California Pizza Kitchen

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3) 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?

The CEO of the California Pizza Kitchen is faced with the dilemma if is the ideal time to repurchase shares, leveraging the company’s balance sheet with ample borrowing available on its existing line of credit. The first matter that needed to be clear is that in the markets applies the “informal” rule that debt financing is good news to investors and provides a signal to them, of course with the assumption that we talk for a healthy, profitable company as CPK. It is, although, known that increasing a firm’s leverage may imply a lower credit rating which yields to a higher cost of capital, and may increase bankruptcy risks and costs. The bottom line, in this matter, is that the company would add value to shareholders by operating at its optimal level of leverage. After this certain point, the actual cost of debt diminishes profit margins and decrease assets turn. As a result of these, it is a thorough an analysis of company’s returns and cost because of leverage, in order to conclude if is a “good” idea and if company can afford to add debt in its balance sheet to repurchase its stocks, the time that exists the scenario for company’s expansion.

The equity required rate of return, according to CAPM, depends on how risky the firm is in relation to the market. CPK’s data provides that its unlevered beta is 0.85, which means that the company is less risky that the market. If CPK decide to use debt, is expected that the leverage will increase the expected rate of return on the equity, this is simply because leveraged investments are riskier than unlevered. Also, the company’s beta will be increased and will be closer to that of the market. We calculated the levered beta of the company in 3 percentages of debt, using the company’s market value of debt and equity, because investors are those who are going to value the firm. We found the beta will be 0.87 in 10%, 0.89 in 20% and 0.92 in 30% of leverage respectively (Appendix 1). The next step is to calculate the required cost of equity, using the levered beta, market premium (average return of small cap 600 restaurants which was equal to 7.4%) and risk free the US Bond Treasury of 10 years, which was equal to 5.1%, yielded that the expected return will be higher in every stage of higher leverage. Subsequently, we estimated the return on equity (ROE) via DU PONT analysis, which helped us locate the underperforming parts of the business, breaking it into 3 components parts in order to determine what kind of ROE is being generated, and to examine the quality of that return.

DU PONT ANALYSIS

Revenue (in thousands)

555.000

Debt ratio

0%

10%

20%

30%

Profit Margin

0,04

0,03

0,03

0,03

Total Assets turnover

2,46

2,46

2,46

2,46

Equity multiplier

1,00

1,11

1,25

1,43

ROE

8,99%

9,52%

10,19%

11,05%

The above table makes it clear that as the leverage level increases, the ROE increases also. Profit margin appears a deduction equal to 1% because of the interest payments that company has to do, but the equity multiplier is increasing with higher percentage in every level, which implies that the added debt to the balance is the reason of the increase in ROE, and not any change in the company’s management or total assets. The rising ROE suggests that CPK will increase its ability to generate profits without need as much equity capital.

Comparing the return on equity that CPK provides to its shareholders and expected cost of equity based on markets returns, it is clear that CPK presents a better performance than the irrespective returns on the market, and better rewards for its shareholders. As the company issues more debt, the difference between ROE and cost of equity is becoming bigger. Shareholders enjoy better returns.

If CPK decides to be leveraged its cost of capital will change. Specifically, the new cost will be the weighted average of cost of debt and equity. The company unlevered has a cost a capital 7.05% (Appendix 1) which starts to decline in every level of leverage. Because of tax shields the firm will “enjoy” tax payments deductions, as the WACC will be 6.8% in 10%, 6.55% in 20% and 6.28% in 30% of leverage. Company’s cost will be lower and as result, if CPK keeps the other elements unchanged, the firm’s value will increase. Based on the hypothesis of Modigliani& Miller about firm’s value and in the fact that theorem was developed in a world without taxes but in reality the interest on debt is tax deductible, we suppose that the value of the company increases in proportion to the amount of debt used. The source of additional value is due to the amount of taxes saved by issuing debt instead of equity. To be more precise, firm’s value will be equal to unlevered value, which is equal to the market value of unlevered equity, plus the tax shields it saves. The initial value was 643.773m and will change to 653.364m, 667.472m and 686.099m respectively in every examined level of leverage. The percentage change in firm’s value will continue to grow up until the point at which the cost of capital will be higher than the return on assets. Company will have no incentive to use more debt after this point.

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The above diagram shows clearly that ROE (the level of profitability which a firm realizes by the money which was given to them by equity investors) continues to be higher than the cost of capital (WACC, the minimum rate of return that a firm’s need to earn for its