Blaine Kitchenware Inc.
The Share Repurchase Proposal
Lecturer: Dr Radoslawa Nikolowa
School of Economics and Finance
Blaine
Kitchenware company.
65% of their activity is US based.
Some seasonality of the sales.
The CEO (Dubinski) is a member of the founding family.
Have been expanding by acquiring small independent manufacturers.
ROE below average for the industry.
$231 millions in cash and marketable securities on their balance sheet in 2006.
The Terms of the Proposal
Use $209 million of cash from its balance sheet and $50 million of new debt
bearing interest at the rate of 6.75% to repurchase 14 million shares at the price
of $18.5 per share.
• (Note that Blaine’s current stock price is $16.25)
First Thoughts on the Proposal
Some of the pros and cons arguments that you may be having in mind:
Pros Cons (Concerns)
Tax shield Repurchase too large?
Control by the family Premium too large?
Less appealing for a Risky?
takeover May jeopardize future
investments?
Blaine Kitchenware Inc.
Blaine’s Balance Sheet Before and After
Lecturer: Dr Radoslawa Nikolowa
School of Economics and Finance
Blaine’s Balance Sheet for 2006 Before and After the Repo
$ in Assets 2006 2006 Pro-forma
thousands ($ in thousands) (pre repo) (post repo)
Cash and marketable securities 230,866 21,866
Other current assets 108,812 108,812
Plant, Property, & Equipment (PPE) 174,321 174,321
Other assets 78,254 78,254
Total assets 592,253 383,253
Liabilities and Shareholders’ Equity
Current liabilities 76,581 76,581
Debt 0 50,000
Nonfinancial liabilities 27,309 27,309
Total liabilities 103,890 153,890
Shareholders’ equity 488,363 229,363
Total liabilities and shareholders’ equity 592,253 383,253
Blaine Kitchenware Inc.
Is Blaine risking distress?
Lecturer: Dr Radoslawa Nikolowa
School of Economics and Finance
Blaine’s Leverage Ratio
Blaine’s leverage ratio (or debt-to-total capital ratio):
𝐷𝐷 50,000
= = 18%
𝐷𝐷 + 𝐸𝐸 50,000 + 229,363
Debt-to-equity ratio:
𝐷𝐷 50,000
= = 22%
𝐸𝐸 229,363
Peer Comparison
Home &
Blaine Hearth AutoTech XQL Corp. Bunkerhill EasyLiving
Total debt 50,000 372,293 4,973,413 972,227 391,736 177,302
Book equity 229,363 475,377 3,283,000 2,109,400 804,400 94,919
Debt to equity 22% 78% 151% 46% 49% 187%
Debt to capital 18% 44% 60% 32% 33% 65%
Net Debt
Net debt: Debt minus excess cash.
Excess cash: cash that is unnecessary for operations (i.e. not part of working
capital).
What is Blaine’s net debt?
Net debt (after repurchase) = $50,000 – $21,866 = $28,134
Net debt to “net total capital” = 11%
Interest Coverage Ratio
Annual interest on new debt is $50 million x 6.75% = $3.375 million.
2006 EBIT is 63.9 million.
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
(EBIT) interest coverage ratio = = 18.9
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
Is Blaine risking financial distress by recapitalising?
Bond Ratings and Financial Ratios
Ratio AAA AA A BBB BB B CCC
EBIT interest
21.4 10.1 6.1 3.7 2.1 0.8 0.1
coverage
Debt/Capital
23% 38% 43% 48% 63% 75% 88%
ratio
Bond ratings and default probabilities
Default rates of corporate bonds by S&P’s rating at time of issue.
Percentage Defaulting Within
Rating at Time 1 Year after 5 Years after 10 Years after
of Issue issue Issue Issue
AAA 0 0.1 0.5
AA 0 0.3 0.9
A 0.1 0.7 2
BBB 0.4 3.4 6.9
BB 1.4 12.4 21
B 6.1 26.8 35.4
CCC 30.9 53 58.4
Blaine Kitchenware Inc.
Blaine’s Profit and Loss Statement
Lecturer: Dr Radoslawa Nikolowa
School of Economics and Finance
Pro-forma Income Statement
$ In thousands
2006
Post-Repo Int. Rate 6.75%
EBIT 63,946 Int. earned 5.85%
Plus: Other Income 1,279 on cash
Less: Interest expense 3,375
Earnings Before Tax 61,850
Less: Taxes (30.8%) 19,023
Net Income 42,827
Post-Repo Pre-Repo
ROE (return on equity) 18.7% 11.0%
Understanding ROE
𝑵𝑵𝑵𝑵 𝑵𝑵𝑵𝑵 𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺 𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨
𝑹𝑹𝑹𝑹𝑹𝑹 = = × ×
𝑺𝑺𝑺𝑺 𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺𝑺 𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨 𝑺𝑺𝑺𝑺
ROE = Profit margin x Asset Turnover x Financial Leverage
• ROE incorporates both operational and financial performance.
• Uses information from both income statement and balance sheet.
In Blaine’s case, why does ROE go up?
𝟒𝟒𝟒𝟒,𝟖𝟖𝟖𝟖𝟖𝟖
𝑹𝑹𝑹𝑹𝑹𝑹 = =18.7%
𝟐𝟐𝟐𝟐𝟐𝟐,𝟑𝟑𝟑𝟑𝟑𝟑
Profit margin: goes down.
Asset Turnover: doesn’t change (if assets are defined as operating assets, i.e.
excluding cash).
Financial leverage: goes up.
Excess Cash in the Presence of Taxes
Lecturer: Dr Radoslawa Nikolowa
School of Economics and Finance
The Tax Cost of Excess Cash
Excess cash comes with a negative tax shield, i.e., can destroy value.
Intuition:
Assume firm XYZ has $100M excess cash in a bank account at 10% interest.
At the end of the year XYZ receives $10M in interest, pays corporate tax
10𝑀𝑀 × 𝑡𝑡𝐶𝐶 and pays a dividend to equity-holders 10𝑀𝑀 × (1 − 𝑡𝑡𝐶𝐶 ).
If XYZ distribute the $100M to its shareholders instead. The shareholders could
deposit it in a bank and received $10M interest payment from the bank (pre-
personal tax).
The Trade-off Theory
(for a firm with cash balance C)
Firm
Value
Vu + TS
PV of Vu
tC
negative
tax shields
0 Negative net C D*
debt region Debt
Vu = Unlevered Enterprise Value + Cash (assuming full distribution)
Blaine Kitchenware Inc.
Blaine’s Tax Shield
Lecturer: Dr Radoslawa Nikolowa
School of Economics and Finance
Does the Restructuring Create Value?
𝑃𝑃𝑃𝑃 𝐷𝐷𝐷𝐷𝐷𝐷 = 𝑇𝑇𝐶𝐶 × 𝐷𝐷
How much debt is raised? Which is correct:
𝑃𝑃𝑃𝑃 𝐷𝐷𝐷𝐷𝐷𝐷 = 0.308 × 50𝑀𝑀 = $15.4𝑀𝑀 ($0.26 per share)
𝑃𝑃𝑃𝑃 𝐷𝐷𝐷𝐷𝐷𝐷 = 0.308 × 259𝑀𝑀 = $79.8𝑀𝑀 ($1.35 per share)
Does the Restructuring Create Value?
𝑃𝑃𝑃𝑃 𝐷𝐷𝐷𝐷𝐷𝐷 = 𝑇𝑇𝐶𝐶 × 𝐷𝐷
How much debt is raised? Which is correct:
𝑃𝑃𝑃𝑃 𝐷𝐷𝐷𝐷𝐷𝐷 = 0.308 × 50𝑀𝑀 = $15.4𝑀𝑀 ($0.26 per share)
𝑃𝑃𝑃𝑃 𝐷𝐷𝐷𝐷𝐷𝐷 = 0.308 × 259𝑀𝑀 = $79.8𝑀𝑀 ($1.35 per share)
Tax shield vs Buy Back Premium
Tax shield is at best $1.35 per share, but the firm is paying a premium of $2.25
per share. Is this a problem?
Suppose Blaine offers to buy shares at $18.5, and the stock is trading at $16.25.
If you had shares would you sell them?
In tender offers, in cases of oversubscription, shares are allocated on a pro-rata
basis: all shareholders are treated equally.
Repurchases are akin to a special dividend; they both are a simple change in
capital structure: less equity, more debt!
Blaine Kitchenware Inc.
Summary and Conclusion
Lecturer: Dr Radoslawa Nikolowa
School of Economics and Finance
Restructuring Effect on Control
Family control has fallen through acquisitions...but still 62%
Three cases:
• Only Family tender: control falls to 50%
• Family tender like everyone else: control remains at 62%
• Family doesn’t tender: control increases to 81%
What is most likely?
Summary of Our Findings So Far
The repurchase proposal will
• Increase ROE and EPS
• Create valuable tax shields
• Increase family control?
Only benefits... Any cost?
The Costs
Jeopardize the acquisition strategy
Expose the firm to market fluctuations in demand, aggressive behaviour by
competitors, etc.
Risk of financial distress.
𝑃𝑃𝑃𝑃 𝐶𝐶𝐶𝐶𝐶𝐶 =
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 × 𝐶𝐶𝐶𝐶𝐶𝐶(𝑤𝑤𝑤𝑤𝑤𝑤𝑤 𝑖𝑖𝑖𝑖 ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎)
Blaine’s Capital Structure Pre-repurchase
Firm
Value
Vu + TS
PV of Vu
t*231
negative
tax shields
0 Negative $231M
net debt Debt
region
Vu = Unlevered Enterprise Value + Cash (assuming full distribution)
Conclusions
• Restructuring creates value: Debt interest creates tax shield: less paid out in
terms of tax
• Payout excess cash
• Be careful: ROE and EPS increase even without value creation
• Are taxes and costs of financial distress the only frictions we need to worry
about?
