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# CORPORATE FINANCE PROF. R.

C AGARWAL

## Case study analysis

Blaine Kitchenware Inc. Capital Structure
51. Priyanka Shimpi 52. Dilip Singh 53. Prabhdeep Singh 54. Shalini Singh 55. Amin-ul-Aziz
3/9/2010

## What is a Stock Split?

A stock split is a corporate action which splits the existing shares of a particular face value into smaller denominations so that the number of shares increase, however, the market capitalization or the value of shares held by the investors post split remains the same as that before the split. For e.g. If a company has issued 1,00,00,000 shares with a face value of Rs. 10 and the current market price being Rs. 100, a 2-for-1 stock split would reduce the face value of the shares to 5 and increase the number of the companys outstanding shares to 2,00,00,000, (1,00,00,000*(10/5)). The share price would also halve to Rs. 50 so that the market capitalization or the value shares held by an investor remains unchanged. It is the same thing as exchanging a Rs. 100 note for two Rs. 50 notes; the value remains the same. The impact of this on the share holder: for example ABC is trading at Rs. 40 and has 100 million shares issued, which gives it a market capitalization of Rs. 4000 million (Rs. 40 x 100 million shares). An investor holds 400 shares of the company valued at Rs. 16,000. The company then decides a 4-for-1 stock split (i.e. a shareholder holding 1 share, will now hold 4 shares). For each share, they receive three additional shares. The investor will therefore hold 1600 shares. So the investor gains 3 additional shares for 59 each share held. But this does not impact the value of the shares held by the investor since post split, the price of the stock is also split by 25% (1/4th), from Rs. 40 to Rs.10, therefore the investor continues to hold Rs. 16,000 worth of shares. The market capitalization stays the same - it has increased the amount of stocks outstanding to 400 million while simultaneously reducing the stock price by 25% to Rs. 10 for a capitalization of Rs. 4000 million. The true value of the company hasn't changed. Pre-Split Post-Split 200 mill. Rs. 20 Rs. 4000 mill

2-for-1 Split
No. of shares Share Price Market Cap. 100 mill. Rs. 40 Rs. 4000 mill.

4-for-1 split
No. of shares Share Price Market Cap. 100 mill. Rs. 40 Rs. 4000 mill. 400 mill. Rs. 10 Rs. 4000 mill.

## Why Stock Split?

Though there are no theoretical reasons in financial literature to indicate the need for a stock split, generally, there are mainly two important reasons. 1. As the price of a security gets higher and higher, some investors may feel the price is too high for them to buy, or small investors may feel it is unaffordable. Splitting the stock brings the share price down to a more "attractive" level. In earlier example to buy 1 share of company ABC you need Rs. 40 pre-split, but after the stock split the same number of shares can be bought for Rs.10, making it attractive for more investors to buy the share.
2. Splitting a stock may lead to increase in the stock's liquidity, since more investors are able to

afford the share and the total outstanding shares of the company have also increased in the market.

A method for company to invest in itself by buying shares from other investors in the market. Buybacks reduce the number of shares outstanding in the market. Buy back is done by the company with the purpose to improve the liquidity in its shares and enhance the shareholders wealth. The company has to disclose the pre and post-buyback holding of the promoters. To ensure completion of the buyback process speedily, the regulations have stipulated time limit for each step. For example, in purchases through stock exchanges, an offer for buy back should not remain open for more than 30 days. The verification of shares received in buy back has to be completed within 15 days of the closure of the offer. The payments for accepted securities has to be made within 7 days of the completion of verification and bought back shares have to be extinguished within 7 days of the date of the payment. Companies making profits typically have two uses for those profits. Firstly, some part of profits is usually repaid to shareholders in the form of dividends. The remainder, termed stockholder's equity, are kept inside the company and used for investing in the future of the company. If companies can reinvest most of their retained earnings profitably, then they may do so. However, sometimes companies may find that some or all of their retained earnings cannot be reinvested to produce acceptable returns. Share repurchases are one possible use of leftover retained profits. When a company repurchases its own shares, it reduces the number of shares held by the public. Share repurchases avoid the accumulation of excessive amounts of cash in the corporation.

Why companies buyback? 1. Unused Cash: If they have huge cash reserves with not many new profitable projects to invest in and if the company thinks the market price of its share is undervalued. Eg. In India Bajaj Auto went on a massive buy back in 2000 and Reliance's recent buyback. 2. Tax Gains: Since dividends are taxed at higher rate than capital gains companies prefer buyback to reward their investors instead of distributing cash dividends, as capital gains tax is generally lower. 3. Exit option: If a company wants to exit a particular country or wants to close the company. 4. Increase promoter's stake : By reducing the number of shares in the market.

## Buybacks can be carried out in two ways:

1. Shareholders are presented with a tender offer where they have the option to submit a portion of or all of their shares within a certain time period and at usually a price higher than the current market value. Another variety of this is Dutch auction, in which companies state a range of prices at which it's willing to buy and accepts the bids. It buys at the lowest price at which it can buy the desired number of shares.

2. Companies can buy shares on the open market over a long-term period subject to various regulatory guidelines like SEBI in India.

## In 1 promoters can participate in buyback and not in 2.

Buy Back Shares Face value remains unaffected It leads to cash outgo It decreases he stake of public and increases stake of promoters Float (publicly held shares) decreases Can lead to a change in market capitalization

Split of Shares Face value decreases It does not lead to any cash outgo It does not affect stake of any party Float (publicly held shares) increases Mostly does not affect market capitalization

## Decision of Repurchase- The dilemma

Blaine Kitchenware Inc. is faced with a dilemma as to not go for the suggested buyback or to pay heed to the investment banker and repurchase its own shares. And also if BKI does repurchase its shares, should it only partially repurchase the market float or should it go for complete buyback ( in which the Blaine family becomes the owner of all the remaining shares). Also they have to think of the effect of repurchase on the various factors like the risks involved in raising a debt for repurchasing (especially when the company is by and large very conservative and it is debt free), its acquisition plans ( which is mainly done by cash and BKI stocks), the earnings per share, dividend per share (which will become more flexible as now the shares will be with the family shareholders only and thus a reduction in dividends can be easily accepted), ownership structure, capital structure and of course the reputation of the company in the market after the buyback. Therefore, we can consider three scenarios and then analyze the effect of these on the above mentioned factors and then decide whether Blaine should follow them keeping in mind the existing shareholders' perspective as well as Blaine's controlling family perspective. These scenarios are: 1. BKI should not go for any buyback of shares. 2. BKI should go for only partial repurchase, by using only its cash and cash equivalents and marketable securities and not raising any debts. 3. The company should buy its entire market float and let the controlling family be the shareholders of the remaining shares. Each of these scenes is evaluated and calculations will give us an idea about whether the buyback is justifiable or not. And also the different perspectives of family and minority share holders have on this issue.

## Scenario one- BKI should not go for any buyback

Total no. of shares: 59.052 Million Net Income: 48.477 Million Hence, Earning per share: Net Income/Total No. of shares = 48.477/59.052 = 0.821 Market price of the share: \$16.25 Price to earnings ratio = Market price of the share/EPS =16.25/0.821 =19.79 Calculation of ROE: ROE = (\$ 48.477 million/ \$ 488.363 million)* 100 = 9.926% Conclusion: This scenario will maintain the company status as under leveraged and highly liquid This scenario fails to create value for the shareholders and both minority shareholders and promoters will suffer There is a need to change the current capital structure as it is providing lower returns

Scenario two- A partial buy-back using only cash and cash equivalents/ Market securities
Total Cash and Cash Equivalents = \$66.557 Million We are keeping 10% of the cash and cash equivalent aside for daily operations. Therefore 6.557 Million have been kept as buffer for rotating working capital requirements. Remaining Cash and Cash equivalents = \$60 Million Marketable Securities = 164.309 Million Total amount available for buy-back = 224.309 Million Assumption: The share price has increased from \$16.25 to \$16.50, an increase of 1.5% as it so often happens when a company puts out an offer to buy-back the shares. No. of shares bought = 224.309/16.50 =13.59 million These shares are retired. Therefore the no. of remaining shares = 59.052-13.59 = 45.462 million Calculation of EPS: Earnings per share: net income in the year 2006/ total no. of shares Now, net income will change because we will also have to account for the loss in the interest which the company could have got if it had invested its cash and cash equivalents and market securities in the US treasury securities. This interest rate is the average of all the yields on U.S treasury securities provided in the exhibit 4 which is 4.92%. Therefore, net earnings after reducing 4.92% of \$224.309 million= \$ 48.477- (0.0492* 224.309) = 48.477- 11.036 = \$ 37.441 million Therefore EPS = 37.441/45.462 = \$ 0.824 Expected Market price of the share now = Expected EPS*P/E ratio Assuming: P/E ratio remains constant Therefore, Expected Market price = 0.824*19.79 = \$ 16.307

Increase in value per share for shareholders = \$16.307-\$16.25 = \$ 0.057 Money spent per share for partial buyback = \$224 million/59.052 million = \$3.793 Therefore, increase in value per share is lesser than money spent per share Calculation of ROE: Net income = \$ 37.441 million Shareholders' equity = \$ 488.363 million - \$ 224.00 million = \$ 264.363 million { shareholders' equity will be reduced as cash and cash equivalents and market securities are being used up for the buyback indication a reduction in the asset side of the balance sheet of the company and thus an appropriate adjustment will have to be done on the liabilities side as well} Therefore ROE = (\$ 37.441 million/ \$ 264.363 million) * 100 = 14.163 % Conclusion: The companys management which appears to be reluctant to raise any debt, will not have to forego its zero debt policy The company will have a better Return on Equity The company might have to raise debt if it has to continue its growth through inorganic route The share holders will have a better value after this whole exercise The management will have an increased stake and will have more discretion in making decisions

## Scenario three: When Blaine repurchases its entire market float

Assumption: 1. The controlling family of Blaine Kitchenware Inc. still owns 62% of its average outstanding shares and the market float is 38% of the total outstanding shares. 2. As in case of partial buyback, the company will use all of its cash and cash equivalents (except some about 10 % for its daily operations), and market securities and for the remaining amount required for the total buyback, Blaine will raise a debt at an interest rate of 6.35 % (assuming that the company has a rating of a on Moodys scales of corporate ratings.) 3. The shares are bought back at a premium of 13.8% on the market price of \$16.25/share i.e. at \$18.5/share, because otherwise the outside investors would not be interested to give up their shares at the existing share price as they are expecting it to increase in the coming years considering the profitability of the company. So for complete buyback Blaine needs to repurchase 38% of 59.052 million shares, that is 22.439 million shares. Therefore, total number of shares left after complete buy-back = 62% of 59.052 million shares = 36.612 million Shares. Calculation for the amount of debt to be raised: No. of shares to be bought back = 22.439 million shares. Therefore the total price of all the shares to be bought back = 22.439*\$18.5 = \$415.121 million Less cash and cash equivalents and market securities = Therefore the debt to be raised for complete buyback = = Calculation of EPS: Interest to be paid = 6.35 % of 190.812 million dollars: = \$ 12.116 million Now, EBIT in the year 2006 = \$ 70.010 million Less: loss due to use up of cash & cash equivalents and market securities @ 4.92% = \$ 11.036 million \$224.309 million 415.121- 224.309 \$190.812 million @ a rate of 6.35%

Revised EBIT Less interest (@ 6.35%) Earnings before tax Tax (@ 40%) Net income

= \$ 58.974 million = \$ 12.116 million = \$ 46.858 million = \$ 18.743 million = \$ 28.115 million

EPS = Net income/total no. of shares remaining = 28.115/ 36.612 = \$0.768 Expected Market price = EPS* P/E ratio = 0.768* 19.79 = \$ 15.199 The money spent per share in case of complete buyback of shares: Total price for the entire market float to be bought back/total no. of outstanding shares = \$ 415.121 million/59.052 million = \$ 7.029 And since the new market price is \$ 15.199 and the earlier market price was \$ 16.25, Therefore, decrease in value per share for the shareholders = 16.25-15.199 = \$ 1.051 Hence, in this case the outgo per share is greater than the value per share; it does not lead to creation of more shareholder value (for the shareholders who retain shares) Calculation of ROE: Net income = \$ 28.115 million Shareholders' equity = \$ 264.363 million Therefore, ROE = (\$ 28.115 million/ \$ 264.363 million) * 100 = 10.635 % Conclusion: The company will have to raise considerable debt for the required buyback The promoter will have the complete stake and absolute decision making powers, dividend policy can be made suiting the familys need The companys debt-equity ratio will remain below 1 which is comfortable The return on equity will improve which will help family realize better value for their stake The minority shareholders will gain in the form of 13.48% premium The complete stake in hands will provide a buffer that may allow company to issue shares in case of an acquisition without reducing the promoters stake below crucial 51% level.

Conclusion
Looking at the scenarios mentioned, one thing we can say for sure is that remaining as-it-is is not a good option. The company is over-liquid and under-levered. Since it is a family owned business, there is a conservative debt policy. This has led to Blaine building up a huge war-chest to remain staid & debt-free. This scenario fails to create value for the shareholders and both minority shareholders and promoters will suffer. Therefore, the real question now is what to do with the burgeoning coffers. In the second scenario, all the cash & cash securities plus the market securities are used by the company to buy-back the shares. Since no debt is being raised, it might find favour with the family which seems risk-averse to us. The management will have an increased stake, will find off the acquisition chances and will be able to provide more dividends to the remaining share-holders. A natural doubt raised is, why would the existing shareholders be willing to sell their equity back to the company? We discussed this within our group and have reached a common stand that since the company, in comparison with its peers, has a low market-beta better thing for the stock-holders to do will be to sell the stock and invest in alternates. Another scenario pointing to the extreme is to completely buy-back the market float. This will involve the company raising a significant debt. But this will give a complete control to the promoters. Familys needs concerning the dividend amount/growth can be better met through this option. The policy can be set according to their expectations. The return on equity will improve which will help family realize better value for their stake. From the share-holders point of view, they are getting a premium on the current market price if they go ahead with the offer. 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. Hence, it can be said that the best option to exercise is to go for a complete buy-back of the market float.

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