Case 33 California Pizza Kitchen163 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: 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. 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? 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. . 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. Is there a case for that? This question is designed to introduce a discussion of the Modigliani-Miller value irrelevance of capital structure decisions.xls) is available for students. Teaching Plan 1. Using case Exhibit 9. 5.164 Case 33 California Pizza Kitchen What role does the tax deductibility of interest play in encouraging debt financing at CPK? 4. The technical note. Maybe we can all be right. 2. End with a class vote on the alternatives. 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. What capital structure policy would you recommend for CPK? Supplementary Material A spreadsheet (Case_33.xls) is also available for instructors. and the concept of risk-sharing. 3. levered betas.” (UVA-F-1168) is available as a review of the theory and application of the issues surrounding financial risk. the class can discuss ROE. What should Collyns recommend? This question invites a wrap-up of the case discussion. A spreadsheet (TN_33. “The Effects of Debt Equity Policy on Shareholder Return Requirements and Beta. Borrow $68 million (30% debt to total book capital). Maintain existing financial policy with no debt. In this case. Maybe we can all be right. say 20 minutes into the class session. the instructor can ask the class to draw comparisons with CPK. I like to do this example with a couple of real pizzas. Management is considering the benefits of borrowing to repurchase shares The four alternatives considered explicitly in the case are 1. 2. Borrow $23 million (10% debt to total book capital). Then the instructor can ask if the person would rather pay $10 for the eight-slice pizza. . Representative student “champions” can be recorded to facilitate subsequent discussion. 4.1 The instructor can alternatively draw two pizzas on the board. 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. Once the class is convinced. Since this is a “pizza case. food input.10. This discussion can end with the instructor inviting each student to vote on the alternatives at hand. 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. CPK’s stock price is down 10% to $22. is there a case for that? This question is designed to introduce a discussion of the Modigliani-Miller value irrelevance of capital structure decisions. Of particular importance are the following points. CPK has shown strong operating performance recently despite industry challenges of increasing labor. The instructor can ask if anyone is willing to pay $5 for the four-slice pizza.” an engaging way to stimulate this discussion is with the traditional pizza example of capital structure theory.Case 33 California Pizza Kitchen 165 Case Analysis 1. 3. “Staying power” requires a strong balance sheet. The students will quickly recognize that the value of CPK depends on the total size of the profits 1 A particularly memorable way to introduce this discussion is to orchestrate a pizza delivery to the classroom at a particular appointed time. Its management has an agenda of expanding the company with 2007 growth requiring $85 million in capital expenditures. Borrow $45 million (20% debt to total book capital). and energy costs. 2. The pizzas should be identical except that one pizza might be cut into four slices and the other cut into eight slices. 166 Case 33 California Pizza Kitchen and not on how the profits are divided up. Leverage is simply a way of slicing up the business risk. In the suggested study questions. Since the weighted average cost of capital (WACC) reflects the total risk. This exhibit provides a simple pro forma estimate of the value of debt tax shields for three recapitalization scenarios (10%. To demonstrate this point with the case example. 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. while the high-leverage ROE increases even more to +30%. The pizza experience becomes a striking example that can easily be hearkened back to in subsequent class sessions. 3. students are invited to complete a variety of different tasks with respect to case Exhibit 9. Financial leverage and financial risk The instructor can draw attention to the apparent appeal of leverage in increasing the expected ROE of CPK. the no-leverage ROE rises to +22%. Alternatively. In this case. The instructor can refer back to the pizza argument with respect to risk. These tasks include calculating the implied ROE. the no-leverage ROE drops to −18%. The exercise provides two main learning points: Comprehending the effect of financial leverage and financial risk on firm returns. In the first round. 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. 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. To illustrate the point. 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. and number of shares outstanding for each scenario. the WACC should not change with simply slicing up the risk across various types of contracts. The students should quickly see the magnifying effect of leverage on the risk of equity returns. the instructor must alter the beta . The mechanics of debt tax shields can be facilitated through a discussion of case Exhibit 9. The instructor can invite students to explain the exhibit and then present their analyses regarding each of those tasks. How does debt add value to CPK? Conceptually. Understanding the effect of tax shields on value and the cost of capital. while the high-leverage ROE drops even more to −29%. costs of capital. if the EBIT line is multiplied by a factor of 2. stock price. The instructor can ask whether equity investors should be happy with the same level of return for a much higher risk. the EBIT line can be multiplied by a factor of −1. students will appreciate that leverage comes with additional risk. The total risk is unadjusted. 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. Exhibit TN1 provides instructor solutions to that exercise. When pushed. and 30%). 20%. One way to explore that issue is through an analysis of the sustainable growth rate. In expectations. PN. 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.129 million shares outstanding. 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. the stock price will change to reflect the anticipated tax shield but the number of shares remains constant.Case 33 California Pizza Kitchen 167 formula in the study questions to remove the portion of risk that the government bears in the tax shield. At the time of the announcement of the recapitalization. To motivate the sustainable growth rate. it is helpful to break the task down by event time. To help students understand the mechanics. Since CPK management has an important growth trajectory for the business. The instructor can have the students present and discuss their analyses. Number of shares repurchased = D/PN. shares are repurchased in the amount of the debt raised. . the instructor can start with the sources and uses of cash. Later. This revised formula is L = U[1 + D/E].10 + D × t/29. Exhibit TN1 provides the analysis for that exercise. The new shares-outstanding number is equal to the original number of shares outstanding less the number of shares repurchased. 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. The definition below excludes the possibility of new equity financing. at the recapitalization. An illustration of each component of the cost of capital at each scenario may be helpful. 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. Students frequently struggle with estimating the effect of the tax shield on the stock-price effect and estimating the number of repurchased shares. the repurchase occurs at the new share price. one might question whether the growth path exceeds the firm’s ability to sustain such growth. The instructor can review the students’ cost of capital estimates and discuss how the tax shield allows leverage to reduce the WACC. Post-announcement share price = PN = $22. The instructor can encourage consensus on the motivation and mechanics for how the tax shield enters into the weighted-average costs of capital. not including any increases in new working capital (NWC). we get: NWC + PPE = NOPAT + Net new debt − Dividends and repurchases − Interest payments. CPK’s growth rate should be at about that level.5% to 8. An epilogue for the case is included in Exhibit TN2. where growth in total capital is equal to TC/TC. Dividing both sides of the equation by total capital (TC) gives the following equation: Growth in total capital = ROC + D/TC – Payments/TC. The internally generated funding for growth will be adversely affected if the industry’s economics deteriorate further and reduce business’s ROC. and payments are equal to dividends plus repurchases plus interest payments. The 2007 capital expenditure was expected to be $85 million. . Setting those equations equal to each other and rearranging terms. 5. depreciation was likely to be $35 million based on historical values and the first six months of 2007. ROC is equal to NOPAT/TC. ROC. 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.5% expected growth rate. With ROC for CPK running at approximately 10%. management restricts the funding of business growth to the level generated by the operations of the business. By using debt capacity to repurchase shares. The growth in new stores for 2007 was estimated at 16 to 18 on a base of 213 stores.168 Case 33 California Pizza Kitchen Sources of cash = NOPAT + Net new debt. What should Collyns recommend? The class can close with a discussion on the recommendation. representing a 7. Uses of cash = NWC + PPE + Dividends and repurchases + Interest payments. except share data. (4) Market values of debt equal book values.Case 33 California Pizza Kitchen Exhibit TN1 CALIFORNIA PIZZA KITCHEN Pro Forma Tax Shield Effect of Recapitalization Scenarios (dollars in thousands. (3) No earnings per share calculated on treasury stock. figures based on end of June 2007) _____________________ Notes: (1) Interest rate of CPK’s credit facility with Bank of America: LIBOR + 0.80%. 169 . (2) EBIT includes interest income. The company planned to fund the new program with borrowings under an expanded credit line and available cash balances. is an effective way for us to return capital to stockholders. The [share repurchase agreement]. Management and our Board are confident about the strength and long-term prospects of our Company. Exhibit TN2 CALIFORNIA PIZZA KITCHEN Epilogue Over the month of July. Co-CEOs Rosenfield and Flax remarked. . and reduce our overall cost of capital. the company announced its intention to repurchase an additional $46. CPK repurchased $16. leverage our balance sheet.170 Case 33 California Pizza Kitchen Source: Case writer analysis based on CPK financial data.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.3 million shares. in conjunction with our expanded credit facility. In early 2008.