California Pizz Kitchen Case Study

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Nike Inc.

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Fabio Cuetara

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Bus 428A Seminar in Financial Management

Fabio Cuetara X__________________

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Recommendation

After careful consideration and analysis, I recommend that California Pizza Kitchen take on 20% debt of the total capital structure. The stock price is undervalued and because of low interest rates the company can take on debt to buy back stock. By buying back stock the total number of shares outstanding will decrease therefor the stock price will rise.

A major reason why CPK should raise debt is because then they will also make money with the increase of the stock price. Of course, those earnings will not be on the balance sheet unless they liquidate the stock.

CPK paid about $10MM in taxes last year and by raising the debt they are able to hide behind a tax shield that will lower income thus lower taxes paid.

CPK should take the 20% option because it is leverages the company in a moderate fashion while still getting the added benefits of repurchasing stock like the increase of stock price, EPS and P/E ratios.

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Cost of Capital; Debt Vs. Equity

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The major question is whether CPK should fund the repurchase of stock through debt or equity. To analyze the difference between we can compare the cost of vs. the cost of equity. The cost of equity before and debt is 9.71%. On the other hand the cost of debt is 6.16%. The difference is over 300 basis points.

When the amount of debt on the balance sheet increases the cost of equity increases as well because the increase of beta and risk. Below is a chart showing the increase of the cost of equity, WACC, Beta when the company raises debt.

Effects of...