Decision Criteria:
The alternative available to the Susan is to introduce the debts in the capital structure of the company. The alternative capital structure is that it will introduce 10 percent debt, 20 percent and 30 percent debts in the capital structure of the California Pizza Kitchen. All these three criteria are discussed below;
10% Debt in Capital Structure:
The first alternative is to raise the debts up to 10 percent of the equity in the capital structure of the company. California Pizza Kitchen would use the financing received from the debt issuance to repurchase the some of the floating shares of the company. Therefore, the outstanding shares of the company reduces equivalent to the amount of 10 percent of the debt issued in the capital structure of the California Pizza Kitchen, this repurchase of the outstanding share of the company increases the wealth of the shareholders. These increases of 10 percent debts in the capital structure of the company will impact on different key variables that the company leverage status would change from unlevered company to the levered company, because before these new issuance of 10 percent debts, the company has no debts in the capital structure of the company. This leverage will change the ungeared beta 0.85 of the California Pizza Kitchen to geared beta in0.91. The increase in beta, willincrease the cost of equity of the California PizzaKitchen to 7.19 percent, because increase of 10 percent debts in the capital structure of the company will increase the risk of the equity investors.
Moreover, the weighted average cost of capital of the California Pizza Kitchen would decrease to 6.88 percent, due to the injection of 10 percent debts in the unlevered capital structure of the company, because debts arethe cheapest source of financing as compared to equity financing.
Furthermore, the return on equity of the California Pizza Kitchen would also increase to 9.52 percent, which is before the 10 percent debts in the capital structure of the company is 8.99 percent. This increase in return on equity is partially due to the repurchase of shares from the market and partially due to increase in earnings attributable to shareholders because of the tax shield on interest payment of the debts.The Price earnings ratio of the California Pizza Kitchen would also increase to 32.47 times, this increase in the price earnings ratio is due to the increase in market price per of the company to $22.36 per share, which is before the injection of 10 percent debts in the capital structure of the company is $22.10.
Therefore, the shares repurchase from the open market through the amount receive through the debt financing of 10 percent are 1,022 shares, and the new number of outstanding shares after the 10 percent debts in the capital structure of the California Pizza Kitchen are 28,108, which before the new debts of 10 percent are 29,130.
20% Debt to Equity
The second alternative is to raise more debts in the capital structure of the California Pizza Kitchen, the further increase of debts in the capital structure will increase the leverage ratio of the company, but this would increase the earnings of the company as California Pizza Kitchen receives more tax shield on the interest payment of the debts.Theincrease of debts to equity to 20 percent in the capital structure of the company will increase the beta of the California Pizza Kitchen to 0.96, and this increase in beta would increase the cost of the equity of the company to 7.31 percent, this increase in cost of equity of the company is due to the increase in risk of the ordinary shareholders of the California Pizza Kitchen. Increasing debts to 20 percent of the equity in the capital structure of the company, would reduce the weighted average cost of capital of the company to 6.88 percent.
Furthermore, the return on equity of the company will increase to 10.19 percent and at the same time price earnings ratio of the California Pizza Kitchen would also increase to 33.29 times. This increase in the price earnings ratio is due to the increase the market share price of the company to $22.64 per share.
Moreover, the shares repurchase from the open market through the amount receive through the debt financing of 20 percent are 2,044 shares, and the new number of outstanding shares after the 20 percent debts in the capital structure of the California Pizza Kitchen are 27,086..............................
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