BLAINE KITCHENWARE INC: CAPITAL STRUCTURE CASE STUDY

By:

Abhinav Goel – A023

Shreya Gupta – A025

Nooruddin H – A026

Anuj Kant – A029

Apaar Miglani – A036

Udit Narindra – A040

Introduction

• Recent development is consolidation in a fragmented industry

• Acquisitions of BKI were done through cash and company stock

• Margins dropped in the last three years despite launch of high-end products• Integration costs and inventory write downs for their recent

acquisitions

• Imports and private labels caused the industry to lower prices to maintain sales growth, but Blaine did not follow

• Growth in top line thus was attributable to recent acquisitions

Introduction (Contd.)• ROE levels were disturbingly low at 11%

• partly due to dilutive acquisitions

• Very conservative w.r.t to outside borrowings• Dividend payout and Capex were small enough to be funded by the

operating cash flows

• Current levels of dividend payout are unsustainable• leading to lower cash for reinvestment• Shareholders not satisfied with marginal increase in dividend

• Stock price at all-time high; share repurchase plan is a tough decision• Killing of war chest for acquisition• Future need for debt becomes more real• Growth without acquisition seemed difficult; organic growth

expectation of only 3%

Q1

Are Blaine’s current capital structure and layout policies appropriate?

• Appropriate is a very subjective term; however, the company is over-liquid and under-leveraged

• Changing times, where topline growth, ROE and size matters more

• Leverage is an important tool to increase ROI and ROE, which needs to be used by Blaine

• Funding everything by high-cost low-risk equity• makes the investments less attractive • but more secure

• A portion of Capex and acquisitions should be funded with debt• maximise return on equity

Q1

• Debt has a lower cost of capital • further enhanced by the tax shield it receives on the interest payment• has higher risk, as interest receives highest priority in Cash flows

• Industry average net-debt-to-equity ratio is about 17% while Blaine is at about (24%)

• Only equity funding it is further destroying ROE for its shareholders• little incentive to stay with a company that has lowest ROE • further risk of diluting it

• Cash management is also an important issue when having huge cash and marketable securities• End up investing in less-profitable projects• Cost efficiency receives lower priority• Idle Cash reduces value of the company

Q1

Should Dubinski recommend a large share repurchase to Blaine’s board? What are primary advantages and disadvantages of such a move?

Q2

Dubinski can recommend a large share repurchase to the board using cash and cash equivalents and raising some debt.

Advantages

1. Debt has a lower cost of capital

2. Increase leverage - invest in its business without increasing shareholders' equity

3. Deliver better return on equity 4. Increased control for family

members - reversing downward trend from IPO.

5. More flexibility in setting future dividends per share

Disadvantages

1. The company's asset base will decrease – it would have to borrow money if it wants to acquire another company or expand its production

2. Increasing long-term debt may cause financial distress - larger portion of its EBIT is used to pay for interest expenses.

3. Loss of control for smaller shareholders as family ownership rises to 81%

4. Volume is reduced- reducing liquidity of the stock is reduced in the secondary markets

Q3

Blaine will use $209 million in cash from its Balance Sheet and $50 million in new debt bearing interest at the rate of 6.75% to repurchase 14 million shares at a price of $18.50 per share.

How would such a buyback affect Blaine?

Balance-Sheet (Post-Leverage)Share-Repurchase (With Leverage)Liablilities Amount Assets Amount2

Accounts Payable 31936Cash & Equivalents 21866Accrued Liabilities 27761Marketable Securities 0Taxes Payable 16884Liquid Assets 21866

Accounts Receivable 48780Total Current Liabilities 76581Inventory 54874Other Liabilities 4814Other Current Assets 5158Deferred Taxes 22495Total Current Assets 130678Debt 50000Total Liabilities 153890Property, Plant & Equipment 174321Shareholders'Equity 229363Goodwill 38281

Other Assets 39973

TOTAL 383253TOTAL 383253

• Asset base has decreased substantially due to the cash being used for share repurchase

• Shareholder’s Equity has also declined due to the outstanding shares being repurchased

• The company has added debt to fund the share-repurchase

Projections, 2007

Particulars 2004 2005 2006 2007EBITDA 69370 68895 73860 83765Depreciation 6987 8213 9914 10211Other Income 15719 16057 13506 0EBIT 78102 76739 77452 73553Interest Expense 0 0 0 3375EBT 78102 76739 77452 70178Tax 24989 24303 23821 28071Net Income 53113 52436 53631 42107Shares Outstanding 41309 48970 59052 45052EPS 1.29 1.07 0.91 0.93Equity 417377 458538 488363 253018ROE 0.13 0.11 0.11 0.17Dividend 18589 22871 28345 18452.32

Div/NI 0.35 0.44 0.53 0.44

Financial Ratios

Ratios 2004 2005 2006 2007

Interest Coverage N.A N.A N.A 22Debt/Equity N.A N.A N.A 0.20EPS 1.29 1.07 0.91 0.93RoE 0.13 0.11 0.11 0.18Family Ownership (%) 0.62 0.62 0.62 0.81

Shareholding Structure:

Family – 36612 (81%)

Public - 8440 (19%)

Q4

As a member of Blaine’s controlling family, would you be in favour of this proposal? Would you be in favour as a non family shareholder?

How does the proposal above differ for a special dividend of $4.39 a share?

Q5

Proposal Vs Special Dividend• Buyback saves on Dividend distribution tax.• Through buyback , company can save on dividends that

need to be paid in future.• Raising money in future will be difficult for the company • Higher D/E ratio.• Current share price is $16.25, whereas proposal is to buy

shares at a $18.50,offering a premium of $2.5.• In comparison, the special dividend is proposed at $4.39,

which far exceeds the premium offered in buyback.• For Promoters: BUYBACK• For Shareholder: DIVIDEND

Q6

• What do the quotes for default spreads over 10 year Treasury bonds imply about BKI’s cost of debt at the various levels of debt?

• What do your calculations imply about Blaine’s optimal capital structure?

• Based on these calculations, how many shares should Blaine purchase and at what price?

Treasury Stock Default Spreads

Interest Coverage Ratio Rating Spread13.00 AAA 0.65%9.50 AA- 0.80%7.00 A 0.85%5.00 BBB+ 1.83%4.00 BB+ 2.98%2.50 B+ 4.10%

10 Yr Treasury Yield 5.02%

What do these quotes imply about BKI’s cost of debt at the various levels of debt?Deteriorating Interest payment capacity increases the risk of default and thus the default spread

Buyback

CalculationsTotal Amount available for repurchase

New Shareholder Equity

No. of Shares Bought Back

PAT and other Ratios

EPS at different Price Levels

 Share Price

16.25 17 18 19 20 21 22 25

Rating                

AAA 0.774 0.761 0.747 0.735 0.724 0.714 0.706 0.685

AA- 0.780 0.766 0.749 0.735 0.7228 0.712 0.702 0.679

A 0.788 0.771 0.753 0.736 0.7225 0.710 0.700 0.674

BBB+ 0.770 0.753 0.733 0.716 0.702 0.689 0.678 0.651

BB+ 0.742 0.723 0.702 0.684 0.669 0.656 0.644 0.617

B+ 0.706 0.687 0.666 0.648 0.632 0.619 0.608 0.580

Promoters’ Holdings After Buyback

16.25 17 18 19 20 21 22 25

AAA 84.96% 83.59% 82.00% 80.63% 79.44% 78.39% 77.46% 75.21%

AA- 88.27% 86.65% 84.78% 83.17% 81.78% 80.55% 79.47% 76.87%

A 91.87% 89.96% 87.76% 85.88% 84.26% 82.84% 81.60% 78.62%

BBB+ 94.39% 92.26% 89.83% 87.75% 85.97% 84.41% 83.05% 79.80%

BB+ 97.78% 95.35% 92.58% 90.24% 88.23% 86.49% 84.96% 81.35%

B+ 100.27% 97.61% 94.59% 92.05% 89.87% 87.99% 86.34% 82.46%

Share Premium

 Outstanding

Shares Share Premium Share Price

16.25 39.85 0.48 16.73

17 40.70 0.47 16.7218 41.72 0.46 16.71

19 42.63 0.45 16.70

20 43.45 0.44 16.69

21 44.19 0.43 16.68

22 44.87 0.43 16.68

25 46.57 0.41 16.66