Preparatory Questions for California Pizza Kitchen

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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
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