i) Do you believe Blaine’s current capital structure and payout policies are appropriate? Why or why not?
Capital structure: Blaine has an unlevered capital structure currently i.e., it is debt free and the entire capitalization is of equity only. However, concluding whether an unlevered or a levered capital structure is appropriate for a company largely depends on the industry debt equity ratio i.e., the debt equity ratio of the similar companies within the industry. If we see the debt/equity ratio within the industry, we see that each of the five companies is levered ones and their debt equity ratios (Debt/book value of equity) are 0.78, 1.51, 0.46, 0.48 and 1.86. Given the Total capital and revenue, it would not be viable to compare the Blaine with AutoTech Appliances, XQL Corp. and Bunkerhill, Inc. However, EasyLiving Systems and Home & Hearth Design come quite closer in terms of total capital and revenue and they have a debt/equity ratio of 1.87 and 0.78 respectively. Debt being a cheap source of finance and given the industry standards confirming the availability of the debt as well as the conformity by the rivals in subscribing to the debt capital, it seems wise to have a levered capital structure instead of having a completely unlevered one as it would have affected the cost of capital of the company.
Payout ratio: The payout ratio of the company has been increasingly increasing for the past three years. This shows that the company has been keen on less retention of money to further invest. The justification can be drawn from the diminishing returns for the last three years. The company has been earning less profits and hence it is of the opinion of distributing the profits to shareholders instead of retaining it for further investments. Dividend payout ratio increases when Growth < Cost of equity. The situation is not ideal for a company if it’s dividend payout ratio is increasing as it shows the lack of trust in growth prospects of the company. It is a form of returning the money back to shareholders and the shareholders who are out there for investment purposes feel it a better option to stay their money invested in a growing company instead of receiving petty dividends. 53% of dividend payout is a very big ratio by any standard and hence it cannot be stated as ideal. The company has been earning profit and it should seek and endeavor further growth opportunities instead of returning it back to shareholders.
Dividend payout ratio 0.35 0.44 0.53
Net Income Margin 0.18 0.17 0.16
ii) Should Dubinski recommend a large share repurchase to Blaine’s board? What are the primary advantages and disadvantages of such a move?
The main fix in the case is whether Blaine Kitchenware’s should opt for repurchasing its own shares or not. If Blaine’s Kitchenware repurchases its shares, they must consider whether to partially repurchase the market float or go for a complete buyback where Blaine’s family would become the owner of all the remaining shares. They also have to consider of the effect of the repurchase on various factors like the risks involved in raising a debt especially when they are large, very conservative and debt free. They should also consider things such their acquisition plans, their earnings per share and their dividend per share, ownership structure, capital structure and of course the reputation of the company in the market after the buyback. With this in mind we can consider a few situations and then decide what Blaine should do, keeping in mind the perspective of both the existing shareholders’ as well as Blaine’s c family’s. Since no debt is being raised, if all the cash & cash securities plus the market securities are used for the buy-back, his family may like this option. Their management will have increased stakes, this will reduce their chance of being acquired and this will provide more dividends to their remaining shareholders.
There is a big question facing Blaine and that is why would their existing shareholders want to sell their equity back to the company? Another scenario is to completely buy-back the market float. Although this will involve the company raising a significant debt, this will also give them complete control to the promoters. It is probable that their family’s needs concerning the dividend amount and growth can be better met through this option and the policy can be set according to their expectations. The return on equity will increase which will aid the family in better realizing value for their stake. From the point of view of the shareholders, they are getting a premium on the current market price if they go ahead with the offer and since debt is being raised ‘ the WACC will come down. We think that this could possibly be the best option for Blaine’s Kitchenware to make.
According to their current situation we do not think their current capital structure and payout policies are appropriate. Blaine is currently over-liquid and under-levered and their shareholders are suffering from the effects. Since Blaine Kitchenware is a public company with large portion of its shares held by their family members, they have a financial surplus, which decreases the efficiency of its leverage. In other words, Blaine does not fully utilize its funds. Since they are totally equity financed, there is no tax shield. A surplus of cash lowers the return on equity and increases the cost of capital; also large amount of cash may offer incentives to acquirer to and also decrease the enterprise value of Blaine. Acquirers could pay way less than they originally expect to buy out the firm.
Regarding their payout policies, the management’s goal is to maximize the shareholder’s value, rather than paying dividend. The management should use the available cash and invest in attractive investments. Although investors take dividend as an indicator for a company to succeed, they also expect dividend will be paid continuously at either stable or growing rate. In summary, in order for Blaine to keep its current payout policies, they must reduce numbers of outstanding shares throughout share repurchasing.
iii) Consider the following share purchase proposal: Blaine will use $209 million of cash from its balance sheet and $50 million in new debt-bearing interest at the rate of 6.75% to repurchase 14.0 million shares at a price of $18.50 per share. How would such a buyback 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.
a. We have not been given the seperate data for equity share capital and Retained Earnings. Hence we have assumed the no of equity shares to be 40000000 of face value of $10 each
Net worth in 2006 488362877.6
Retained earnings for the period 2004-2006 89372644.56
The difference is approximately equal to 400000000
b. We don’t have the data of the Blaine’s controlling shares in the company. It has been assumed to be 60% before the share repurchase plan.
No of shares before repurchase 40000000
% shares 60%
No of shares held by the family 24000000
No of shares after repurchase 26000000
% shares after repurchase 92.3%
Now, the comparison is made about the EPS, Debt service coverage ratio, owners’ capital when the company is levered. Following is the operating results for the year 2006 when the capital structure is levered and unlevered.
Operating Results in 2006 Unlevered Levered
Revenue 3,42,251 3,42,251
Less: Cost of Goods Sold 2,49,794 2,49,794
Gross Profit 92,458 92,458
Less: Selling, General & Administrative 28,512 28,512
Operating Income 63,946 63,946
Plus: Depreciation & Amortization 9,914 9,914
EBITDA 73,860 73,860
EBIT 63,946 63,946
Plus: Other Income (expense) 13,506 13,506
Less: Interest 0 3375
Earnings Before Tax 77,451 74,076
Less: Taxes 23,855 29630.5644
Net Income 53,596 44,446
No of shares 40,000 26000
EPS 1.34 1.71
Debt coverage ratio NA 18.95
Debt Equity ratio NA 0.22
Ownership interest 0.60 0.92
Assets: Unlevered Levered
Cash & Cash Equivalents 66,557 0
Marketable Securities 1,64,309 21,866
Accounts Receivable 48,780 48,780
Inventory 54,874 54,874
Other Current Assets 5,157 5,157
Total Current Assets 3,39,678 1,30,678
Property, Plant & Equipment 1,74,321 1,74,321
Goodwill 38,281 38,281
Other Assets 39,973 39,973
Total Assets 5,92,253 3,83,253
Liabilities & Shareholders’ Equity:
Accounts Payable 31,936 31,936
Accrued Liabilities 27,761 27,761
Taxes Payable 16,884 16,884
Total Current Liabilities 76,581 76,581
Other liabilities 4,814 4,814
Deferred Taxes 22,495 22,495
Debentures 0 50,000
Total Liabilities 1,03,890 1,53,890
Shareholders’ Equity 4,88,363 2,29,363
Total Liabilities & Shareholders’ Equity 5,92,253 3,83,253
Cost of capital when the company is unlevered
Dividend per share D1 0.761
Retention ratio b 47.1%
Rate of return r 15.7%
Growth g 7.39%
Price Po 18.5
Ke (D1/Po+g) 11.5%
Cost of capital when the company is unlevered
Weight E 0.821021317
Weight D 0.178978683
It is evident that the cost of capital has reduced when the company decided to go for share repurchase using the surplus cash and debenture issue. The debt capital has been procured at very less cost when compared to equity and hence the WACC has reduced from 11.5% to 10.17%. Using a perfect leverage is always beneficial for a company as it allows to decrease the cost of capital. However, the company must guard itself from getting over-levered.
iv) As a member of Blaine’s controlling family, would you be in favor of this proposal? Would you be in favor of it as a non-family shareholder?
Particulars Unlevered Levered
Net Income 53596 44446
No of shares owned by family 24000 24000
% of total shares 0.6 0.92
% of total profits 32158 40890
The share of the family has been assumed to be 60% i.e., 24000 shares. The family’s earing will be 60% of the total earnings of the firm i.e., $ 32158. Buyback of the shares using the surplus cash and issuing debentures is beneficial for the company as it will give some degree of leverage to the company. Seeing the industry debt equity ratio, the company has kept itself unlevered and this was a bit costly as the cost of debenture is fast cheaper if we compare it with the cost of equity. After the share repurchase, the total percentage share of the family rose as high as 92% and it’s share of profits has surged from $ 32158 to $ 40890 and hence making the share repurchase more profitable for the family. Moreover, the ownership percentage of family has also increased and hence resulting in the more dominant position in the company.
As a non family member, the stock repurchase will make me more skeptical because the shares owned by the family is rising exponentially and hence making it more dominant. This is not a very healthy situation for a public company as the interest of the minority shareholders are sometimes not taken care of. 92% of shareholding by one company makes the position for the rest of shareholders very vulnerable.
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