at $17 million by the end of the summer. In early 2008, the company announced its intention to repurchase an additional $46.3 million shares. The company planned to fund the new program with borrowings under an expanded credit line and available cash balances. Co-CEOs Rosenfield and Flax remarked,

Management and our Board are confident about the strength and long-term prospects of our Company. The [share repurchase agreement], in conjunction with our expanded credit facility, is an effective way for us to return capital to stockholders, leverage our balance sheet, and reduce our overall cost of capital.

----------------------- [1] A particularly memorable way to introduce this discussion is to orchestrate a pizza delivery to the classroom at a particular appointed time, say 20 minutes into the class session.