Introduction: The California Pizza Kitchen is a popular pizza chain that I would guess many of you have eaten at in the past. You will probably be surprised to find that pizza is relevant to this case. We are turning to other topics in corporate finance, so you can expect to learn a lot more in the final weeks of the semester. In this case, you will learn about target debt levels. The mix of debt to equity in a company is an important topic. Too much debt and the company will feel the pressure of keeping up with debt payments, too little debt, and the company is not fully utilizing all of the available capital. M&M first theorized what the optimal debt level for a company is. In this case, you will learn a little about their theory as well as pizza. Questions:

1. Using the scenarios in case Exhibit 9, what role does leverage play in affecting the return on equity (ROE) for CPK?
2. What role does leverage play in affecting the cost of capital? 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: βL = βU[1 + (1 − T)D/E], where βU 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. In your estimate, you may assume that the market risk premium in the CAPM is 8%
3. Based on the analysis in case Exhibit 9, what is the anticipated CPK share price under each scenario? How many shares will CPK be likely to repurchase under each scenario? What role does the tax deductibility of interest play in encouraging debt financing at CPK?
4. What capital structure policy would you recommend for CPK?