The financial team was considering leveraging the company’s capital to repurchase treasury stock, as a way of signaling that the company’s stock was undervalued at its current market price of $22.10. The company has the capacity to borrow up to $75 million (Schill, Bruner, & Eades, 2013). However, borrowing for stock repurchases would be against the management’s goal of growing the business, considering that growing the business entails capital expenditures and not the capital’s restructuring. At the time of preparing this report, the firm needed up to $85 million to invest in capital projects, involving expansion of the chain.
Based on the findings of this analysis, it is recommended that the company should not borrow to finance repurchasing of treasury stock. The company can, however, borrow to fund the capital expenditure projects to the tune of $85 million, as this would be in sync with the management’s goal. Borrowing this amount would result in 27% debt component in the capital structure
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The financial team at California Pizza Kitchen, led by the CFO Susan Collyns, has determined that in the second quarter of 2007, the chain has posted incredibly good results. The report indicates that California Pizza Kitchen has reported a near-record quarterly profit margin of over $6 million (Schill et al., 2013). Such a good performance was against the backdrop of tough economic conditions, which weighed down on many organizations. Despite the good performance, the company’s share price had dropped 10% within the month of June, with the MPS having closed at $22.10. At this price the market capitalization of the company’s shares stood at $643,773, 000.00. However, the decrease was giving the company’s finance team a headache and they were considering engaging in a treasury’s repurchase. The repurchase of the company stock would require the company to acquire debt capital. The company had no debt in its capital structure, with the company’s management insisting on staying power, which means that the capacity to borrow $75 million was being reserved for that time when the company would require borrowing for development and expansion of operations. The dilemma in this case, therefore, is on whether or not the company should get debt capital, in order to engage in the repurchase of treasury stock.
The case at hand involves the analysis of long-term implications of levering the firm’s capital. Speaking in financial terms, levering a firm’s capital has positive implications, which boil down to the fact that the interest paid on debt capital is tax deductible. This results in the tax shield effect, meaning that the firm’s tax liability is reduced due to the deduction of interest expense in the computation of after tax income. To this effect, renowned researchers Modigliani and Miller, have recommend that the firm should have a levered capital structure, which means that a part of the firm’s capital ought to be sourced from debt. The tax advantages of levering the firm’s capital up to 30% are as shown in the attached Pro Forma Tax Shield Effect of Recapitalization in the appendix.
Despite the proof that levering can be advantageous to a company, like California Pizza Kitchen, the reason for levering is of great importance in the consideration on whether to lever of not. In the case at hand, one of the reasons for borrowing, according to the firm’s policy, should only be for capital expenditure or development practices. The decision being assessed in this case, however, involves another cause, which is to repurchase treasury stock. Notably, the repurchase of treasury stock can be analyzed under signaling theory, meaning that it would signal to the market that the company’s shares are undervalued, hence resulting in the appreciation of share prices and reverting the trend that has seen the MPS lose by 10% within the month. However, the reason why the finance team led by the CFO, is considering this decision is because it is not clear, whether it would be acceptable in the light of the company’s focus on borrowing to meet the management’s goal of growing the business (Schill et al., 2013).
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From the analysis, the decision to borrow for repurchase of treasury stock is not aligned to the management’s goal of growing the business. This determination is based on three important observations with first being the fact that the company will be converting equity into debt, with nothing being invested in capital expenditures. Secondly, the move will result in a reversal of benefits of going into an IPO, considering the proceeds of the IPO were solely used in converting the company’s debt capital into equity. In other words the company used the IPO proceeds to repay the debt. Thirdly, the decision to borrow for repurchase of treasury stock would diminish the company’s staying power, which is currently indicated by the capacity to borrow up to $75 million. This means that the company may not be able to access enough cash for capital expenditure, especially when considering the planned expansion in 2007, when the company already required up to $85 million (Schill et al., 2013). In other words, the analysis reveals that the real decision that the company should be making is on whether to borrow for repurchase of treasury stock or for the financing of planned capital expenditures, which amount to $85 million.
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Based on the analysis above, this report recommends that the company should not borrow to finance the repurchasing of company’s shares. The decision is not in sync with the management’s goal of growing the business. However, the company should consider utilizing the staying power or the current capacity to borrow by borrowing the $75 million for investment in the planned capital expenditures. The rest $10 million can be sourced from the retained earnings. Alternatively, the company could also consider borrowing up to $85 million, considering both – the cost of retained earnings and the cost of debt capital, especially when noted that the cost of debt capital is considerably lower than the cost equity (Schill et al., 2013). The implication of borrowing to finance capital projects would result in tax shield benefits of levering. Secondly, it would also result in the reversal of share prices, hence it is more advantageous than borrowing for repurchasing treasury stock. Notably, this is also in agreement with the company’s goal of growing the business. Borrowing $85 million would result in a 27% proportion of debt capital in the capital structure, which appropriate for the firm’s conservative capital structure.