Professional Documents
Culture Documents
Abdalla Al Hosany
07-Mar-14
Table of Contents
Abstract ......................................................................................................................................................... 3
Background ................................................................................................................................................... 4
Question 1: Do you believe that Blaine's current capital structure is optimal? Why or why not? ........... 4
Question 2: What are primary advantages and disadvantages of a share repurchase that Dubinski
could recommend to the board? ............................................................................................................... 6
Question 3: Consider the following proposal for share repurchase. Blaine will use $209 Million cash
from its balance sheet, and $50 Million in new debt at interest 6.75%, to repurchase 14 million shares
at the price of $18.5. How would such a buyback affect Blaine? Consider the impact, among other
things, on BKI's earnings per share, ROE, the family's ownership interest (percentage), and the
company's cost of capital (WACC). ........................................................................................................... 7
Question 4: As a member of the Blaine's controlling family, would you approve the plan? Why? .......... 8
Question 5: As a minority shareholder not member of the family, would you approve it or not? Why? . 8
Bibliography .................................................................................................................................................. 9
Abstract
This case study analyses the capital structure of Blaine kitchenware and suggests a potential
restructuring option to its owner / Managing Director Mr. Dubinski. The answers to the questions
within the case helps to summarise a possible decision for him. It mainly focuses on the debt leverage
aspect of the capital restructuring and how it benefits the company from being overliquid and
underleveraged to one which has better EPS, lower taxation and one that is not afraid to take a little risk
for a more secure future.
Background
Blaine Kitchenware, Inc is a major player in the home appliances industry and has been an American
Brand serving the domestic and international markets for over 80 years. It started as a family owned
enterprise and despite facing competition, IPO, etc have continued to prosper under a major family share
holding. The CEO, Victor Dubinski took over the reins from his uncle in 1992 and has steadied the
company into a very safe, low risk company with adequate growth potential. He is looking to unleash the
unrealized value from discussions with a potential banker who has put this thought and possibility of a
buyout by a group of investors.
(Please refer to the static trade-off model based on the Miller-Modigliani theorem; and you can include
your own observations about optimal capital structure.)
Each company is run by a management that has an underlying sense of business. Some are
conservative, others are daring. We cannot necessarily say if it is good or bad if the company is
performing its primary duties well. At the same time, we also need to look at the current capital structure
and payout policies of BKI to make an analyst / investor opinion of the company’s financial structure. It is
important to know what the market sentiment on the company is as this is a publically traded firm.
Investors are looking at long term value of the firm.
Summary:
The current approach of the management is to lower the risk and hence they have maintained the
firm debt free.
They have not looked at leverage to:
o Lower Cost of Capital as a result of reduced taxation (they have paid consistently ~32%
and are expected to pay 40% in future)
With each acquisition their outstanding shares have increased (by 17,000 till 2006) and this has
in effect reduced their EPS to $0.91 (2006)
This has also made their ROE (11%) the lowest in the industry despite the fact that they are
among the healthiest and safest.
In addition to this, their payout ratio has increased from a healthy 35% to 52.9% in 2006. This
essentially means that they are not able to make as much cash as they were earlier and hence
the rate of growth of their cash will decrease. A future acquisition may increase the outstanding
shares yet again and this can become a vicious cycle.
Relying 100% on equity and not utilizing their strong balance sheet to leverage at attractive
interest rates are actually hampering their growth and ability to be flexible in decision making ex:
o Make an acquisition
o Enter new markets
As per the Miller-Modigliani (MM) study, (Eugene & Joel, 2013) under a given restrictive set of conditions,
the capital structure of firm has not impact on its valuation. Some of these restrictive conditions set forth
by the MM theory are as follows:
The above assumption is clearly unrealistic and represents a financial Utopia, if you will. Hence the MM theory
led to the foundation of further research on capital structure and its effects. Detailed study on effect of taxes
and bankruptcy led to “the trade-off theory of leverage” which analyses the correlation between leverage, stock
prices and potential affects of bankruptcy. This theory states that firms trade off the tax benefits of debt
financing against problems caused by potential bankruptcy. (Eugene & Joel, 2013).
Value of
Blaine’s Stock
The above figure helps us to understand the trade-off model better. When you have debt, there is always an
interest to be paid and this is deductable as an expense. This makes debt less expensive than equity as
shareholders always look to earn more. In effect, it provides a tax shelter benefit by the government indirectly
paying part of the cost of the debt. Thus more the debt implies more interest and thereby more EBIT goes to
the shareholders. As per MM, this factor appreciates the stock prices. So in theory a 100% debt as seen in the
graph should mean the highest stock prices possible. But in real world, firms target debt rations much less than
this as a 100% leverage is a potential for bankruptcy. There is a threshold level, D1 as in the above chart
where the effect of the leverage is negligible to cause any bankruptcy. Beyond this, there is a cost related to
bankruptcy and they slowly begin to offset the benefits offered by leverage. Between D1 and D2 there still
remains a significant benefit in terms of tax shelter that the stock prices continue to rise albeit at a lower rate.
Beyond D2, however the costs of bankruptcy are more than the tax benefits and then we can see the stock
prices taking a hit. D2 in a way can be called as the threshold or maximum point of balance where stock prices
are highest and debt ratio is at optimum. The limits D1 and D2 are not fixed, it is dependent on factors like
business risks, cost of capital, cost of bankruptcy, geography of operations, etc.
From this theory, it is clear that Blaine Kitchenware has to use debt as a key tool to improve its stock prices
and thereby improve its earnings. It will also help the company save taxes and hedge better against a future
takeover or an acquisition. The valuation of the firm can also improve as a result of this.
Concerns:
The above work is mostly based on empirical and theoretical work and hence is at best approximations of the
actual curves.
Another point is that firms which have had less debt than suggested have enjoyed much higher valuation and
better profitability. Examples are Apple, Google, Intel, etc. These have further led to more realistic studies on
capital structure like signal theory, etc.
So for Blaine also, they should be prudent when it comes to leveraging the company. At the same time the
family has been historically conservative in their approach and the huge amount of cash they have will be good
for them.
To conclude, I think that to unleash their potential as a firm they need to be ready to take a little more risk
and use some debt leverage to buy back some shares. This will not only reduce their tax burdens, but
also drive their market value (less shares available for trade) upwards. Additionally, they will have better
bargaining power with future acquisitions and pay via the share holding or debt route as necessary.
Increasing share holder value (re-purchase) will drive the market prices eventually and with lesser
shares, it will greatly improve both the family and remaining share-holders value
Debt leverage will decrease the Tax burden on the company and lower the overall cost of capital
EPS will improve with lesser outstanding shares, this will also drive the market value of the
company positively
Payout ratio will stabilize to manageable levels, where there is enough to plough back to research
and other investments.
With lower outstanding shares, Dividend per share will improve which will further improve the
market value and investor confidence
Family’s holding will subsequently increase and this means more control over the future direction
and better leverage at the time of acquisition or market expansion
It is estimated that the current stock prices is near to the historic high, it may not have to pay too
high a premium for this repurchase.
Stockholders can tender or not.
Helps avoid setting a high dividend that cannot be maintained.
Repurchased stock can be used in takeovers or resold to raise cash as needed.
Income received is capital gains rather than higher-taxed dividends.
Stockholders may take as a positive signal--management thinks stock is undervalued.
The future forecasts for the business look stagnant with their current product mix. They need an
acquisition to grow more as per market movements. A repurchase program might make sense for
companies which have cash and a strong positive earnings outlook. For BKI, it still needs to scout
for opportunities for this growth in earnings. So the cash and debt might actually be needed at
that time.
A repurchase program can drive the stock prices to overdrive. There by forcing BKI to pay more
than it planned to for a given amount of shares.
Leverage also drains you of cash flows and initial earnings might not translate into dividend
payout
May be viewed as a negative signal (firm has poor investment opportunities).
IRS could impose penalties if repurchases were primarily to avoid taxes on dividends.
Selling stockholders may not be well informed, hence could be treated unfairly.
Firm may have to bid up price to complete purchase, thus paying too much for its own stock.
Question 3: Consider the following proposal for share repurchase. Blaine will
use $209 Million cash from its balance sheet, and $50 Million in new debt at
interest 6.75%, to repurchase 14 million shares at the price of $18.5. How would
such a buyback affect Blaine? Consider the impact, among other things, on BKI's
earnings per share, ROE, the family's ownership interest (percentage), and the
company's cost of capital (WACC).
Workings:
ROE = Return on Equity = Sales / Total Assets (shareholder equity) = 53,630 / 229,363 = 22%
EPS = Earnings per Share = Net Income / Number of Shares = 53,630 / 45,052 = $ 1.14
EPS has increased by 25% to $ 1.14. Clearly the lesser outstanding shares showcase the
company as earning better for its shareholders than otherwise.
ROE has doubled to 22% from 11%. A metric which puts it closer to the mean (26%) of the
industry benchmark.
The family’s ownership has increased to 81%, a controlling majority with which they not only
retain more dividend / earnings. But also can set the course for future organic and inorganic
growth.
Cost of Capital
Re r = Rf + beta x ( Km - Rf ) Rf + Beta x
4.91% + 0.56 x
The cost of capital (WACC) is around 5% which much lesser than what the company is able to
make.
Additionally, the debt ratio is 8.4% (1:0.084) and the interest coverage is 18.95 (much higher than
1.5). These values are clear indicators that the company’s financial health continues to be robust
and infact has been improved from previous situation.
Considering the above, as a member of the family, I will approve the plan.
Nevertheless, having a leveraged company also positively impacts the minority shareholder in terms of
unlocking the value of the firm. Hence, I will still be inclined to support this move.
Bibliography
Eugene, F. B., & Joel, F. H. (2013). Chapter 14: Capital Structure & Leverage. In F. B. Eugene, & F. H. Joel,
Fundamental of Financial Management (pp. 488-515). Florida: Brigham Houston.