Evaluation on Share Repurchase Proposal of Blaine Kitchenware Inc.
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1. Inappropriate current capital structure and payout policies3 2. Advantages and disadvantages of large share repurchase proposal4 a. Effects of share repurchase on assets, liabilities and equity on balance sheet5 b. Effects of share repurchase on debt ratios and interest coverage ratio5 c. Effects of share repurchase on Earnings Per Share and Return On Equity5 d. Bonus question—effects on wacc6
4. Effects of the proposed share repurchase on shareholders6 Appendix7
The main problem faced by BKI is over liquidity and under leverage. The capital structure of Blaine is too conservative. The main source of funding for business comes from equity capital. It would not be rational for a public company to be funded only by equity, which caused the company’s Return on Equity much lower than the industry average. In the meantime, current payout policies make payout ratio go up, lowering efficiency of the firm. The company can solve these problems by issuing debt to repurchase its stock. Debt is a lower cost source of financing and allows a higher return to the. In addition, the company can benefit from tax-deductible interest and thus lower tax burden. However, debt is not always excellent, and we should analyze whether the profitability of raising the debt is greater than the cost of leverage. Overview of problems
Blaine Kitchenware was a mid-sized producer of small appliances primarily used in residential kitchens. By 2006, the company’s products consisted of a wide range of small kitchen appliances including deep fryers, griddles, toasters, ovens etc. Blaine had just fewer than 10% of the $2.3 billion U.S. market for small kitchen appliances. During the year ended December 31, 2006, Blaine earned net income of $53.6 million on revenue of $342 million.
Approximately 85% of Blaine’s revenue and 80% of its operating income came from the sale of mid-tier products. Despite the company’s profitability, returns to shareholders had been somewhat below average. Blaine’s return on equity (ROE) was significantly below that of its publicly traded peers. Moreover, its earnings per share had fallen significantly since 2004, partly due to dilutive acquisitions. Blaine’s financial posture was conservative; only twice in the history had the company borrowed beyond seasonal working capital needs. The first was during World War II and second during oil shock of 1970s. Analysis on Capital Structure & Payout Policies of Blaine
1. Inappropriate current capital structure and payout policies Currently, the main source of funding for its business comes from equity capital. However, this capital structure and payout policies for Blaine’s Kitchenware Inc. is not the most appropriate. Here are some explanations. First, current capital structure makes high cost of financing despite its low risk. Although risk will increase as debt increases, debt financing will lower the cost of capital and increase returns to shareholders. Debt is a lower cost source of funds and allows a higher return to the shareholders by leveraging their money. Additionally, the company can benefit from tax shield by tax-deductible interest payment. Second, current capital structure may lower efficiency of the firm. In 2006, the company Return on Equity (ROE) was 11%, which is below the industry average of 19.5%, which would lead outsiders undervalue the firm. This evidence shows that shareholders are paying for this over-liquid and under-levered capital structure.
As stated in the case, “Despite the company’s profitability, returns to shareholders have been somewhat below average”. In other words, it hurts the value of firm in the long run. They are not maximizing firm value by staying away from debt financing. Under current payout policies, the company’s dividend per share has risen slightly over the past three years; however, the company newly issued great number of shares with acquisitions, which is also inappropriate. First, current payout policies directly increase payout ratio by issuing large amount of new shares. High payout ratio shows that the company has to spare a large amount of cash to pay dividends rather than invest in more profitable projects. In addition, given that dividends per share climbed slightly, earnings per share dropped greatly from 1.29 to 0.91, meaning current payout policies limit the value of shareholders. Although riskier, debt financing helps company have a better financial structure and because Blaine Kitchenware refuses to do so, we agree that their capital structure and pay out policies are not the most appropriate for the firm. 2. Advantages and disadvantages of large share repurchase proposal The large share repurchase should be recommended to Blaine’s board. The followings are advantages of share repurchase.
First, a large share repurchase will significantly increase shareholders’ percentage ownership of BKI. BKI has been under levered for decades. The company acquisitions of several small manufacturers made shareholders’ equity be diluted even more. In other words, shareholders, especially the main shareholders in Blaine’s board, are paying for BKI’s over-liquidity. This share repurchase will not only give the board more flexibility to allot dividends, but will lead to a stable development of BKI’s business in the long run. In addition, practically, conducting a large share repurchase by leveraging the company is not costly. Tax shield coming from debt will benefit the operating cash flow of BKI’s business. Additionally, shareholders’ equity will get a much higher return than that of an under-levered company due to lower cost of debt. Again, the board will be the biggest beneficiary. Last but not least, action of repurchasing shares would decrease payout ratio significantly. BKI’s increasing payout ratio due to growing number of shares outstanding is not a good sign for a healthy company. Share repurchase will be very effective to solve this problem.
Decreasing payout ratio means the company can actually spare more money for future investment and growth. Besides, earnings per share will go up with share repurchase, which is good news for all shareholders. Admittedly, there are two disadvantages of this proposal. The main concern would be liquidity problem. Large share repurchase may require the cost of BKI’s assets, especially cash. This move may cause some short-term liquidity problem for BKI, when it would like to make expansion. Additionally, since market has a significant influence on the main business of BKI (kitchenware appliances), interest expenses may become a burden for this company when economy doesn’t go well. In conclusion, though large share repurchase has some disadvantages, it’s still the right choice at this time for BKI . 3. Effects of Share Repurchase on financial ratios
Before calculation, here are some assumptions:
a. Blaine’s managers expected top line growth of 3% for fiscal year 2007, so we assume revenue in fiscal year 2007 would be 352.52 million dollars (342.251(revenue in 2006)* 1.03=352.52). b. Since BKI executives expected the firm to achieve operating margins at least as high as its historical margins, we assume operating margin in 2007 would be 21.4%, at least as high as that in 2004, which is the highest among past three years. Therefore, we can get estimated operating income that is about 75.44 million dollars in 2007. c. We assume the Blaine borrow debt in the beginning of May, so in fiscal year 2007, accrued interest expense would be 2.25 million dollars ($ 50 Mil. * 6.75%*8/12= $ 2.25 Mil.) d. We assume that other income in 2007 would be average of past three years since it has been stable recently, so other income would be 15.094 million dollars. e.
We assume growth rate of dividends per share in 2007 would be average growth rate of past 3 years since dividends per share had risen only modestly during 2004–2006, so dividends per share in 2007 would be $0.50 per share. f. We view the return on S&P 500 of 10% as the market return because we believe S&P 500 captures most market systematic risks. g. We view the return on 30-day US treasury securities of 4.55% as risk free rate because we believe the shortest-term of US treasury securities would be most likely to be risk free. a. Effects of share repurchase on assets, liabilities and equity on balance sheet Decrease in contributed capital is 259 million dollars (14 mil. * $ 18.5 = $259 mil). Therefore, total assets decrease by 209 million dollars in cash and marketable securities; total liabilities increase by 50 million dollars in debt and total equity decreases by 259 million dollars in common stocks. b. Effects of share repurchase on debt ratios and interest coverage ratio i) Debt ratio
Since the firm is financed fully by equity before, debt ratio before repurchase is zero. After the repurchase, debt ratio will increase to 13.05% (Debt ratio= Debt/ Total Assets = $ 50 Mil./ $ 383.253 Mil. = 13.05%) ii) Interest coverage ratio
From assumptions stated before, we can get interest coverage ratio that would be 33.53 (interest coverage ratio= EBIT/ Interest expense= 75.44 / 2.25= 33.53) c. Effects of share repurchase on Earnings Per Share and Return On Equity i) Effects on earnings per share
If Blaine would not take the repurchase proposal, given everything else equals, EBT would be $90.53 million (75.43+15/094=90.53). Income taxes would be $36.21 million and net income would be $ 54.32 million. Then, earnings per share would be 0.92 (EPS= Net Income/ Number of shares = 54.32/ 59.052= 0.92). Exhibit 1 shows partial income statement. After the repurchase, assuming that everything else equals, EBT would be 88.28(EBT= EBIT – interest expense + other income = 75.44-15.094-2.25=88.28). Tax rate is 40% and income taxes would be $ 35.31 million and net income would be $ 52.97 million. Earnings per share would increase from 0.92 to 1.18(Earnings per share = Net Income/ number of outstanding shares = 52.97/ 35.052= 1.18). The partial income statement is stated in Exhibit 2. ii) Effects on ROE
Without repurchase, dividends in 2007 would be $ 29.27 million ($0.5 * 59.052mil. =$29.27 mil.) and predicted equity in 2007 would be $ 513.42 million (Computation of estimated equity in 2007 is stated in Exhibit 3). ROE would be 10.58 %( ROE= Net Income/ End of Period Book Equity= 54.32/513.42=10.58%). After repurchase, dividend in 2007 would be $ 22.33 million ($0.5 * 35.052 mil. = $22.33 million) and predicted equity in 2007 would be $ 260 million (Computation of estimated after-repurchase equity in 2007 is showed in Exhibit 4). ROE would increase from 10.58% to 20.37% (ROE = Net Income / Equity = 52.97/ 260.00= 20.37%). d. Bonus question—effects on wacc
Before repurchase, WACC should be(WACC=re= rf + beta*(rm – rf)=4.55%+0.56*(10%-4.55%)=7.60% After repurchase, equity value of Blaine would be $ 883.462 million (Equity value= stock price per share * number of shares = (59.052-14)* 18.5= 883.462). Given levered is 0.5936(=u + D/E*(u-d)=0.56+50/883.462=0.5936), we can see cost of equity would be7.79 %( re=rf + beta*(rm – rf) = 4.55%+0.5936*(10%-4.55%) =7.79%). Therefore we can know that WACC would be 7.57 %( WACC= *re + *(1-Tc)* rd=7.79%+*(1-40%)*6.25%=7.57%) 4. Effects of the proposed share repurchase on shareholders
Yes the share repurchase can create value for the shareholders. Because as a fully equity firm Blaine is over-liquid and under-levered. This action would not increase raise the value of shares from shareholders immediately because the increase in the percentage of shareholders’ ownership in the company would be offset by the decrease in total equity value. However, by issuing debt and repurchase shares, the shareholders can benefit from the nature of the debt that is tax deductible. The really value created by the repurchase is the tax shield. By replace part of the dividend payments to interest payments, which are tax-deductible, the firm can increase its cash flows and thus increase its firm value. The action of issuing debt and repurchasing shares can actually increase the risks of the firms.
However, from the past performances and future forecasts in the case study we can see that Blaine is operating very well and the increasing risk would not effect the firm dramatically. For the estimate we can see the increase in value for Blaine’s shareholders are the tax shields gained from the new issued debt. Tax shield= value of debt ✕ tax rate = 50,000,000✕40%= 20,000,000 So the estimated increased value would be 20 million.