Group 7: Blaine Kitchenware Inc.

Maitreyee Shukla 122Nikesh Solanki 123Vasvi Gakkhar 124Sakshi Madan 125Chintan Shah 126Sourabh Arora 387Kumudini Mahajan 388

Vasvi Gakkhar

INTRODUCTION TO THE CASE

Blain Kitchenware• Mid-sized producer of small Kitchen appliances.• Well Known Brand • Family promoted, Victor Dubinski CEO.• Captures 10% of $2.3bn US market.• Competitive advantage such as “smart” technology

Financial Policy• Conservative financial posture• 2 times in 85years company had debt• On both occasions debt was repaid as quickly as possible• Blaine’s balance sheet was the strongest in the industry

Main Problem• Lacked 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???

Problem• Consider the following share repurchase proposal: Blain 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 million shares at a price of $18.50 per share. How would such 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.

Concept of Buyback• A company reacquiring/repurchasing its own shares• A means for the company to invest in itself• Leads to decrease in the number of shares outstanding in the

market• Improvement in liquidity of shares & enhancement of the

shareholder’s wealth are the main motives

Concept of Buyback• Profit earned by companies can be used in two ways:

1)Rewards to shareholders in form of dividends

2)“Stockholder’s equity”

Concept of Buyback

• “Leftover retained earnings”: when a part or whole of the retained earnings cannot be invested to produce acceptable returns.

• These are used in share repurchases.

Why companies opt for buyback?

• Unused cash• Tax gains• To increase stake of promoters• Exit option

Unused cash

• Huge cash reserves

• Not enough profitable projects

• Market price of share is undervalued

Tax gains

• Taxes on dividends are high

• Capital gains taxes are generally lower

To increase stake of promoters

• As a result of buyback, the number of shares available in the market decreases.

• Thus, promoter’s stake increases.

Exit option

• If a company wants to move out of the country

OR

• If the company wants to shut down business

Methods of Buyback• Tender Offer: • Shareholders are presented with a tender offer where they have the

option to submit a portion of or all of their shares within a certain time period and at usually a price higher than the current market value.

• Open Market: • Companies can to buy shares on the open market, just like an

individual investor would, at the market price.

• Book-Building Process: • The book building process is a mechanism of price discovery which

helps determine market price of securities.

Advantages of Buyback of Shares• Increase confidence in management• Enhances shareholders value• Higher Share Price• Reduce takeover chances• Increase ROE• Psychological Effect• Excellent Tool For Financial Reengineering

Disadvantages of Buyback of Shares• Sending Negative Signals• Backfire for a company competing in a high-growth industry • When company pays too much for its own shares

No Buyback

Partial Buyback of 14 million share by raising $ 50 million debt at 6.75%

Complete Buyback

Approach 1 : No Buyback• Total Shareholder’s Equity : 59.052 million• Net Income : $ 53.63 million

• Earnings Per Share : $ 0.908• Market Price of Share : $16.25

• Price-Earning Ratio: 17.89 (Assumption)• Earning Yield : 5.6 %• ROE : 10.9 % (Against Industry Means)

Implications• No debts• Prone to acquisitions• This approach will maintain the company’s status as under

leveraged and highly liquid.• This approach fails to create value for the shareholders.• Need for Capital Restructure immense.

Approach 2 : Partial Buyback • Marketable Securities = 164.309 Million• Total Cash and Cash Equivalents + Marketable Securities =

$230.866 Million

• Proposal to buy 14 million shares using Cash & Equivalents and raising $ 50 million debt

Forecasted Earning Statement

Operating Results: 2004 2005 2006 2007

Revenue 2,91,940 3,07,964 3,42,251 3,52,518

Less: Cost of Goods Sold 2,04,265 2,20,234 2,49,794 2,55,575

Gross Profit 87,676 87,731 92,458 96,943

Less: Selling, General & Administrative 25,293 27,049 28,512 29,964

Operating Income 62,383 60,682 63,946 66,979

EBIT 62,383 60,682 63,946 66,979

Plus: Other Income (expense) 15,719 16,057 13,506

Earnings Before Tax 78,101 76,738 77,451

Less: Taxes 24,989 24,303 23,821

Net Income 53,112 52,435 53,630

Forecasted Net Income• Forecasted EBIT : $ 66.979 Million• Loss due to use up of cash & cash equivalents and market

securities = $209 Million @ 4.92% = $ 10.282 Million• Revised EBIT : $ 56.697 Million• Debt Interest : $ 3.375 Million• Tax @ Rate 40% : $ 21.328 Million• Net Income : $ 31.992 Million

EPS & Ratios• EPS : $ 0.710

• ROE : 11.46 %

• Interest Coverage Ratio : 16.79

• D/E Ratio : 0.178

Approach 3: Blaine repurchases its entire market float.• As we know;

62% : Owned by Family38% : Market floatFor Partial Payback: Company will use Cash and Cash

Equivalents (10% will be used for daily operations)and Market Securities

For total buyback: Debt to be takenShares has to be taken back at a premium rate of

13.8% on market price ($16.25 to $18.5)

• Market: 38% of 59.052 million shares is 22.439 million shares• Shares left after complete buyback: 62% of 59.052 million

shares is 36.612 million shares owned by family.

Calculation for the amount of debt to be raised:

1. No. of shares to be bought back = 22.439 million shares.2. Total Price = 22.439*$18.5 = $415.121 million3. (Less) Cash and Cash Equivalents and market securities =

$224.309 million4. Total debt reqd for total buyback = $190.812 million @ a

rate of 6.35% [Exhibit 4]

Interest to be paid• 6.35 % of 190.812 million dollars= $ 12.116 million

Contd…• EBIT = $ 66.979 million • (Less) Loss due to use up of cash & cash equivalents and

market securities = 60.557 + 164.309= $224.866 Million• Interest @ 4.92% = $11.06 Million [Exhibit 4 – Avg of yields on

US Treasury Securities]

So, Revised Data• Revised EBIT = $ 55.919 million• Less interest (@ 6.35%)= $ 12.116 million [calculated earlier]• Earnings before tax= $ 43.803 million• Tax (@ 40%)= $ 17.52 million [Note]• Net income= $ 26.283 million

EPS for Scenario 3• EPS = Net income/total no. of shares remaining

= 26.283 / 36.612= $ 0.717

Expected Market Price• Expected Market price = EPS* P/E ratio

= 0.717 * 17.89 = $ 12.84

• Decrease in value per share for the shareholders = 16.25-12.84

= $ 3.4• Does not lead to creation of more shareholder value (shareholders

who retain shares)

ROE• Net income = $ 26.283 million• Shareholders' equity = $ 263.477 million• ROE = ($ 26.283 million / $ 263.477 million) * 100

= 9.97 %

Debt Ratio• Debt to equity: Debt/Equity= 0.724

Interest Coverage

= EBIT/Interest Expense= 4.589

WACC

• WACC – Weighted Average cost of Capital

raised (i.e. Relative cost of debt and equity

raised)

• The Higher the WACC the less likely it is , that the company is creating value.

WACC : An Investment Tool• Investors use WACC as a tool to decide whether to invest.

• WACC represents the minimum rate of return at which a company produces value for its investors

Cost Of CapitalWACC = [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 = (6.72- 5.02) = 1.7%

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

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

Therefore WACC = Re*(E/V)] = 5.972 * (1.31) = 7.82

Interest Shield• A reduction in tax liability coming from the ability to deduct

interest payments from one taxable income.

• For example, a mortgage provides an interest tax shield for a property buyer because interest on mortgages is generally deductible• An interest tax shield may encourage a company

to finance a project through debt because dividends paid back on stocks issues are never deductible.

Example of a Interest Tax Shield

• Suppose two firms L and U are identical in all respect except that firm L is levered and firm U is unlevered.

• U is an all equity financed firm while firm L employ equity and 5000 debt at 10% rate of interest

• Both firms have an EBIT of Rs2500, pay corporate tax at 50% and distributed 100% earnings as dividends to shareholders

• You may notice total income after corporate tax is Rs 1250 for the unlevered firm U and Rs 1500 for the livered firm L

• Thus levered firm L investors are ahead of unlevered firm U by Rs250 • You may also noticed that tax liability of levered firm is less then unlevered

firm by Rs250• For firm L tax savings has occurred on account of payment of interest to

debt holders

CONCLUSION

Scenario 1 – BKI should not go for any buyback.

•Company is over-liquid and under-levered

•Family owned business: conservative debt policy

•Failed to create value for stakeholders

•Both minority shareholders and promoters will suffer

Scenario 2 – A partial buy-back using only cash and cash equivalents/ Market securities

•Uses $209 million of cash from its balance sheet and $50 million in new debt

•Management will have an increased stake

•Low market as compared to the peers, stockholders to sell the stock and invest in alternates

Scenario 3 – When Blaine repurchases its entire market float

•Company raising a significant debt

•Complete control to the promoters

•Return on Equity will improve

•Shareholders will get a premium on current market price

•Dividend policy can be made

Thank you.