were approximately 11% per year which was below the 16% annual compounded returned by shareholders of Blaine’s peer group during the same period.
Blaine’s financial posture was conservative, only twice in the history had the company borrowed beyond seasonal working capital needs. The first was during World War II and second during oil shock of 1970s.
At the end of 2006, the company held $231 million in cash and securities, Blaine’s balance sheet was the strongest in the industry. Given such substantial liquidity, Blaine had terminated in 2002 revolving credit agreement designed to provide standby credit for seasonal needs.
In the recent years the company’s largest uses of cash had been common dividends and cash paid in various acquisitions. Dividends per share had risen only modestly during 2004-2006. However, as the company issued more shares the number of outstanding shares climbed as a result earnings per share decreased from $1.29 to $0.91 from 2004-2006 and payout ratio rose significantly to over 50% in 2006.
The next use of funds was capital expenditures, which were modest due to
Blaine’s outsourcing of its manufacturing. Average capital expenditure of
Blaine during the past three years was just over $10 million per year. In recent years, after tax cash generated from operations had been more than four times average capital expenditures.
Question 1:- Do you believe Blaine’s current capital structure and layout policies are appropriate?
Answer:- The capital structure of Blaine is prudent and conservative. The main source of funding for business comes from equity capital. Such capital structure makes the risk of its financing low as well as the cost of its financing high. Thus, the returns to shareholders are lower from the industry average. Blaine is an over-liquid and under-levered company and its shareholders are paying a price for it. It would not be rational for a public company to be funded only by equity. It's too inefficient. In 2006, the company Return on Equity (ROE) was 11%, which is below the industry average of 19.5%. Also the increasing trend in
BKI’s payout ratio was unsustainable
Debt is a lower cost source of funds and allows a higher return to the equity investors by leveraging their money. In addition, the company can deduct the interest paid on the debt from their income and thus reduce the tax burden. With an increase of future corporate tax from 30.8% to 40%, it would be beneficial for the firm to deduct interest payments to pay fewer taxes. Debt greatly reduces the role of integrated enterprise cost of capital. Therefore, it can increase earnings per share and its stock value by improving the proportion of corporate debt appropriately, which assumes a crucial role of financial leverage. Enterprises financial leverage of funds has a magnifying affect, when the business uses the liabilities, the effects of financial leverage will show. However, debt is not always excellent, and we should firstly analyze whether the profitability of raising the funds for capital is greater than the interest rate. If it is so the use of debt will substantially increase their earning per share.
Question 2:- Should Dubinski recommend a large share repurchase to Blaine’s board? What are primary advantages and disadvantages of such a move?
Answer: - Dubinski should recommend a large share repurchase to the board using cash and cash equivalents and raising some debt.
Advantages of share repurchase:-
- Debt is a lower cost source of funds and allows a higher return to the equity investors by leveraging their money.
- The company can use the increase in leverage to invest in its business or acquire another company without increasing shareholders' equity.
- Assuming that family members held on to their shares, their percentage ownership of Blaine would rise, reversing a downward trend dating from
BKI’s IPO. It also would give the board more flexibility in setting future dividends per share.
- The company will have a better Return on Equity.
- Since, debt is being raised – the WACC will come down as a) cost of equity decreases b) the contribution of cost of equity to WACC decreases with cost of debt being included; which is usually less than COE due to tax benefits involved.
Disadvantages of share repurchase:-
- The company's assets will decrease. It would have to borrow money if it wants to acquire another company or expand its production.
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As the firm increases the amount of long-term debt, the financial distress increases because a larger portion of its operating income is used to pay for interest expenses. The kitchenware appliances market is closely related to the economy. If the economy goes into a recession, the firm could have a hard time paying for the interest expenses.
Question 3:- Consider the following share repurchase proposal: Blaine will use $209 million in cash from its balance sheet and $50 million in new debt bearing interest at the rate of 6.75% to repurchase 14 million shares at a price of $18.50 per share. How would such a buyback would affect Blaine? Consider the impact on among other things, BKI’s earnings per share and ROE, its interest coverage and debt ratios, the family’s ownership interest , and the company’s cost of capital.
Answer: - After taking the loan of $50 million and using $209 million cash from its balance sheet:-
1. Total assets = $592,253,000 - $209,000,000 = $383,253,000
Total Liability= $103,890,000 + $50,000,000
= $153,890,000
Shareholder’s Equity = Total Assets – Total Liabilities
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Earnings per share = Net Income/ Total no. of shares outstanding
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Interest Coverage = EBIT/ Interest
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Return on Equity = Net Income/ Shareholder’s Equity
- Family’s ownership
Blaine Family holds 62% of 59,052,000 shares and rest is held by public. No. of shares with family = 36,612,000
No. of shares with public = 22,440,000
14 million shares out of 22,440,000 will be bought back.
No. of shares with public = 8,440,000
No. of shares with family = 36,612,000
Percentage of shares with family = 36,612,000 / 45,052,000 = 81.26 %
Family’s Ownership interest will increase from 62% to 81.26% after the share repurchase
- WACC = Ke*(E/V) + Kd(1-t)*(D/V) Ke = Cost of Equity
Kd = Cost of debt
V = D+E (V = value of the firm, D = value of the debt and E = value of the equity)
T = tax rate
P/E ratio for 2006 = 16.25/.91
Assuming P/E ratio to be constant, the share price after the buyback will be :
= 17.85 * .887 Expected market price = $15.84
Total value of equity: - total no. of shares * expected market price of share
= 45,052,000 * 15.84 = $713,543,529
V/E = (713,543,529 + 50,000,000) / 713,543,529 = 1.07
Beta (levered) = Beta (unlevered) * V/E
= 0.56 * 1.07
= 0.6
Cost of Equity = Risk Free rate + Beta * Risk Premium = 5.1 + (.60 * 1.7)
= 6.12 %
WACC = Ke*(E/V) + Kd(1-t)*(D/V)
= 6.12 (.9346) + 6.75 (1-.4) (.0655) = 5.72%
Therefore by including debt in its capital structure, the following are the benefits to the company:-
- Increase in return on equity from 11% to 17.42%.
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Since, debt is being raised – the WACC has come down as the cost of equity decreased to 6.118% and the contribution of cost of equity to WACC decreases with cost of debt being included; which is usually less than cost of equity due to tax benefits involved.
- Family’s Ownership has increased from 62% to 81.26% after the share repurchase. This is will give them a lot more power on the board and will be able to control the dividends to be given.
- Interest coverage ratio is 20.73, which is sufficient to service the debt.
- Earnings per share has reduced slightly from 0.91 to 0.887. This is because of two reasons. The tax rate has increased from 30.8% to 40 % which takes away a major part of earnings. Also, we have assumed that the source other revenue was interest on marketable securities held by the company which is not there anymore because it is used in the buyback.
