BLAINE KITCHENWARE, INC.

Capital Structure

Introduction to the Case

KaramVeer Singh 376

Blain Kitchenware

Mid-sized producer of small Kitchen appliances. Family promoted, Victor Dubinski CEO. captures 10% of $2.3bn US market. Competitive advantage such as smart technology Brand recognition 2 times in 85years company had debt

Major Segments
Major Revenue

Food preparation

Cooking appliances

Beverage making appliances 2% market share

400000 300000

200000
100000 0 Blaine Kitchenware Easy Living System Home & Hearth Design -100000 -200000 -300000 Cash & Securities Net Debt

Main Problem

Lacks of organic growth ROE 11% , below industry average Downward trend in its operating margin Decreasing net margin Dividend payout ratio over 50%

Main Issues

BKI is over liquid and under-levered PE firms purchase all outstanding shares Takeover of BKI Whether to buy-back shares or to pay dividends???

Dilemma of Buy Back

375 - Swapnil Vashishtha

Dilemma

Buy Back

Companies return cash to stockholders in the form of dividends Stock buyback has emerged as an alternative

Repurchase Tender Offers

Privately Negotiated Repurchase s

Open Market Purchases

Capital Structure
380 Ritwa Lokhandwala

Capital Structure

Capital Structure of a firm refers to the combination mix of debt and equity i.e., sources of funds, which a company uses to finance its overall operations and growth A firm's capital structure is then the structure of its liabilities Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered. It is monitored by debt to equity ratio

Example

A corporation that sells $30 billion in equity and $70 billion in debt is said to be 30% equity-financed and 70% debt-financed. Thus, firm's ratio of debt to total financing, 70% is referred to as the firm's leverage.

Capital Structure
Capital Structure

Debt- Capital

Equity-Capital

Long-term debt

Specific shortterm debt(bond issued)

Preferred Equity(or retained earnings)

Common Equity

Capital Structure

Equity Capital: This refers to money put up and owned by the shareholders. Equity:
Contributed

capital, which is the money that was originally invested in the business in exchange for shares of stock or ownership Retained earnings, which represents profits from past years that have been kept by the company and used to strengthen the balance sheet or fund growth, acquisitions, or expansion.

An example: A speculative mining company vs. proctor & Gambler

Capital Structure

Debt Capital in a company's capital structure refers to borrowed money that is at work in the business. The safest type is generally considered longterm bonds because the company has years, if not decades, to come up with the principal, while paying interest only in the meantime. Other types of debt capital can include shortterm commercial The cost of debt capital in the capital structure depends on the health of the company's

Capital Structure

Other Forms of Capital:

There are actually other forms of capital, such as vendor financing where a company can sell goods before they have to pay the bill to the vendor, that can drastically increase return on equity but don't cost the company anything. This was one of the secrets to success of Wal-Mart. Wal-Mart has often able to sell Tide detergent before having to pay the bill to Procter & Gamble, in effect, using PG's money to grow his retailer. The cost of other forms of capital in the capital structure varies greatly on a case-by-case basis and often comes down to the talent and discipline of managers.

Good Capital Structure

Firstly, the good capital structure will result in a low overall cost of capital for the company Secondly, the only variation in capital structure we will consider is in the overall amount of borrowings which firms use.

Assumptions and Definitions

To examine the relationship between capital structure and cost of capital the following assumptions are commonly made:

There is no consideration of income tax, corporate or personal. However we consider the implications of tax in some cases. We assume firms policy of paying all of its earning as dividends i.e., 100% dividend ratio is assumed. Investors have identical subjective probability distributions of operating income for each company. It is assumed operating income remains same over period of time. It is assumed that there is no transaction cost incurred if the firm changes its capital structure instantaneously.

Assumptions and Definitions

Assuming, debt is perpetual: Cost of Debt = Annual interest charges/Market value of debt rD = I /D Assuming, 100% dividend payout ratio and earnings constant: Cost of Equity = Equity earnings/Market value of equity rE = P/E Thus, Capitalization rate of the firm = Operating income/Market value of equity rA = O/V = O/ (D+E) Capitalization rate of the firm = Weighted average cost of capital rA = rD(D/D+E)+ rE(E/D+E) what happens to these rates if D/E changes

Calculation of Capital Structure

115 Ankitesh Mathur

Net income approach

This approach, the cost of debt, Rd and the cost of equity, Re, remain unchanged when D/E varies The constancy of Rd and Re with respect to D/E means that Ra, the average cost of capital, measured as Ra=Rd [D/D+E] + Re[ E/D+E]

D=market value of debt E=market value of equity

Net income approach:- graph

From the graph it is clear that as D/E increases, Ra decreases because the proportion of debt, the cheaper source of finance, increases in the capital structure.

Net operating income approach

According to the net operating income approach, the overall capitalization rate and the cost of debt remain constant for all degrees of leverage Ra and Rd are constant for all degree of leverage. Given this the cost of equity can be expressed as: Re=Ra+(Ra-Rb)(D/E)

Net operating income approach

The critical premises of this approach is that the market capitalizes the firm as a whole at a discount rate which is independent of the firms debt-equity ratio As consequences the division between debt and equity is irrelevant. An increase in the use of debt funds, which are apparently cheaper, is offset by an increase in equity capitalization rate

Net operating income approach

Traditional proportion

Rd remains constant up to a certain leverage then rises increasingly Re rises gradually up to a certain degree at a constant rate Ra decreases up to a certain point then remains un affected and finally rises beyond the point

Traditional proportion:- graph

Traditional proportion
Implication: Cost of capital depends upon capital structure Optimal capital structure minimizes cost of capital
Before

optimal point: Real marginal cost of debt < real marginal cost of Equity After optimal point: Real marginal cost of debt > real marginal cost of Equity

Modigliani & Miller Position

Complete and perfect capital markets Capital Structure Does Not Matter IF
No

Taxes - Assumption Relaxed No Bankruptcy Costs No Costs of Enforcing Debt Contracts or issuing securities. Investment Opportunities are given Homogeneous Expectations about the Investment Opportunities of Firms

MM Proposition I

The value of firm is equal to its expected operating income divided by the discount rate appropriate to its risk class. It is independent of its capital structure. V=D+E=O/R V= market value of firm E= market value of equity D= market value of equity O= expected operating income R= discount rate applicable to the risk class to which the firms belongs MM invoked an arbitrage argument to prove this proposition.

MM Proposition II

The cost of equity capital for a levered firm = Re=Ra+(Ra-Rd)(D/E) Expected return on equity= Expected return on assets +[expected return on assets expected return on debt] debt-equity ratio

MM Proposition II graph

FEATURES OF APPROPRIATE CAPITAL STRUCTURE

117 Harsh Mehta

FEATURES

Combination at that level of debt equity proportion where the market value per share is maximum and the cost of capital is minimum.

FEATURES
Capital structure should have the following features

Profitability or Return

Solvency or Risk
Flexibility

Controllable

Forms of Capital Structure

Following are the forms of capital structure:

Complete equity share capital; Different proportions of equity and preference

share capital;

Different proportions of equity and debt capital and

Different proportions of equity, preference and

debenture (debt) capital.

Equity Capital

Equity Capital refers to money put up and owned by the shareholders. Various forms are:
Common

stock Preferred stock Convertible Debenture (Hybrid Securities)

Equity Capital
Advantages
1.

Disadvantages
1.

2.

3.

The funding is committed to the firms projects & business only. No regular service to the shareholder. Follow up funding may be provided by investors if company performs well.

2.

Raising equity is costly, time consuming and may also take away the management focus away from the core business. More number of decision makers.

Debt Capital

The debt capital in a company's capital structure refers to borrowed money that is at work in the business.

The different debt instruments are:

Long

term loans Bonds Leasing

Debt Capital
Advantages Disadvantages

Does not dilute the stake of the owner. Scope for large profits. Easier forecasting. Helps in lowering of taxes.

Delayed break even points. Loss in flexibility. Assets are needed to be pledged.

Factors affecting capital structure

Internal External Size of company Nature of industry Investors Cost of inflation Taxation policy

Financial leverage Risk Growth and stability Cost of capital Asset structure

Importance of Capital Structure

Decision Making Calculate Cost of Capital To Reduce Risk To Adjust according to Business Environment Idea Generation of New Source of Fund Maximize the value of the firm or WACC. Provides a signal that firm is following proper rules of corporate finance to improve its balance sheet.

Decision Making
Types of analysis used in choosing capital structure : PBIT-EPS analysis ROI-ROE analysis Leverage analysis Ratio analysis Cash flow analysis Comparative analysis

To Reduce Risk

When we make capital structure before actual getting money from money supplier, we can do many adjustments for reducing our overall risk.
For a new business, there will be lower rate of return than the profits. But if the ROI is high in the initial years itself, then the future financing can be done using debt options.

To Adjust according to Business Environment

If government of India cuts off his relation with China, from where Company X is getting its fund, it will definitely tough for us to get more money from China. But proper planning of capital structure of future sources will be helpful for us to enlarge our area for getting money. In finance, it is called manoeuvrability. It means to create mobility of sources of fund by including maximum alternatives in planned capital structure.

Suppose, if RBI increases the interest rate, it means your cost for getting debt will be high, at that time, you can choose any other cheap source of fund.

Idea Generation of New Source of Fund

Good planning of capital structure will make versatile to finance manager for getting money from new sources.

Cost Of Capital

WACC = [Rd*(D/V)*(1-Tc)] + [Re*(E/V)] Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V=E+D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate

Re = Ri + B(EMRP) Ri = Risk Free rate of return = 5.02% B = market Risk = .56 EMRP = Equity market risk premium = (6.725.02) = 1.7%

Therefore Re = 5.02 + [.56*1.7] = 5.972

Rd= 0 Re = 5.972 Debt = (230,866) Debt/ Value = -.31 Therefore Equity/Value = 1- (D/V) = 1.31 Therefore WACC = Re*(E/V)] = 5.972 * (1.31) = 7.82

BKIs Capital Structure & Policies

377 Yuyutsu Tulshyan

BKIs Capital Structure

Conservative financial policies

Only

two borrowings

Debt free
Cash and securities : $ 230,866,000 Total Debt :$0 Net Debt : $ (230,866,000)

Strong liquidity

BKIs Capital Structure

Largest Uses of Cash

Pay

Dividends Acquisitions

BKIs Capital Structure

Average Capital Expenditure = $10 million After-tax operating cash flow more than 4 times

Market Capitalization
Current Stock Price = $16.25 = 59,052,000

Average Outstanding Shares

Market Capitalization = Current Stock Price * Average Outstanding Shares = $ 959,596,000

Reserves & Surplus

Book equity = $ 488,363,00 Includes the equity value and the reserves and surplus owned by the company. Reserves and Surplus = Book Equity Cash & Securities = $ 488,363,000 - 230,866,000 = $ 257,497,000

Special Dividends

In case the company plans to give out outstanding shares, the amount of the dividends paid per share would be: Reserves and Surplus / Number of Outstanding Shares = 257,497,000 / 59,052,000 = $ 4.39

Debt Ratio

Defined as the ratio of Net Debt to Equity

For BKI the debt ratio was (230,866,000)/959,866,000 -24.06% Whereas, Industry Average was 17%

How Appropriate is it?

114 Omkar Malage

Threats
1. Take over threat

Attract hostile takeover

Enterprise value = 729 million Market capitalization = 959 million

Risks
2. Re-investment risks

Capital misallocation Invest in some wrong / weak projects

Dividends ?...
3. Inappropriate policy

Consistent increase in the pay-out ratio

Managements goal is to maximize share-holders value.

Should use the cash in more attractive investments. Investors expect the dividends to continue

Share Repurchase Advantages

Get rid of surplus cash. Decrease the cash carrying cost. Reduce the risk of unattractive re-investments. Increase buying cost of hostile take-overs.

thus by discharging cash BKI can decrease its asset and equity on book and there-by increase its ROE.

Difference from Proposal

374 Suman Rathi

Difference Between Proposed sketched of Case Study and Special Dividends Of 4.898/share.

Proposed Sketch: Buyback Of Share

Option 1: Buyback Of Shares
Assumptions: Buyback price for share 18.5$.

Option 2: Pay Special Dividends of $4.39/share

Advantage Of Buyback

Share repurchase will decrease the number of share outstanding and increase the family ownership.

From investors perspective, instead of being passively given dividend which subject to income tax, they have more flexibility to choose when they want to sell to taxed, and the capital gain tax will be slightly lower than the income tax.

Cont..

In addition, share repurchase might send a signal to the market that the share is undervalued thus boosting the share price. If the share is fairly valued, market can also interpret the buyback as a positive signal that management is confident in their future business

Conclusion
ROE and Earnings/Share both are highest in case of Buyback. Therefore company should go for buyback.

Thank You
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