Given the price drop, the management team of California Pizza Kitchen discussed repurchasing company shares. With little money in excess cash, a large share repurchase program would require debt financing. The company is looking into this option.
Michael J. Schill and Elizabeth Shumadine
Harvard Business Review (UV1203-PDF-ENG)
September 02, 2008
Case questions answered:
Case study questions answered in the first solution:
- In what ways can Susan Collyns facilitate the success of California Pizza Kitchen?
- 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: bL = bU[1 + (1 − T)D/E], where bU 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.
- 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?
- What capital structure policy would you recommend for CPK?
Case study questions answered in the second solution:
- What are the ROE, Beta, COE, WACC, and Internal Growth rates of the firm?
- What are the assumptions and why?
- Should CPK repurchase? If so, why?
- How should CPK structure this debt?
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California Pizza Kitchen Case Answers
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Executive Summary – California Pizza Kitchen
California Pizza Kitchen was founded in 1985 by attorneys Rick Rosenfield and Larry Flax in Beverly Hills, California. Despite industry challenges, California Pizza Kitchen has had a continuous strong performance.
Since going public in 2000, CPK’s management has avoided putting any debt on the balance sheet and has followed a conservative financial policy. Despite a great performance, California Pizza Kitchen’s stock price has dropped 10% in the last month to a value of $22.10.
Given the price drop, the management team has discussed repurchasing company shares. CPK has a strong potential for growth due to several factors. It has a licensing agreement with food giant Kraft, it has the potential for growth to 500 locations across the U.S., and its marketing expenses are the lowest in its industry.
While it has a lot of room for growth and expansion and currently outperforms competitors, California Pizza Kitchen only has a little excess cash, which brings the issue of using debt financing at a possible 10%, 20%, or 30% amount to repurchase shares.
If CPK decides to pursue a debt-financed stock buyback program, it needs to find the optimal amount of debt. A level that will increase their financial capabilities yet not over-leverage the firm.
It is my opinion that California Pizza Kitchen best benefits by staying with its 0-debt financing capital structure. With no debt, the company can continue to grow using its many current advantages while taking on no new risks.
Though it is not ideal that the stock price is decreasing, CPK retains higher earnings per share at this level. It can also keep open its line of credit for whatever the economy throws at it.
1.1 The Company
Inspired by the gourmet pizza offerings at Wolfgang Puck’s celebrity-filled restaurant, Larry Flax and Rick Rosenfield created the first California Pizza Kitchen in 1985 in Beverly Hills, California.
Expansion across the state, country, and globe followed in the next two decades. By 2007, the company had 213 locations in 28 states and 6 foreign countries. While mostly based in California, the casual dining model has done well throughout all U.S. regions with its family-friendly surroundings, excellent ingredients, and inventive offerings.
California Pizza Kitchen derives its revenues from three sources: sales at company-owned restaurants, royalties from franchised restaurants, and royalties from a partnership with Kraft Foods to sell CPK-branded frozen pizzas in grocery stores.
While the company has expanded beyond its original concept with two other restaurant brands, its main focus remains on operating its 170 company-owned full-service CPK restaurants.
Despite industry challenges of rising commodity, labor, and energy costs, California Pizza Kitchen has made near-record quarterly profits of over $6 million. Despite the strong performance, industry difficulties are such that CPK’s share price declined to a current value of $22.10.
Given the price drop, the management team discussed repurchasing company shares. With little money in excess cash, a large share repurchase program would require debt financing.
Since going public in 2000, California Pizza Kitchen has avoided putting any debt on the balance sheet. The rationale is that a strong balance sheet will maintain the borrowing ability needed to support CPK’s expected growth plans. Yet, with interest rates on the rise from historical lows, we are aware of the benefits of levering up CPK’s equity.
The recent 10% share price decline seems to raise the question of whether this is an ideal time to repurchase shares and potentially leverage the company’s balance sheet.
California Pizza Kitchen’s main goal for the use of financing is to balance the return of capital to shareholders while maintaining management’s goal of growing the business.
CPK obtains revenues from three sources: sales at company-owned restaurants, royalties from franchised restaurants, and royalties from a partnership with Kraft Foods to sell CPK-branded frozen pizzas in grocery stores.
The first option is to continue the development of California Pizza Kitchen Restaurants for the expansion of the company to new locations.
The company now owns 170 full-service restaurants, with development plans on schedule for opening 16 to 18 new locations this year, and analysts estimate the potential for growth to 500 units.
The company and investors are confident about CPK’s success and prospects with franchising full-service restaurants internationally with 15 current locations and more planned.
Franchising agreements pay California Pizza Kitchen…
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