California Pizza Kitchen Risk Analysis Based on information provided in the case, we estimated the Weighted Average Cost of Capital for California Pizza Kitchen to be:
9.64% = (1-32.50%)*6%+9.64%*643,773)/643,773 California Pizza Kitchen is an unlevered company that has no debts in the capital structure of the company, and whose sole source of financing is equity. With a return on equity of 10.1% in 2006, CPK earned a return greater than its cost of capital, but did not benefit from financial leverage. Below we will illustrate how levered cost of capital may be a cheaper alternative for CPK. Increases of debts in the capital structure of the company will impact different key variables that the company leverage status would change from unlevered company to the levered company, because before these new issuance of debts, CPK had no debts in the capital structure of the company. In assessing the effect of leverage on the cost of capital, we estimated the Weighted Average Cost of Capital for a leverage of 10% debt to be:
9.26% = (1-32.50%)*6%*22,589+(4.2%+.82*6.4%)*628,516/(22,589+628,516) A leverage of 10% debt would change the unlevered beta 0.85 of CPK to levered beta of 0.82. The decrease in beta would reduce the cost of equity for CPK to 9.45%, because an increase of 10% debt in the capital structure of the company would reduce the risk of the equity investors. A leverage of 20% debt would decrease the Weighted Average Cost of Capital to:
8.91% = (1-32.50%)*6%*45,178+(4.2%+.79*6.4%)*613,259/(45,178+613,259) This would change beta to 0.79 and would reduce the cost of equity for CPK to 9.27%. A leverage of 30% debt would decrease the Weighted Average Cost of Capital to:
8.58% = (1-32.50%)*6.16%*67,766+(4.2%+.76*6.4%)*598,002/(67,766+598,002) This would change beta to 0.76 and would reduce the