Brief history of CPK (p.3) Reasons for CPKs success (p.3) Ways to facilitate the success of CPK (p.3-4) Anticipated effect of changing the capital structure on return on equity (p.4) Anticipated effect of changing the capital structure on cost of capital (p.5) Expected number of shares of CPK that can be repurchased (p.6-7) Anticipated effect of changing the capital structure on CPKs stock price (p.6-7) Our recommendation (p.7) In order to explore whether or not California Pizza Kitchen should change their capital structure, we must first look at the brief history of the firm to get a better idea of the corporate culture and the firms appetite for risk. California Pizza Kitchen started in 1985 and they have been rather successful given …show more content…
As we see in Exhibit B in the appendix, with an increase of 10, 20, and 30 debt to total capital, we see our ROE increase to 9.52, 10.19, and 11.05 respectively. However this increase in ROE comes at a price, as the overall risk of the company is increased with the addition of the debt obligations. In Exhibit B, we see that the beta of equity increase as we increase our debt in the capital structure, and increasing beta indicates increased systematic risk for the firm. This increase in beta is also a factor that contributes to the increased cost of equity. As shown in Exhibit B, the cost of equity increases 21 bps with the addition of 10 debt, 43 bps with the addition of 20 debt, and 67 bps with the addition of 30 debt into the capital structure. The increased basis points come as investors will begin to demand a higher rate of return on their investment as more debt is added to the structure because, as residual claimants, their claim to assets are reduced in favor of the bond holders. This increased rate will make it more difficult to raise future capital in the equity market if needed. However, by issuing debt which has a lower cost of capital at 6.16 and repurchasing equity that has a cost of capital of 13.37 (unlevered), the company can reduce its overall cost of capital, or the weighted average cost of capital (WACC). The WACC is measured by taking the weight of debt
The mixture of debt-equity mix is important so as to maximize the stock price of the Costco. However, it will be significant to consider the Weighted Average Cost of Capital (WACC) as well so that it can evaluate the company targeted capital structure. Cost of capital (OC) may be used by the companies as for long term decision making, so industries that faced to take the important of Cost of capital seriously may not make the right choice by choosing the right project(Gitman’s, ).
The statement of cash flows outlines some of the changes to the capital structure. The company added $164.5 million in a consolidated loan facility, and it paid out $138.1 million in dividends. There were no share buybacks during the year. The company states in the annual report (p.4) that it intends to maintain a conservative gearing ratio. The company in this section attributes its increased borrowings to projects and opportunities on which it has embarked. These investments lie within the integrated retail, franchise and property system. One of the
At first, WACC and CAPM was attempted to be used as a source of cost of capital. However, for WACC, there is no available proportion of debt and cost of debt for MW. For CAPM, no available data seems to support the acceptable
If the leverage increases from expected level, D/C will increase, the levered beta will increase, the cost of equity will increase, the after-tax cost of debt will keep the same. In addition, the weight of the after-tax cost of debt will increase and the weight of the cost of equity will decrease. It looks like that it is difficult to determine how WACC will change. However, according to the Figure 3-8 about the effects of capital structure in Chapter 15, we can find that when the debt ratio is 40%, WACC reaches the minimum value, so in this case, when the leverage change from 20% to 40%, WACC will decrease, and when the leverage bigger than 40%, WACC will increase.
By leveraging their company, California Pizza Kitchen adds value to their Total Market Value of Capital. They also increase their share price. It should be considered that as they increase their debt to equity ratio, they also increase their risk of default.
Cost of Equity is the return that stockholders require for a company. A company’s cost of equity represents the compensation that the market demands in exchange for owning the assets and bearing the risk of ownership. Based on capital markets the cost of equity varies in direct relation to the assumed risk in that specific market. The distinctive of the firm is the sensitivity to market risk (β) which depends on everything from management to its business and capital structure. Therefore past performances and present conditions have a direct effect on the overall value. Applying calculations at a divisional level allows specified markets to be analysis based on present market conditions for that service or product. The formula used to calculate Cost of Equity is:
Our analysis attempts to answer the question, “What are the things a company must consider when analyzing a new investment or project?” According to the text, a firm’s first objective when deciding to take on new debt should be that its return on net assets (RONA) should be greater than its weighted average cost of capital (WACC). Since we are working with an income statement only and do not have an amount for net assets, we will instead use return on invested capital (ROIC), which measures how well a company is using its money to generate returns. Comparing a company 's return on capital (ROIC) with its cost of capital (WACC) reveals whether invested capital was used effectively. From our spreadsheet calculations we see that using our estimated operating profit provides us with a 19.9% return on invested capital with only a 7.2% weighted average cost for that same capital. If these numbers are even close to correct, George should definitely make the move.
To relever the βe, we use the formula, βe = βu +(D/E)*(βu-βd). And the “Target D/E” was found by taking “Target D/V” divided by “1-Target D/V”. So we get the new βe, 1.3576. Then to get cost of equity, we use the CAPM formula, Re=Rf+β(EMRP), 11.7679%. Since we have get the cost of equity and cost of debt, we can determined the WACC, which is equal to Equity/Value*Cost of Equity+Debt/Value*Cost of Debt*(1-tax rate). In the end ,we arrived at 8.48%.
On the other hand, more debt does not affect the risk of the project under taken, but means less equity holders , these bring more risk to equity holders, the cost of equity increases with debt. assume Ra is the WACC without leverage.
|Debt to equity ratio shows the relative mix of the investors supplied capital and the extent to which the company is financed by borrowed |
Weight of Equity = 71%; Equity Cost of Capital = 12%; Weight of Debt = 29%; Debt Cost of Capital = 4.55%
According to strategic planners of the company quick service restaurants would remain the largest segment over the following decade. Based on their analyses, quick service, casual dining and take out segments would be attractive. On the other hand, PepsiCo. invested to casual dining like Pizza Hut Café and experienced that their know-how for this segment is low. (Reinemund: “We needed people to come in and break the mold of our thinking. We knew enough to know what we didn’t) Additionally, Salsa Rio Grill which is also an investment for casual dining was a failure, but it has also mentioned it could be successful with a different setting. These are aspects that we have to think whether to acquire CPK. The case also mentions that PepsiCo. needed non-traditional program to increase points of distribution. That can be achieved with carts. The company also purchased carts from COC because they saw a potential future that the location of sales was really important.
From this set of problems, we can see that leverage is good for the firm. Leverage has increased the value of the firm as a whole and increased the price per share. Although the cost of debt increases the firm's risk because it increases the probability of default and bankruptcy, therefore shareholders will require higher rates of return on the equity they provide, debt also provides tax savings. And we can see that in table 4, where we calculated the total value of the firm as the pure business cash flows plus the tax savings. Another reason why debt increases firm value is the fact that it reduces WACC, because the cost of debt is generally lower than the cost of equity. Another option that shareholders can do is using homemade leverage. Shareholders should pay a premium for the shares of a levered firm when the addition of debt increases value.
The course project involved developing a great depth of knowledge in analyzing capital structure, theories behind it, and its risks and issues. Before I began this assignment, I knew nothing but a few things about capital structure from previous unit weeks; however, it was not until this course’s final project that came along with opening
To estimate the cost of equity, we need to compute the beta of equity for each division using comparable companies. As the betas of debt were not provided, we made 2 assumptions: a. same business lines have the same beta of debt; b. Expected return of debt = Rf + βb*[E(Rm) – Rf*(1-T)] (Rf: risk free rate, E(Rm): expected