Business Case Analysis

Blaine Kitchenware, Inc.

Capital Structure

1. Do you believe Blaines current capital structure and payout policies are
appropriate? Why or why not?
The fiscally conservative culture at Blaine Kitchenware (BKI) is what allowed it to
achieve that led to a debt-free balance sheet with sizable cash and short-term
investments. This resulted in the company having a capital structure solely consisting
of equity. From a financial theory standpoint, an all equity capital structure is not
considered the best for a publicly traded company. In theory, the optimal capital
structure for a company is the combination of debt and equity that results in the lowest
weighted average cost of capital. This, in turns, results in the maximum value for the
company. Althought the cost of debt is cheaper than the cost of equity, it increases the
financial risk to a firm. Plus, each subsequent issuance of debt by a highly leveraged
firm costs more than the previous one. Additionally, increasing leverage raises the cost
of equity, as expressed in the relationship between asset beta (U) and equity beta (L).

Although optimizing the capital structure through the addition of debt may
increase the total value of the firm, especially considering the impact of the tax shield for
debt, having no debt has its advantages. In the past, the company has primarily used
cash or equity to finance acquisitions. It wouldnt have been unreasonable to use cash
and debt to finance some of the acquisitions. One of the shortcomings of using stock to
make acquisitions is that companies tend to pay more using stock than they would
using cash because there is no large financial impact on the firm. Using debt would
have been less dilutive on existing shareholders. Also, in pecking order theory, equity is
the most expensive and least desirable source of funds for expansion because it has
the highest expected return by investors.
A challenge BKI must face is the perception of being considered a mature
company, although it is one of the smallest in its peer group by revenue. Its beta, 0.56,
suggests that it is a mature company that doesnt move much one way or another when
the market moves. Its beta is also much lower than the average for its peer group and
also suggests a low cost of equity, according to the Capital Asset Pricing Model below.

Another challenge that BKI must address is the impact of share growth due to
acquisition on the dividend payout policy. Its acquisition policies have resulted in more
and more of the companys cash being used to fund dividend payouts, which have led
to an increasing dividend payout ratio, slowing the growth of retained earnings and
slowing the capacity to make future acquisitions. The acquisition premium for equity
transactions is greater than that for cash transactions due to the volatility in return on
the stock prices and the likely reduction in value if they try to sell a substantial portion of
their new stock holdings.

Blaine Kitchenwares capital structure is good for a company that intends to grow
organically, has relatively low annual capital expenditure requirements and wants to
minimize financial risk to the firm over the long-term, especially recessions. The trouble
with BKIs dividend payout policies is that it does reflect the policies of larger, more
mature companies that have limited investment opportunities due to their size.
Examples include GE, IBM and Altria. With its approach to acquisitions and slow
growth, its current policies are unsustainable. It is probably in the long-term interest of
shareholders and the company for it to reduce its dividend payments, even if the stock
would be punished by the market for such a step.
2. Should Dubinski recommend a large share repurchase to Blaines board?
What are the primary advantages and disadvantages of such a move?
Dubinski should recomment a large share repurchase to the board of directors.
Blaine is a prime candidate for recapitalization due to its cash hoard and slow growth. A
repurchasing program of one form or another can help the company lessen the impact
of past stock acquisitions on future financial performance. It could also allow the
company to have a more reasonable and sustainable dividend payout, while allowing
the founding family to increase their relative ownership levels.
Although it runs counter to the companys financially conservative culture, there
are a number of advantages. First, there is the opportunity for the share price to
increase. All else being equal, two ways that a repurchase, including debt, can
contribute to the value of a firm by causing some of its financial ratios to improve, such
as EPS and ROE, and the benefit of the present value of the interest tax shield (PVITS),
as presented below. Blaines projected tax rate (tC) for 2007 is estimated to be 32%.

Second, a large share repurchasing will help the company reduce the annual
cash drain of paying dividends, while being able to maintain them for the shares that
remain. However, the cash savings would more than make up for it. Third, a
repurchasing program would give shareholders the control on whether to retain
ownership in the firm or decide to take capital gains and incur taxes. Last, the addition
of debt to the capital structure will lower the weighted average cost of capital and the
debt to market value of equity ratio will be small enough that it shouldnt have a
significant impact on the cost of equity, based on the equation below.

Other considerations that Blaines board must entertain include the possible
signalling effects of a repurchasing program. It could be perceived positively as a
company perception that the stock is cheap and possibly caust the stock price to
increase. Even if the board doesnt want to do a one-time large repurchase, the
company could certainly afford to annual repurchases of several million dollars worth of
stock without hurting its cash levels and keeping its capacity to make future acquisitions

3. Consider the following share repurchase 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, BKIs earnings per share and ROE, its interest coverage
and debt ratios, the familys ownership interest, and the companys cost of
capital.
Many activist investors often try to persuade the boards of companies that they have
invested in with little or no debt to recapitalize to enhance the value of their stock or to
divest some of their cash to shareholders. Blaine, with no debt, currently has a cost of
capital of approximately 8.38%. The debt option comes with an after-tax cost of 4.59%
(using an effective tax rate of 32%). However, after consideration of a debt issue of $50
million, the cost of equity would increase to 8.53% and the weighted average cost of
capital would only decrease to 8.29%.
In consideration of the share repurchasing program, proposed to the CEO, that
entails buying back 14 million shares of Blaine Kitchenware stock at an average cost of
$18.50 per share, funded with $209 million in cash and short-term investments from the
balance sheet and $50 million in debt, the impact of the 23.7% reduction of shares
outstanding has to be evaluated. First the present value of the interest tax shield would
be $16 million, which increases existing share value by $0.27 per share. Second, it
would markedly improve some of the key financial ratios for profitability and reduce
others. To demonstrate the impact of recapitalization and a share repurchase program
on the company, estimated financial statements were made for 2007 one without the
share repurchase program and one reflecting the impact of the share repurchasing
program. Those financial statements are presented below and on the following page.

Comparison of Estimated 2007 Balance Sheet

Balance Sheet

w/o Program

w/Program

Assets
Cash & Cash Equivalents
Marketable Securities
Accounts Receivable
Inventory
Other Current Assets

89,751
163,087
50,792
55,094
4,288

68,267
19,757
50,792
55,094
4,288

Total Current Assets

Property, Plant & Equipment
Goodwill
Other Assets

363,013
179,551
38,281
39,973

158,684
179,551
38,281
39,973

$620,818

$416,489

Total Assets

Balance Sheet

w/o Program

w/Program

Liabilities & Shareholders' Equity

Accounts Payable
Accrued Liabilities
Taxes Payable

33,059
28,139
18,084

33,059
28,139
18,084

Total Current Liabilities

Long-Term Debt
Other liabilities
Deferred Taxes

79,281
0
3,577
23,695

79,281
50,000
3,577
23,695

106,553
514,265

156,553
259,936

$620,818

$416,489

Total Liabilities
Shareholders' Equity
Total Liabilities & Shareholders' Equity

Comparison of Estimated 2007 Income Statement

Income Statement
Revenue
Less: Cost of Goods Sold

w/o Program
$352,519
257,288

Gross Profit
Less: Selling, General & Admin

95,231
29,367

EBIT
Less: Interest Expense
Plus: Other Income (expense)

65,863
0
13,911
79,775
25,528

Earnings Before Tax

Less: Taxes

w/Program
$352,519
257,288
95,231
29,367
65,863
1,688
13,911
78,087
24,988

Net Income
54,247
53,099
Dividends
28,345
22,526
Net Income to Retained Earnings
25,902
30,573

The bottom line impact of the repurchasing program would be a net reduction in
book value of $254,329,000 with a slight bump in the stock price, reflecting the change
in net income to retained earnings. The table on the following page shows how the
book value and market value of equity would change for 2007 with a share repurchase
plan.

Measure
Long-term debt
Equity (book value)
Share price
Shares outstanding
Equity (market value)
Debt to capital (book)
Debt to capital (market)

Recapitalization
with Share
Repurchase

Prerepurchase

$50,000
$259,936
$16.71
45,052
752,721
0.192
0.062

$0
$514,265
$16.44
59,052
970,630
0.00
0.00

The share repurchase program would give Blaine better financial ratios than if it
maintained the status quo. Price per share, earnings per share, return on equity and
net operating profit after taxes per share would increase. While the book value per
share and total market capitalization would decrease, it would allow the family
shareholders to increase their holdings and control over the company. These projected
changes are shown in the table below based on the 2007 estimated financial
statements from the previous page.

2007 Estimated
Financial Ratios
w/o Program
w/Program
$0.92
$1.18
EPS
ROE
Debt Ratio
NOPAT per Share
Book Value per Share
Market Capitalization
Share Price
D/V
E/V

10.5%

20.4%

0.00
$0.88
$8.71
970,630
16.44

0.12
$1.15
$5.77
752,721
16.71
0.062
0.938

0.000
1.000

4. As a member of Blaines controlling family, would be in favor of this proposal?

Would you be in favor of it as a non-family shareholder?
The promise of a share repurchasing program is that it would increase the
proportion of company ownership by the family and, while reducing the the number of
shares outstanding and the magnitude of dividend payments, would increase the
percentage of dividends that would go to family interests. It also paves the way for a
sustainable dividend payout ratio. The repurchasing program would also increase the
financial risk to the firm, not because of the debt, but the consumption of the cash that

the company has amassed. That cash is not only a source of funds for potential
acquisitions in the future, but a cushion for the hard times, such as recessions.
As a member of Blaines controlling family, I would mostly be in favor in some
form of share repurchasing program. Given how much hard earned cash it would
consume, I would probably prefer an scaled back program that spread the cost over
several years, such as spending $30 million per year for 10 years, keeping enough cash
to make future acquisitions, if the opportunity arises. Moreover, the repurchasing
program, by itself, wont solve the biggest problem of Blaine Kitchenware, which is the
fact that the company is not realizing the value that it expects from its acquisitions and
that it is also not responding effectively to competition. A share repurchasing program
has to be done in coordination with a strategy to improve the companys competitive
position.
As a non-family shareholder, I would probably support the share repurchasing
program, as proposed. It would provide me with the opportunity to choose to divest out
of my current position or hold onto it in anticipation of better future performance and
returns. Shareholders who are primarily interested in the dividend income would
probably prefer if the company would just increase its dividend payments to transfer
some of its excess cash if it cant find appropriate investment opportunities that produce
a return for shareholders. When coupled with operational and financial improvements,
non-family shareholders should support a share repurchasing program to unlock some
of the value of the firm and return excess cash to shareholders.

5. How does the proposal sketched above differ from a special dividend of $4.39
per share
An alternative to a share repurchasing program is a special dividend of $4.39 per
share, where a company with a large cash hoard disburses a portion of those funds
because they do not have enough investment opportunities to use it with. Therefore, it
makes more sense to return excess cash to shareholders to allow them to decide what
to do with the cash. One of the advantages of issuing a special dividend is that the
transaction costs related to buying back shares on the open market, as well as the
expected premium, can be avoided.
A disadvantage of a special dividend is the tax consequences of the action. With
a share repurchasing program, shareholders can decide whether they are ready or not
to incur a tax liability through capital gains. With a special dividend, they have no
choice in incurring a tax liability for income and the problem of double taxation still
persists. The special dividend causes some shareholders to have increased tax
burdens that they cannot pair with investment losses the way they can with a
repurchasing program. The gains from a share are unrealized until the stock is sold.
Last, the size of the special dividend also has to be considered. If it is too large, it could
hurt Blaines ability to invest in new products, make acquisitions and ride recessions.

The difference between a special dividend and a share repurchasing program will
be reflected in some key financial indicators. The book value of equity will be greater,
but with more shares outstanding, the estimated value per share after the special
dividend will be much lower, at $12.75 per share. Additionally, many of the financial
profitability ratios will be lower, including EPS, ROE and cash flow per share. Finally, a
special dividend will not do anything to make Blaines dividend policy sustainable.

Measure
Long-term debt
Equity (book value)
Share price
Shares outstanding
Equity (market value)
Debt to capital (book)
Debt to capital (market)

Prerecapitalization
$0
$514,265
$16.44
59,052
970,630
0.00
0.00

Recapitalization
with Special
Dividend
$50,000
$305,265
$12.75
59,052
752,721
0.192
0.062