Value of equity after recapitalization formula

Approved Logo 1 Sept 2013

BNFN 4304 – Financial Policy

Mr. Masood Aijazi

Case 33: California Pizza Kitchen

Spring Semester 2017 – 2018

Written By

Maryam Barifah 1420023

Nour Abdulaziz 1420149

Shrouq Al-Jaaidi 1420072

Balqees Mekhlafi 1420231

Submission Date

22/03/2018

CASE 33

CALIFORNIA PIZZA KITCHEN

Guidance Sheet

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 learning 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.

Questions

1. What is going on at CPK? What decisions does Susan Collyns face? In what ways can she facilitate the success of CPK? What do you recommend?

1. Using the scenarios in case Exhibit 9, what role does leverage play in affecting the return on equity (ROE) for CPK?

1. Is the capital structure decisions relevant for maximizing the shareholders’ value? What is the ratio of debt-to-equity that maximizes the shareholder’s value? Why should the stockholders care about maximizing firm value? Shouldn’t they be interested in strategies that maximize shareholder value only?

What are the key drivers for increasing value of CPK how it affects its capital providers i.e. shareholders and creditors.

1. How does debt add value to CPK?

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

1. What should Collyns recommend?

Note: A spreadsheet is provided to assist students. Students however can create their own analysis, financial model, spreadsheet, schedule or tables.

Please submit your case write up, presentation and spreadsheet. Please put you names on the spreadsheets as well,

Table of Contents 1. What is going on at CPK? What decisions does Susan Collyns face? In what ways can she facilitate the success of CPK? What do you recommend? 3 2. Using the scenarios in case Exhibit 9, what role does leverage play in affecting the return on equity (ROE) for CPK? 5 3. Is the capital structure decisions relevant for maximizing the shareholders’ value? What is the ratio of debt-to-equity that maximizes the shareholder’s value? Why should the stockholders care about maximizing firm value? Shouldn’t they be interested in strategies that maximize shareholder value only? 7 Distribution of Shares Between Controlling & Non-Controlling Shareholders 8 Distribution of Shares Between Controlling & Non-Controlling Shareholders After Buyback 9 4. How does debt add value to CPK? 9 5. What is the case for not doing the recapitalization? 10 Sources of cash = NOPAT + Net new debt 10 Growth in total capital = ROC + Change in D/TC – Payments/TC 11 6. What should Collins recommend? 11

1. What is going on at CPK? What decisions does Susan Collyns face? In what ways can she facilitate the success of CPK? What do you recommend?
California Pizza Kitchen (CPK), a company that was founded from an idea that was an escape for 2 defense lawyers, which is now being led by Susan Collyns who is the Chief Financial Officer. CPK was founded in 1985 in Beverly Hills, California. By mid 2007, it expanded to a total of 213 retail outlets throughout the US and internationally with 40% of their operations being centered in California. At the moment CPK is operating at fully owned outlets; some of them are partnerships and rest are operating as franchises, these are considered to be the main sources of income.

In 2007 when the financial team was compiling the preliminary results for the second quarter, it was realized that despite the fact that the share price of the firm had dropped by 10% the previous month to the current value it is at of $22.10, CPK was still operating at an impressive profit level which was led by a strong revenue growth level in comparison to their competitors in the market, which were all suffering from increased prices of commodities and an increase production costs. In addition to this CPK’s management also made sure that they have a conservative financial policy which was to avoid any debt to appear in the balance sheet statements.

CPK is considering to open at least 16-18 new branches with a possible closure of an older branch in the near future, to achieve financing for such a project Collyns needs to concern herself with what will be the most appropriate capital structure to move forward with. The plan of action being considered at the moment is the share repurchase this is also motivated by the fact that share price is actually depressed at the moment. The effect of this share repurchase will be observed in the market, so what can be expected is a higher value of the stock in the future which will be caused by an increased return on equity, reduced cost of capital and also an increase in stock price. But for this to be done CPK might need to consider debt financing although they actually try to avoid adding any debt to the firm. So, capital structure is the biggest issue that she is facing currently.

CPK has a strong foundation which can lead to having an optimistic future lining ahead of them which is evaluated by the analysis of the market and the management’s confidence in the firms. The numbers found in the statements and the revenue growth of the firm when compared to the industry is very good indicator to the firms future success.

A suggestion to help Collyns facilitate the success of CPK is to continue expanding branches both domestically and internationally since consumers have a very good response to CPK, this is also shown in the financial statements and it is recorded a growth of 15% in the second quarter of 2007 while competitors only grew by 5%. What Collyns can also do is that she can increase its marketing strategy to attract more customers to the firms since CPK is currently spending less than their competitors on marketing, it is believed that can increase of sales can be done by an increase in marketing.

CPK’s revenues have three main sources; sales at company owned restraunts, royalties from different franhied restaurents and royalities from their partnership with Kraft Foods, CPK should sustain this pattern while also deveopling different alternatives to increase and improve the overall performance of the firm.

Other possible alternatives to help facilitate CPK’s success is to consider merging or creating partnerships with other business to increase channels and get a better control on cost of goods sold levels in production.

We suggest that Susan should approach debt financing to repurchase the company’s stock to increase the share price, also the money can help in the expansion of the branches. The company will also gain many benefits from going with the decision of capital restricting; which is debt financing, the main benefit is an interest tax shield. If Collyns doesn’t decide to go this route it can lead to increasing equity, which is a difficult thing to do.

2. Using the scenarios in case Exhibit 9, what role does leverage play in affecting the return on equity (ROE) for CPK?
As we computed the financial leverage for CPK from 1-1-2006 to 1-7-200, we have found that the financial leverage was 28% in 1-1-2006, 32.5% in 32-12-2006 and 33.5% in 1-7-2007. The financial leverage of the company has slightly increased during 1.5%

The financial leverage increasing may improve the ROE for a company because a company could outsource money in the utilization of a company’s operations with a few or even without requiring investments from equity.

Looking at a company’s income statement during 2006 to 2007 in Exhibit 3, we find that the net income was 19,490 and 21,000.

Calculating the ROE, we found the ROE was 9.88% in 2006 and 10.08% in 2007. This means that the ROE of the company has improved because they had expanded their business by using higher debt for the company’s operations while slightly increasing the equity as part of the expansion.

As for the cost of capital, our calculation has shown a different WACC for three different Debt/total capital scenarios of 10%, 20% and 30% in Exhibit 9. Posed at 8.35%, 8.82%, and 8.17% respectively. The financial leverage impact to cost of capital in term of increasing the financial leverage was the WACC decrease due to the proportion differentiation of debt to total capital from 10%, 20% and 30% respectively.

The effects of financial leverage on BETA was the increase the ROE but it entails high risk. The second concern that we have was the effect of leverage on the WACC by calculating the company’s beta using the CAPM model. The unlevered beta was 0.85, which is the beta of the company without any debt. It removes the financial effects from leverage. We have used the formula “ Where BL is the firms’ beta with leverage, Tc is the tax rate and D/E is the company’s debt to equity ratio. Coming with 0.87, 0.89, and 0.915 at a debt to total capital of 10%, 20% and 30% respectively.

The effects if financial leverage on cost of equity was that the higher the financial leverage, the higher the cost of equity as we have calculated in exhibit 9. We have concluded this after we have used the formula Rf= Rf+ Beta x (Rm - Rf)

3. Is the capital structure decisions relevant for maximizing the shareholders’ value? What is the ratio of debt-to-equity that maximizes the shareholder’s value? Why should the stockholders care about maximizing firm value? Shouldn’t they be interested in strategies that maximize shareholder value only?
What are the key drivers for increasing value of CPK how it affects its capital providers i.e. shareholders and creditors.

Modigliani-Miller theory basically states that the market value of any firm is determined by their earning power, any risk from underlying assets and its independent way of them choosing to finance their investments. So the basic idea behind this theory is that it does not make any difference whether a firm will finance itself with either debt or equity. So the way that it is applied in this case is that the value of CPK does not depend on the way the profits are divided up but on the total size of profits.

When calculating what the effect of a share repurchase will do to the firm, the calculations are shown below. Using a 10% debt to total capital structure will drive up the price of the stock up to $22.35, this will cause a 1.13% increase and will allow a possible buy back of 1,011,000 shares which is equal to a 3.47% decrease in shares. A change of 20% debt to total capital structure will move the price to $22.60, it will cause a 2.26% increase and this will help buy back 1,999,000 shares to be bought back and a 6.685 decrease. A 30% debt to total capital structure will jump the stock price to $22.86, a 2.99% increase and allow a repurchase of 2,965,000 shares, a 10.18% decrease in shares.

It is our opinion, a debt issuance to buy back shares is the best step forward for the company to do. What is recommended is for them to issue around $45,178,000 worth of debt in order to achieve a 20% debt to total capital structure. It is also recommended for CPK to use this money to buy back approximately 1,999,000 shares of their stock. This will cause an increase of 2.26% of share price which will be appeasing to their shareholders. This level is chosen because of the obvious benefit to the shareholders and because the level of risk that is involved for the shareholders is considered to be moderate. Even though if they use a 30% debt to total capital structure it will be more beneficial to shareholders, this carries too much of a risk for Collyns. By going for the most conservative 20% leverage, it will leave more room for a change in capital structure in the future, so if they want to further expand it will be possible.

The states of shares which are owned by two different sets of shareholders which is shown in the below table;

Distribution of Shares Between Controlling & Non-Controlling Shareholders
Shareholders

Percentage of Shares

Number of Shares

Controlling Shareholders

51%

14,856,300

Non-Controlling Shareholder

49%

14,273,700

Total Shares

100%

29,130,000

In the proposed scenario, the controlling shareholders will not want to lose any shares because of the controlling issues. Because of this the non-controlling shareholder will be the ones to lose some of their shares. With CPK’s case when repurchasing the shares from the non-controlling share, this repurchase which will be done by tender offer will lead to the controlling shareholders to have a significant number shares more than their counterparts and will have a marginal increase in company decisions.

Distribution of Shares Between Controlling & Non-Controlling Shareholders After Buyback
Shareholders

Percentage of shares

Number of Shares

Controlling shareholders

54.7%

14,856,300

Non-Controlling Shareholders

45.3%

12,291,321

Total Shares

100%

27,147,621

The repurchase will have many adverse effects on the different shareholder groups. The non-controlling shareholders who did not tender their shares, will have experienced a major increase in the value of their shares. However the non-controlling shareholders who did tender their shares would have experienced a 20 cent per share gain in addition to the increase in the market value of their share. The effect on the controlling shareholders will be as follows, it will increase negotiation power if in the future the shareholders would want to tender their shares. This will result in if CPK would have to purchase their shares at a premium which would comprise of 1) a loss in the stake of the corporation and 2) a loss in value of control.

4. How does debt add value to CPK?
For many companies debt is considered a liability that they owe to their creditors and there is always an ongoing concern to repay it. But yet there are certain advantages carried by acquiring debt for a company. The same is applicable for CPK, as they will be able to benefit from the taxation that occurs when financing a debt. Taxation implication on debt differs from the one on equity. Leveraging CPK will allow them to achieve lower tax rate, since the lower taxable income; lower the tax paid. Moreover, this will be reflected on the company's market value as tax shield raises market value by saving a company's cash flow. Another benefit for CPK will be the rise in ROE that would occur due to the greater proportion of debt compared to equity. But due to the tax shield, income will not be affected greatly. According to the ROE formula; net income/shareholders equity, when equity decreases in a greater proportion to the net income, ROE tends to rise. This also adds value to the company. Since CPK is facing a decline in their stock price due to undervaluation of its stocks, they could repurchase it via the debt. By this CPK will be able to affect the impact of their stocks price and can raise their value again. Debt inquiry will not only benefit CPK, but their shareholders as well, as they will be able to attain greater income due to the tax shield.

5. What is the case for not doing the recapitalization?
The CPK management is known for its conservative financial policy as per its concern for maintaining power. The management should keep in mind the benefits of leverage and tax-shields gains when contrasted with the cost of using all of the borrowing capacity for the future. As CPK has an important growth trajectory, we ought to question whether the growth exceeds the firm’s ability to sustain this growth. To see whether or not this is an issue, we have to analyse the sustainable growth rate through the sources and uses of cash. This method excludes the possibility of new equity financing.

Since the formulas are presented as follows:

Sources of cash = NOPAT + Net new debt

Uses of Cash = change of NWC + change of PPE + Dividends and repurchases + Interest Payments.

We equaled both of the formulas to each other and rearranged the new formula.

We got the equation:

Growth in total capital = ROC + Change in D/TC – Payments/TC

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

By using all the debt capacity to repurchase shares, the management restrics the funding of business growth to the level generated by the business operations, ROC. With the ROC for CPK running at 10%, the growth rate should be equal to that, give or take. The growth in new stores was estimated at 16 or 18 on the basis of 213 stores, which represent 7.5% to 8.5% expected growth rate. The 2007 capital expenditure was expected to be $85 million, depreciation was approximately $35 Million based on historical values and the first six months of 2007. A $50 million increase ($85-$35 million) in net property and equipment, NPE, and 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 will be adversely affected if the industry’s economics deteriorate further and reduce the company’s ROC.

6. What should Collyns recommend?
According to the available financial information, it is most suitable for CPK to finance their debt at 30%. Since CPK did not acquire debt earlier, it is considered risky for them, but the benefits that will arise from it are greater than not having debt at all. Greater returns are forecasted when obtaining debt. Moreover, this time is considered ideal for CPK debt acquirement, as positive prospects are assured from the outperformed benchmarking and the steady growth rate the past 4 years in sales, net operating income and net income. Although we mentioned earlier that there is a slight benefit of repurchasing their stock; as it will raise its value, it is not considered an investment to the firm. In case of a repurchase of stocks, the company will only need to refinance with 20% of the debt, in order to not exceed their credit line of 75 million dollars. The rest of the money could be used in other aspects of the company as to improve and innovate their products.