Essay About Level Of Debt Increases And Return Of Equity

Fina 461 – California Pizza Kitchen Case Study
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California Pizza Kitchen CaseFINA 461 Sec 001Jarrod BantamJake DerrSpencer PhillipsJordan WalzCalifornia Pizza Kitchen has been a successfully ran business for the past three decades. Their diversified strategy has made them profitable through multiple economic swings by reaching out to various market demographics since their opening in 1985. By focusing on families that earn $75,000 and keeping their prices low, they are able to attract multiple different customer segments. Their fast-casual dinners attract the wealthier cliental, and the low costs bring in cost conscious individuals. The most important business move they’ve made was to partner with Kraft foods to take advantage of their supply chain operations and get their pizzas in grocery stores. Since Kraft is an established brand, it has allowed CPK to have their brand marketed through a more effective distribution channels. On top of this strategy they’ve made their product available through multiple sources such as dine in restaurants and allowed franchising to individuals seeking business opportunities. All of these low-cost strategies get their product in consumers hands and allow them to dominate their competition.Leverage has multiple impacts on a company. First, assuming a constant level of EBIT and the total capital, the return of equity on a company will increase as the level of debt increases. You can see in Appendix A that as the debt percentage increases at ten percent increments, the ROE increases at a faster rate each increment. The Return on Equity is calculated as net income divided the book value of equity; as the percent of debt increases, the level of equity must decrease to maintain the same amount in total capital. Even though net income is reduced by the after-tax cost of additional interest, the return on equity increases. This can also be seen using the Du Pont equation, which breaks down return on equity into multiple parts that includes return on assets and the equity multiplier. Assuming a constant ROA, the equity multiplier will increase ROE as the level of debt increases. This is because the denominator in the equity multiplier, equity, will decrease as debt increases to maintain a constant total capital level, and the numerator remains unchanged. This increase in the equity multiplier will increase any positive returns, but it will also amplify any negative returns. So, based on a return basis, any increases in leverage will increases ROE if returns are positive. Since CPK currently has a positive level of net income, any increases in leverage will also increase ROE. Leverage also impacts the WACC for CPK. Currently CPK has zero debt, so their cost of capital is simply their required return on equity. But as you add more debt, you need to take the weighted average of cost for both debt and equity, while also taking into account the tax deductibility of interest on debt. Because the after-tax cost of debt is cheaper than the cost of equity, you will see the cost of capital decrease as the level of debt increases. This creates an incentive for CPK to adjust their capital structure for more debt so they can lower their cost of capital. The relationship between leverage and the cost of capital can be seen in Appendix C.The return on equity is also influenced by the capital structure since the risk of a company, measured by their beta, is impacted by their capital structure. This relationship is seen in Appendix B. CPK’s current beta is an unleveraged beta because the company currently has 0% debt. For the sake of this project we chose to use the leveraged beta to take into account the additional risk by increasing leverage. The relationship of leveraged beta and the level of debt is shown in Appendix C.The anticipated share price increases as the level of debt is increased because the company is getting the additional benefit of reducing the amount of taxes paid through tax deductible interest. The relationship between the percentage of debt and the anticipated share price is shown in Appendix E. This additional amount per share is the present value of interest tax shields, or simply, the amount of debt times the tax rate then divided the current number of shares outstanding. The number of shares repurchased increases as the leverage increases; CPK can repurchase 1.011 million shares, 1.999 million shares, and 2.965 million shares when the debt is 10, 20, and 30% of total capital, respectively. The tax deductibility of interest on debt allows CPK to save cash flow by reducing their tax liability. This means that CPK can reinvest that cash flow into other options, increasing the firm’s value, assuming all else is held equal.