Talgat Bissembayev

D:0556670
ADMN 4300H
Financial Management II
Professor: Dinesh Gajurel
Blaine Kitchenware, Inc. Capital Structure
1. Do you believe Blaine’s 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. Although 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 (βU) and equity beta (βL).

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 wouldn’t 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 doesn’t 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.

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
company’s 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 Kitchenware’s 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
BKI’s 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 Blaine’s 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 company’s 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, as presented below. Blaine’s 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
shouldn’t have a significant impact on the cost of equity, based on the equation below.

1  

Other considerations that Blaine’s 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 doesn’t
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, 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.

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 89,751 68,267
Marketable Securities 163,087 19,757
Accounts Receivable 50,792 50,792
Inventory 55,094 55,094
Other Current Assets 4,288 4,288
Total Current Assets 363,013 158,684
Property, Plant & Equipment 179,551 179,551
Goodwill 38,281 38,281
Other Assets 39,973 39,973
Total Assets $620,818 $416,489
 Balance Sheet w/o Program w/Program

Liabilities & Shareholders' Equity

Accounts Payable 33,059 33,059
Accrued Liabilities 28,139 28,139
Taxes Payable 18,084 18,084
Total Current Liabilities 79,281 79,281
Long-Term Debt 0 50,000
Other liabilities 3,577 3,577
Deferred Taxes 23,695 23,695
Total Liabilities 106,553 156,553
Shareholders' Equity 514,265 259,936
Total Liabilities & Shareholders' Equity $620,818 $416,489

Comparison of Estimated 2007 Income Statement

Income Statement w/o Program w/Program

Revenue $352,519 $352,519
Less: Cost of Goods Sold 257,288 257,288
Gross Profit 95,231 95,231
Less: Selling, General & Admin 29,367 29,367
EBIT 65,863 65,863
Less: Interest Expense 0 1,688
Plus: Other Income (expense) 13,911 13,911
Earnings Before Tax 79,775 78,087
Less: Taxes 25,528 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.
 Recapitalization
with Share
Measure Prerepurchase Repurchase
Long-term debt $0 $50,000
Equity (book value) $514,265 $259,936
Share price $16.44 $16.71
Shares outstanding 59,052 45,052
Equity (market value) 970,630 752,721
Debt to capital (book) 0.00 0.192
Debt to capital (market) 0.00 0.062

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
EPS $0.92 $1.18
ROE 10.5% 20.4%
Debt Ratio 0.00 0.12
NOPAT per Share $0.88 $1.15
Book Value per Share $8.71 $5.77
Market Capitalization 970,630 752,721
Share Price 16.44 16.71
D/V 0.000 0.062
E/V 1.000 0.938

4. As a member of Blaine’s 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 Blaine’s 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, won’t 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 company’s 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 can’t 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 Blaine’s 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 Blaine’s dividend policy sustainable.

Recapitalization
with Special
Measure Prerecapitalization Dividend
Long-term debt $0 $50,000
Equity (book value) $514,265 $305,265
Share price $16.44 $12.75
Shares outstanding 59,052 59,052
Equity (market value) 970,630 752,721
Debt to capital (book) 0.00 0.192
Debt to capital (market) 0.00 0.062

Alternatively, as a family member it would also be in my interest to sell 22.4% of shares

to the company repurchase leaving on hands 65% share. This will be beneficial for
family members because they will be able to diversify their capital by investing into
other companies in other industries. Stock Repurchase will have the same effect on EPS
and ROE and other indicators. If the company were still repurchasing 14 million shares
they should buy 6,612,000 shares at $18.50 per share which is worth$112,322,000 . This
amount stands for 47.22 % of total $259,000,000 spend on repurchase. This action will
allow family members to diversify their portfolios and remain as a major shareholder of
the company with holdings of approximately 66%. Moreover, as company is changing
it's capital structure by leveraging it it implies some risks associated by risk of default.
So, as a major shareholder it would be much more riskier to have 65%+ of the shares if
levered company.
Other alternative as a family member would be selling it's shares for market price
while outsiders would receive 2.25$ premium on each share repurchased. This will
allow to repurchase additional 804,162 shares worth $14,877,000 which will also
increase family's holdings to approximately 68% of 44,247,838 total outstanding shares
which will have additional positive changes to corporations balance sheets and ratios.