Corporate finance group 3 group project topic cpk case study

The key elements of her decision include: To repurchase shares or not: Despite excellent operational success, the company's share price has dropped by 10%, which may indicate a chance to

VIETNAM NATIONAL UNIVERSITY — HOCHIMINH CITY

INTERNATIONAL UNIVERSITY SCHOOL OF BUSINESS

Corporate Finance Group 3

Group Project TOPIC: CPK Case Study

Student Name ID

Vũ Minh Nhật FAFBIU22128 Nguyễn Thanh Vinh BABAIU21583 Trương Nguyễn Minh Quân BAFNIU20401

Class: Thursday 10:35 a.m — 1:05 p.m Room: C.420

Lecturer: Trinh Thu Nga

Ho Chi Minh City, Vietnam

2024

I, What is going on at CPK? What decisions does Susan Collyns face?

1 Overview of CPK

Inspired by the Spago restaurant, Larry Flax and Rick Rosenfield founded California Pizza

Kitchen - an affordable version - which gained a huge following in the 1980s in Beverly Hills,

California By 2007, the company had 213 locations in 28 states and 6 foreign countries CPK's

revenue comes from three sources: company-owned store sales, licensing fees from franchisees,

and licensing fees with its partner Kraft Foods

With the potential of the CPK brand, in 1996 the company developed ASAP - an airport express

franchise program - with HMSHost Although the model initially performed well; but

management later spent more than half a million dollars to shut down the business after some

discrepancies in service between company-owned and franchise restaurants emerged With

CPK’s proven success, the failure of the AS AP chain did not affect the brand’s potential for

international growth CPK has a presence in China, Indonesia, Japan, Malaysia, the Philippines,

and Singapore The company also plans to expand into Mexico and South Korea in 2007 This

will bring the company a large revenue stream of $50,000 to $65,000 per store and then 5% of

total sales

The two leaders at CPK have prioritized creating a menu with premium ingredients These

efforts have helped the company build an effective competitive strategy For example, creating

unique and unobtainable dishes such as Singapore Shrimp Rolls To maintain the uniqueness of

the menu, the company decided to develop a new brand, LA Food Show, as a restaurant to test

new dishes Another competitive advantage is that CPK's average price is $13.30, much lower

than other competitors such as P.F Chang's and Cheesecake Factory

In terms of brand promotion costs, the partnership with Kraft has helped CPK save on this cost

as Kraft is required to spend 5% of revenue on marketing CPK's frozen pizza Furthermore, CPK

only spends 1% of sales on advertising, much less than the 3% to 4% that competitors are

spending, plus the "word of mouth advertising" from their customers proves that the company's

strategy is effective This form of advertising is free but it is very valuable to businesses

Restaurant Industry

Some research shows that CPK’s five-year compound annual growth rate (CAGR) is 6.5%

compared to the average of 5.1%, an impressive figure for the full-service restaurant segment

Along with the advantages, CPK also faces challenges from the effects of microeconomic factors

such as:

¢ Increasing commodity prices

¢ Higher labor costs

¢ Softening demand due to high gas prices

¢ Deteriorating housing wealth Intense interest in the industry by activist shareholders

Despite facing pressures from rising costs of goods sold and minimum wages for employees,

experts predict that consumer demand will not decrease and will continue to increase after the

recession

Recent Development

While other restaurant companies have seen sales and profits decline, CPK's financial report has

recorded impressive growth, growing 16% to $159 million, 37% and 21% respectively in Kraft

royalties and international franchises in the second quarter of 2007, ensuring plans to open 16 to

18 new locations on schedule for the year

The company has managed its two largest expenses well, actual labor costs, which decreased

from 36.6% to 36.3% of total sales, and cost of goods, which remained at 24.5% from the second

quarter of 2006 to the second quarter of 2007

Capital Structure Decision

CPK's book equity was expected to be around $226 million With a share price in the low 20s,

CPK's market capitalization stood at $644 million The company had recently issued a 50% stock

dividend Return on equity (ROE) reached 10.1% in 2006 CPK maintains borrowing capacity

available under an existing $75 million line of credit Interest on the line of credit was calculated

at LIBOR plus 0.80%, With LIBOR currently at 5.36%, the line of credit's interest rate was

6.16%

2 Decisions that Susan Collyns faces

Susan Collyns, CPK's chief financial officer, is facing a critical decision about whether to pursue

a stock repurchase program The key elements of her decision include:

To repurchase shares or not:

Despite excellent operational success, the company's share price has dropped by 10%, which

may indicate a chance to repurchase shares at a discount and provide value to owners

Debt financing for the repurchase:

Due to the lack of spare funds, financing the repurchase would necessitate taking on debt The

company's long-standing conservative financial policy of avoiding debt to maintain financial

flexibility and growth capability would be broken by this

Balancing financial priorities:

Susan has to balance the dangers of changing the capital structure, especially in light of rising

interest rates, against the possible advantages of leveraging the company's equity

IL How does debt affect CPK?

1 Calculation (Exhibit 9 table) Pro Forma Tax Shield Effect of Recapitalization Scenarios (Dollars in thousands, except share

data; figures based on end of June 2007)

Actual

10% 20% 30%

income taxes and interest

Book value

Market value

Market value of capital 643,773 651,105 658,437 665,769

(thousand shares)

(thousand shares)

Earnings per share

Price to earning ratio

a Return on Equity (ROE)

ROE measures how efficiently a company uses its equity to generate profits It is calculated

Net Income

using the formula: Equity (Book Value)

Actual ROE Net Income = 20,299 (as per the table) Equity (Book Value) = 225,888

20, 299 ROE (Actual) = ——— x 100 = 8.99%

Using the formula ( ) 225, 888 °

Actual

10% | 20% | 30%

Net income] 20,299 | 19,359 | 18,419 | 17,480

Equity | 225,888] 203,299] 180,710) 158,122

ROE 8.99% | 9.52% |10.19%| 11.05%

Based on our calculations, CPK’s return on equity (ROE) tends to go up as the debt-equity ratio

increases For instance, the ROEs at 0%, 10%, 20%, and 30% debt-equity ratios are 8.99%,

9.52%, 10.19%, and 11.05%, respectively The reason behind this trend is that when companies

rely more on debt to fund their operations, they’re using less equity This means the profits from

those operations are divided among a smaller amount of equity, which boosts the ROE However,

it’s important to note that taking on too much debt can lead to high interest payments and a

greater risk of default (as suggested by trade-off theory), which could end up lowering both net

income and ROE

b Price Per Share

The price of a share, also known as the stock price, represents the cost of purchasing a single

share in a company This price isn’t constant; it changes based on market conditions Typically, if

a company is viewed positively, its share price will likely rise, while it may drop if the company

fails to meet expectations

It shows that California Pizza Kitchen's share price is $22.10( note 4 exhibit 9 ) Using the

formula below and assuming the market operates efficiently, we can determine the share price at

debt levels of 10%, 20%, and 30%

Steps to Calculate Firm Value with Debt - Example Calculation for 10% Debt/Total

Capital:

1 Firm Value without Debt (Original Value):

This is the current value of the company (also known as the unlevered firm value)

Original Firm Value = Original Price x Number of Shares Outstanding

= 22.10x29,130=643,773(thousand dollars)

2 Tax Shield from Debt:

The tax shield is the additional value created by introducing debt

Tax Shield = Debt x Tax Rate = 22,589x0.325=7,341 (thousand dollars)

3 Firm Value with Debt:

Add the tax shield to the firm's original value to get the new value:

Firm Value with Debt = Original Firm Value + Tax Shield =643,773+7,341=65 1,114(thousand

dollars)

4, Price per Share:

Divide the new firm value (Firm Value with Debt) by the number of shares outstanding:

Firm Value with Debt

Number of Shares Outstanding

Price per Share =

= 651,114 / 29,130 = 22,35

Actual

10% | 20% | 30%

Original Price $22.10 | $22.10 | $22.10 | $22.10

Tax Rate 32.50% |32.50% |32.50%|32.50%

Debt 0 22,589 | 45,178 | 67,766

Original Number of 29,130 | 29,130 | 29,130 |29,130

Shares

Outstanding (thousands)

Price per share $22.10 | $22.35 | $22.60 | $22.86

c Shares Repurchased

Share repurchase, also known as a stock buyback, is when a company’s management decides to

buy back its own shares that were previously sold to the public Companies may choose to

repurchase shares for several reasons, such as signaling to the market that the stock’s value is

expected to rise, improving financial metrics like earnings per share (EPS) by reducing the

number of outstanding shares, stopping a declining stock price, or increasing their equity

ownership Typically, a buyback indicates positive prospects for the company, often leading to an

increase in the stock price

To calculate the number of shares repurchased, we first need to know the current number of

shares outstanding, which is 29.13 million(note 4 exhibit 9) This value will serve as the baseline

for further calculations

Shares Repurchased: The company uses the borrowed debt to repurchase its shares The

number of shares repurchased is calculated as:

Debt Shares Repurchased = ———— _-

oe ° Price per Share

At 10% Debt/Total Capital : Shares Repurchased = 22,589 / 22.35 = 1,011

Shares Outstanding=Original Number of Shares Outstanding—Shares Repurchased

At 10% Debt/Total Capital : Shares Outstanding=29, 130—1,011=28,119(thousand shares)

Actual

10% | 20% | 30%

Original Number of Shares {29,130 |29,130] 29,13 |29,130

Outstanding (thousands)

8

Price per share $22.10 |$22.35 | $22.6 |$22.86

0

Shares repurchased (thousand| 0 1,011 | 1,999 | 2,964

shares)

Shares outstanding (thousand |29,130 |28,119 | 27,13 |26,166

1

Earnings per share (EPS) is a key financial metric that reflects a company's profitability and

market potential A higher EPS indicates greater profitability, which translates to more earnings

available for distribution to shareholders This makes EPS an important measure for investors, as

it provides insight into a company's financial health and performance To calculate EPS, one

typically divides the net income by the number of outstanding shares

Actua

] 10% | 20% | 30%

Net Income 20,299 |19,359|18,419/17,480

Shares outstanding (thousand |29,130 |28,119 |27,131 |26,165

shares)

Earnings Per Share 0.697 | 0.688 | 0.679 | 0.668

e Price to Earnings Ratio (P/E)

The price-to-earnings ratio (P/E ratio) is a valuation statistic that compares a company's price per

share to its earnings per share For instance, the numerator is the stock price per share, and the

denominator is the stock earnings per share The selling price measures the price to earnings or

PE ratio (or multiple) is calculated using the price per share and earnings per share from the

preceding tables

Actual

10% | 20% | 30%

Price per share |$22.10|$22.35| $22.6 |$22.86

Earnings Per Share | 0.697 | 0.688 | 0.679 | 0.668

Price to earning 31.71 | 32.47 | 33.29 | 34.21

ratio

f Beta Bu= B/ (1+ (1 - Te) B/S) Where:

fu: Beta of Unlevered firm B: Market value of debt S: Market value of equity

TC: Tax rate

Debt/ Total capital Actual 10% 20% 30%

Bu 0,85 0,85 0,85 0,85

B 0 22,589 45,178 67,766

5 643,773 628,516 613,259 598,002

B/S 0 3,59% 7,37% 11,33%

Te 32,5% 32,5% 32,5% 32,5%

Beta 0,85 0,87 0,89 0,92

Although financial leverage carries a significant risk, it raised BETA’s ROE The impact of

leverage on the WACC when determining the company's beta using the CAPM model was the

second issue that worried us The company's unlevered beta, or beta without debt, was 0.85 It

removes leverage's negative financial effects We employed the formula "where D/E is the debt- to-equity ratio, Tc is the tax rate, and BL is the firm's beta with leverage." The numbers are 0.87, 0.89, and 0.915 at debt to total capital ratios of 10%, 20%, and 30%, respectively

g Cost of Equity ( Rs)

Rs= Rf + B *(m - rÐ Where

Rf Risk - free rate

Rm: Market Risk Premium

B: Beta of the firm

Debt/ ToTal capital Actual 10% 20% 30%

B 0,85 0,85 0,85 0,85

Rf 5,2% 5,2% 5,2% 5,2%

rm-rf 5% 5% 5% 5%

Rs 9,45% 9,55% 9,66% 9,78%

h WACC WACC=(S/V * Rs) + (B/v*Rb*( 1 -Tc))

Where Rb: Cost of Debt Rs: Cost of equity

Te: Tax Rate

B: Market Value of debt S: Market Value of equity V=S + B ( Total Value)

DEBT/TOTAL CAPITAL Actual 10% 20% 30%

Rb 6,16% 6,16% 6,16% 6,16%

B 0 22,589 45,178 67,766

S 643,773 628,516 613,259 598,002

B+s 643,773 651,105 658,437 665,769

Te 32,5% 32,5% 32,5% 32,5%

Rs 945% 9,55% 9,66% 9,78%

WACC 9,45% 9,22% 9,00% 8,78%

Regarding the cost of capital, our computations in the above figure show a varied WACC for

three unique scenarios of 10%, 20%, and 30% debt to total capital.8.17%, 8.82%, and 8.35%, in

that order WACC decreased as a result of the proportional difference between debt and total

capital, which was 10%, 20%, and 30%, respectively This was the effect of financial leverage on

cost of capital

2 Effects of Debt

Debt is often viewed as having a negative impact on a company's growth This is primarily

because debt can disrupt the normal operations of a firm during the repayment period, especially

if the repayment plan isn’t well structured However, there are also some positive aspects of

taking on debt, particularly for companies looking to grow and expand, and California Pizza

Kitchen (CPK) is no exception