California Pizza Kitchen

California Pizza Kitchen Case

California Pizza Kitchen’s management is considering a finance of a share repurchase program with debt. The company is considering a repurchase due to the 10% decrease in share price and management feels that the market is undervaluing their stocks. Management is having a difficult decision with choosing debt because they did not want to leverage their balance sheet. CFO, Susan Collyns, can facilitate the success of California Pizza Kitchen through one of four different potential policy changes. The first is to maintain operating as is with no debt. The second is to borrow $23 million, which is 10% debt to total book capital. The third option is to borrow $45 million at 20% debt to total book capital ratio. Or the company can borrow $68 million debt would be 30% of total book capital.

By increasing leverage, return on equity will also increase. See calculations performed in the attached excel document in the “my analysis” tab. Cost of capital decreases because debt is cheaper than equity. By adding additional leverage to the balance sheet more financial risk is added to the business, an increase in beta. This is due to the increase in obligations for more debt payments, which in turn can cause stress on the company.

A benefit to an increase in leverage on the business sheet is the tax shield that is created. Additional debt creates an increase in interest expense, which in turn decreases your tax expense. The tax shield allows the government to receive less and the shareholders to receive more.

Another benefit to leveraging a balance sheet is that the weighted average cost of capital (WACC) decreases.

My recommendation would be to proceed with the share repurchase by assuming debt because it is an efficient method of leveraging the balance sheet and lowers the company’s cost of capital while still being able to return additional capital to the shareholders.