Case 33

Topics: Corporate finance, Stock, Operating leverage Pages: 5 (1835 words) Published: December 12, 2012
1. In what ways can Susan Collyns facilitate the success of CPK? a. The avoidance of CPK management to putting any debt in its Balance sheet which relates to the idea of maintaining the borrowing ability needed to support CPK’s expected growth trail but Collyn is convinced with the benefits of leveraging the CPK’s equity; b. Maintain the ASAP restaurants where brand extensions of the company are being disposed. The ASAP restaurants in airport locations numbered 16 and contributed to the revenue and to the success of CPK; c. Maintain the company-owned full-service CPK restaurants which are 170 units and still cite for expansion in other locations locally and internationally; d. Allot more or spend more on marketing the CPK frozen pizza brand; e. Continue to create new menus with high quality ingredients which can leave a mark to customers’ tastes. In this way, customers will likely to come back; f. CPK can spend 3% to 4% of sales on advertising just like what its competitors like Chili’s, Red Lobster, Olive Garden and Outback Steakhouse spent yearly; g. On the financial side, the management should increase its ROE by letting its assets exceed its equity base in the Balance Sheet; h. Leveraging by borrowing to acquire more assets is one way to increase ROE. One benefit with leveraging is that, it reduces the corporate income tax liability of CPK, which had been almost $10 million in 2006.

2. Using the scenarios in case Exhibit 9, what role does leverage play in affecting the return on equity (ROE) for CPK? The operating leverage effect on ROE is percentage change of EBIT is more than percentage change in Sale. If percentage change of EBIT is more than the percentage change in sales, this operating leverage will affect ROE positively because at this level, per unit fixed cost will decrease and small increase in sale will boost EBIT. If EBIT will increase, ROE will also increase. After dividing percentage change of EBIT with percentage changes in sales, we can take ratio of it and it indicates, how will change EBIT if changes will be done in sales. As interest is fixed cost, so with this ROE will increase. A high operating leverage is not good and maybe high risky. While a low operating leverage may be useful when sale market is fluctuating. The effect of operating leverage is the percentage change of EBIT less than percentage Change in Sales. In another scenario, when percentage change of EBIT is less than percentage changes in sales, it means 200% sale will increase, 100% EBIT will increase if operating leverage is 1:2. This situation is less effective for enhancing ROE. The effect of financial leverage on ROE is that financial leverage may decrease or increase return on equity in different conditions. A high financial leverage will incur a huge debt by borrowing funds at a lower rate of interest and utilizing the excess funds in high risk investments in order to maximize returns. While a low financial leverage will mean incurring a low debt by borrowing funds. The asset being purchased decreases its value which is a positive effect. However, the effect of high operating leverage and high financial leverage in the case of CPK will increase Return on Equity but entails high risk as well. While the effect of low operating leverage and with high financial leverage is an optimum combination for bringing optimum ROE (return on Equity). The 10.1% ROE of CPK as per stated in the case, did not benefit from financial leverage

3. How does debt add value to CPK?

4. What about the cost of capital? How does it change under different debt scenarios? In assessing the effect of leverage on the cost of capital, you may assume that a firm’s CAPM beta can be modeled in the following manner: L = U[1 + (1 − T)D/E], where U is the firm’s beta without leverage, T is the corporate income tax rate, D is the market value of debt, and E is the market value of equity. We have computed the financial leverage...
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