RSM433-Case 3 - case write up 1 asdkfj;kjasldf skdkdk kdkd slskd kd PDF

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case write up 1 asdkfj;kjasldf skdkdk kdkd slskd kd...

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RSM433: CASE 3 California Pizza Kitchen Group Members Yuan Ji Le Kang Yuxiao Zhu

1004960802 1005162182 1004353068

Leverage Recapitalization and Value to Shareholders 1. How much will California Pizza Kitchen save in taxes every year for a $60 million recapitalization? Justify your choice of interest rate. (3 points) Since interest payments are tax deductible, CPK would save the amount of interest payments that will be deducted from the earnings being taxed, which is (interest payment * tax rate). Interest payment = 6.16% * $60 million = $3,696,000 Save in taxes = $3,696,000 * 32.5% = $1,201,200 We used the interest rate of CPK’s credit facility with Bank of America is LIBOR + 0.80%, which is 6.16%, because CPK will be paying interest on its line of credit. 2. What will be the book value of equity? (3 points) Before: Book value of equity = $225,888,000 (Exhibit 9) After: Book Value of equity = $225,888,000 - $60,000,000 = $165,888,000 The book value of equity is the accounting value of equity, which is the IPO * number of shares outstanding with adjustment of further additional paid- in-capital and deficit. The book value of liability will increase after the bond issuance by the issuance amount. According to the accounting equation, A = L + E, the book value of equity will decrease by the issuance amount to match the equation. 3. What is the net present value of the interest tax shield in this scenario? (2 points) Assuming that the debt and tax rate are constant, by discounting the amount of tax shield (interest payments * tax rate) by the current 30-year risk free rate to match the duration of the long-term bond, we can get the net present value of the interest tax shield for this $60 million recapitalization: NPV(Tax Shield) = (Rd * D * T)/rf = (6.16% * $60 million * 32.5%)/5.2% = $23.1 million

4. What will be the market value of equity? (4 points) Right after the announcement: Share price will incorporate all information immediately. Thus, after the announcement the share price would increase by the amount of tax shield, which is the NPV of tax shield. New share price P’ = P + (D*T)/N = $22.77 Market value of equity = share price * number of shares = $663,273,000 When it completes the issuance of $60 million in debt: No new information arises, so no change in share price. Therefore, no change in market value of equity. Market value of equity = $663,273,000 When it completes the share repurchase: As the company repurchase its shares using the cash from debt issuance, the number of shares outstanding decreases by the amount of cash from debt issuance divided by the new share price (D/P’), which is $60 million / $22.77 = $2,635 thousands. New number of shares outstanding = $29,130 - $2,635 = $26,495,000 Market value = P’ * new number of shares outstanding = $603,273,000 5. What is the effect on the cost of capital? Please measure the cost of capital before/after (4 points) Before: Value of Debt = $0 Leverage = D/V = 0% T = 32.5% Equity Beta = 0.85 Cost of Debt = Rf + Default Spread = 5.20% + 0 = 5.20% Cost of Equity = Rf + βE * (Rm - Rf) = 5.20% + 0.85*5.00% = 9.45% WACC = Rd*L*(1-T) + Re*(1-L) = 5.20%*0*(1-32.5%) + 9.45%*(1-0) = 9.45% Asset Beta = (1-L) * βE = (1 - 0%)*0.85 = 0.85 After: Value of Debt = $60,000,000 Leverage = $60,000,000/($60,000,000 + $603,273,000) = 9% T = 32.5% Equity Beta = βA * (1/(1-L)) = 0.85 / (1/(1-9%)) = 0.93 Cost of Debt = Rf + Default Spread = 5.20% + (6.16%-5.20%) = 6.16% Cost of Equity = Rf + βE (Rm-Rf) = 5.20% + 0.93*5.00% = 9.87% WACC = R Rd*L*(1-T) + Re*(1-L) = 6.16%*9%*(1-32.5%) + 9.87%*(1-9%) = 9.36%

Conclusion: The Cost of Capital decreased as Leverage increase - Before the leverage recapitalization, the cost of capital solely depends on the cost of equity. When there is no leverage, the cost of debt is the risk-free rate, because the default spread is 0. But the cost of equity has an additional market risk premium to, compensate for the risk to invest in CPK for investors. Therefore, the cost of equity is more expensive than the cost of debt - After the leverage recapitalization, the firm restructured its capital structure. 9% of its capital is financed through issuing debt, which is less costly than financing through equity. Therefore, the cost of capital decreased. Moreover, the interest payment is tax deductible, which gives CPK a tax shield. In turn, the firm of CPK increased as leverage increase. 6. Should the company go ahead with this leveraged recap? What do you think are the possible risks? (3 points) The company should go ahead with this leveraged recap. As we get from calculations in Excel, the market value of the firm before is $643,773,000 and the market value after is $663,273,000 due to tax shield. Moreover, the WACC before is 9.45%, but the WACC after decreases to 9.36%, which is a good sign to the company as we know lower cost of financing leads to higher firm value. Besides, interest payment is tax-deductible, so the company can be benefit from the tax shield of $23,100,000. Debt could use as a discipline device. For large corporations, they tend to have the concern over manager waste spending on large, unprofitable investments. However, when there is debt, the company should make commitment to pay interest payments which reduce excess cash flows. When firm is highly leveraged, the creditors and shareholders will be more insecure with their investment. And in turn, will closely monitor manager’s actions. Risks Some possible risks include liquidity and default risk. Since the leveraged recap increases the company’s leverage, the company may not have enough cash to pay back liabilities on time, which increases the risks of default and the risks of equity holders. Another risk is that the company may miss some expansion opportunities when they do not have much excess cash on hand (The higher the growth rate, the higher the value of equity, the lower the proportion of debt). In the case, it is mentioned that the company is looking for new opportunities and the use of financing may conflict with the management’s goal of growing the business....