BLAINE KITCHENWARE INC: CAPITAL STRUCTURE CASE STUDY

By: Abhinav Goel Shreya Gupta Nooruddin H Anuj Kant Apaar Miglani Udit Narindra

A023 A025 A026 A029 A036 A040

Introduction
Recent development is consolidation in a fragmented

industry Acquisitions of BKI were done through cash and company stock Margins dropped in the last three years despite launch of high-end products
Integration costs and inventory write downs for their recent

acquisitions

Imports and private labels caused the industry to lower

prices to maintain sales growth, but Blaine did not follow Growth in top line thus was attributable to recent acquisitions

Introduction (Contd.)
ROE levels were disturbingly low at 11% partly due to dilutive acquisitions Very conservative w.r.t to outside borrowings Dividend payout and Capex were small enough to be funded by the operating cash flows Current levels of dividend payout are unsustainable leading to lower cash for reinvestment Shareholders not satisfied with marginal increase in dividend Stock price at all-time high; share repurchase plan is a

tough decision
Killing of war chest for acquisition Future need for debt becomes more real Growth without acquisition seemed difficult; organic growth

expectation of only 3%

Q1

Are Blaines current capital structure and layout policies appropriate?

Q1
Appropriate is a very subjective term; however, the

company is over-liquid and under-leveraged Changing times, where topline growth, ROE and size matters more Leverage is an important tool to increase ROI and ROE, which needs to be used by Blaine Funding everything by high-cost low-risk equity
makes the investments less attractive but more secure

A portion of Capex and acquisitions should be funded with

debt
maximise return on equity

Q1
Debt has a lower cost of capital further enhanced by the tax shield it receives on the interest payment has higher risk, as interest receives highest priority in Cash flows Industry average net-debt-to-equity ratio is about 17% while

Blaine is at about (24%) Only equity funding it is further destroying ROE for its shareholders
little incentive to stay with a company that has lowest ROE further risk of diluting it

Cash management is also an important issue when having

huge cash and marketable securities

End up investing in less-profitable projects Cost efficiency receives lower priority

Idle Cash reduces value of the company

Q2

Should Dubinski recommend a large share repurchase to Blaines board? What are primary advantages and disadvantages of such a move?

Dubinski can recommend a large share repurchase to the board using cash and cash equivalents and raising some debt.
Advantages
1. Debt has a lower cost of capital 2. Increase leverage - invest in its business without increasing shareholders' equity 3. Deliver better return on equity 4. Increased control for family members - reversing downward trend from IPO. 5. More flexibility in setting future dividends per share

Disadvantages
1. The company's asset base will decrease it would have to borrow money if it wants to acquire another company or expand its production 2. Increasing long-term debt may cause financial distress - larger portion of its EBIT is used to pay for interest expenses. 3. Loss of control for smaller shareholders as family ownership rises to 81% 4. Volume is reduced- reducing liquidity of the stock is reduced in the secondary markets

Q3
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 affect Blaine?

Balance-Sheet (Post-Leverage)
Share-Repurchase (With Leverage) Liablilities Amount
Accounts Payable Accrued Liabilities Taxes Payable Total Current Liabilities Other Liabilities Deferred Taxes Debt Total Liabilities Shareholders'Equity

Assets

Amount2
21866 0 21866 48780 54874 5158 130678 174321 38281 39973

31936 Cash & Equivalents 27761 Marketable Securities 16884 Liquid Assets Accounts Receivable 76581 Inventory 4814 Other Current Assets 22495 Total Current Assets 50000 153890 Property, Plant & Equipment 229363 Goodwill Other Assets

TOTAL

383253 TOTAL

383253

Asset base has decreased substantially due to the cash being used for share repurchase Shareholders Equity has also declined due to the outstanding shares being repurchased The company has added debt to fund the share-repurchase

Projections, 2007
Particulars EBITDA Depreciation Other Income EBIT Interest Expense EBT Tax Net Income Shares Outstanding EPS Equity ROE Dividend Div/NI 2004 69370 6987 15719 78102 0 78102 24989 53113 41309 1.29 417377 0.13 18589 0.35 2005 68895 8213 16057 76739 0 76739 24303 52436 48970 1.07 458538 0.11 22871 0.44 2006 73860 9914 13506 77452 0 77452 23821 53631 59052 0.91 488363 0.11 28345 0.53 2007 83765 10211 0 73553 3375 70178 28071 42107 45052 0.93 253018 0.17 18452.32 0.44

Financial Ratios
Ratios Interest Coverage Debt/Equity EPS RoE Family Ownership (%)
Shareholding Structure: Family 36612 (81%) Public - 8440 (19%)

2004 N.A N.A 1.29 0.13 0.62

2005 N.A N.A 1.07 0.11 0.62

2006 N.A N.A 0.91 0.11 0.62

2007 22 0.20 0.93 0.18 0.81

Q4
As a member of Blaines controlling family, would you be in favour of this proposal? Would you be in favour as a non family shareholder?

Q5

How does the proposal above differ for a special dividend of $4.39 a share?

Proposal Vs Special Dividend

Buyback saves on Dividend distribution tax.

Through buyback , company can save on dividends that

need to be paid in future. Raising money in future will be difficult for the company Higher D/E ratio. Current share price is $16.25, whereas proposal is to buy shares at a $18.50,offering a premium of $2.5. In comparison, the special dividend is proposed at $4.39, which far exceeds the premium offered in buyback. For Promoters: BUYBACK For Shareholder: DIVIDEND

Q6

What do the quotes for default spreads over 10

year Treasury bonds imply about BKIs cost of debt at the various levels of debt? What do your calculations imply about Blaines optimal capital structure? Based on these calculations, how many shares should Blaine purchase and at what price?

Treasury Stock Default Spreads

10 Yr Treasury Yield
Interest Coverage Ratio 13.00 9.50 7.00 5.00 4.00 2.50 Rating AAA AAA BBB+ BB+ B+

5.02%
Spread 0.65% 0.80% 0.85% 1.83% 2.98% 4.10%

What do these quotes imply about BKIs cost of debt at the various levels of debt? Deteriorating Interest payment capacity increases the risk of default and thus the default spread

Buyback

Calculations
Cash Available & Debt that can be raised

Total Amount available for repurchase

New Shareholder Equity No. of Shares Bought Back

PAT and other Ratios

EPS at different Price Levels

Share Price Rating AAA AA0.774 0.761 0.780 0.766 0.747 0.735 0.724 0.714 0.706 0.685 0.749 0.735 0.7228 0.712 0.702 0.679

16.25

17

18

19

20

21

22

25

A
BBB+ BB+ B+

0.788 0.771
0.770 0.753 0.742 0.723 0.706 0.687

0.753 0.736 0.7225 0.710 0.700 0.674

0.733 0.716 0.702 0.689 0.678 0.651 0.702 0.684 0.669 0.656 0.644 0.617 0.666 0.648 0.632 0.619 0.608 0.580

Promoters Holdings After Buyback

16.25
AAA
AAA BBB+ BB+ B+
84.96% 88.27%

17
83.59% 86.65%

18

19

20

21

22

25

82.00% 80.63% 79.44% 78.39% 77.46% 75.21% 84.78% 83.17% 81.78% 80.55% 79.47% 76.87%

91.87% 89.96% 94.39% 97.78% 100.27% 92.26% 95.35% 97.61%

87.76% 85.88% 84.26% 82.84% 81.60% 78.62% 89.83% 87.75% 85.97% 84.41% 83.05% 79.80% 92.58% 90.24% 88.23% 86.49% 84.96% 81.35% 94.59% 92.05% 89.87% 87.99% 86.34% 82.46%

Share Premium
Outstanding Shares Share Premium 39.85 0.48
40.70 0.47 Share Price 16.73

16.25 17 18 19 20 21 22 25

16.72
16.71
16.70 16.69

41.72
42.63 43.45

0.46
0.45 0.44

44.19
44.87 46.57

0.43
0.43 0.41

16.68
16.68 16.66