APPLIED CORPORATE FINANCE

TAKE-HOME EXAM
Blaine Kitchenware Case
1. Looking at simple performance metrics such as ROE it seems that the company is performing
below its peers. Do you agree? Is the firm's operating performance really that bad? What are the
causes for ROE underperformance?

If we analize the company through the ROE metric, we are going to take into consideration the return based on equity, confirming
that Blaine is the worst performer:

Home & Hearth Design AutoTech Appliances XQL Corp. Bunkerhill, Inc. EasyLiving Systems Blaine Kitchenware Average
ROE 11,30% 43,13% 19,55% 41,66% 13,88% 10,98% 23,41%

In my opinion the metric doesn’t reflect the company performance because the ROE analyzes the profits only dependent on
equity but debt is also an instrument to create value and if we look at the relation between equity and debt we see that this
company is the only one without debt:

Home & Hearth Design AutoTech Appliances XQL Corp. Bunkerhill, Inc. EasyLiving Systems Blaine Kitchenware Average
D/E 78,32% 151,49% 46,09% 48,70% 186,79% 0,00% 85,23%

Looking into other metrics like the relation between EBIT and Sales the results show another scenario for Blaine putting the
company in the best postion when comparing with the peers:
Home & Hearth Design AutoTech Appliances XQL Corp. Bunkerhill, Inc. EasyLiving Systems Blaine Kitchenware Average
EBIT Margin 18,10% 13,86% 16,72% 15,42% 10,38% 18,68% 15,53%

Return is compared with equity in ROE but it’s provided by Equity and Debt which in the case of Blain that only has Equity reduces
the risk but also the speed of return. If we look at the return in comparison with the actual Sales the result are very promising for
the company.
This implies that we might be facing a lack of opportunities to grow the business or that the family structured company is creating
limitations in strategy and long term goals when compared with other companies from the industry.

Detailed calculations in the excel sheet

2. Is the company’s return on capital sufficient to guarantee continuous value creation? What would
you consider to be the minimum acceptable return, taking in consideration the capital markets data
on the case (you may assume a market risk premium of 6% above the return on a long term
Government bond).

To answer this question first is necessary that we know the 2004 2005 2006
ROIC which is shown on the right. To guarantee continuous $ 62 382,50 $ 60 681,50 $ 63 945,75
value creation the ROIC has to be higher than WACC which in EBIT
this case will require a calculation of the WACC. Effective Tax Rate 32,00% 31,67% 30,76%

NOPLAT $ 42 422,63 $ 41 463,76 $ 44 278,54

The first approach to the problem is to calculate the WACC of
the company using the equity beta of the company. This will Current Assets
$ 90 557,25 $ 96 833,43 $ 108 811,59
generate a WACC of 8,4% according with the calculations that (-Cash - Sec)
follow. Payable + Accrued $ 48 710,83 $ 53 509,24 $ 59 696,53

NWCR $ 41 846,43 $ 43 324,19 $ 49 115,06

FA $ 99 401,61 $ 138 546,38 $ 174 321,43

Blaine Kitchenware
ROIC 30,03% 22,80% 19,82%
Equity $ 488 363,00
Debt $ -
Rf 5,0% According with this calculation ROIC > WACC so we can say that
Be 0,56 the company is guaranting a continuous value creation at the
MRP 6% current capital structure and conditions. But the minimum
Re 8,4% acceptable return should be based on the average of the industry
WACC 8,4% beta to be fair to shareholders investing in this industry through
this company.

Detailed calculations in the excel sheet

2. Is the company’s return on capital sufficient to guarantee continuous value creation? What would
you consider to be the minimum acceptable return, taking in consideration the capital markets data
on the case (you may assume a market risk premium of 6% above the return on a long term
Government bond).

Home & Hearth Design AutoTech Appliances XQL Corp. Bunkerhill, Inc. EasyLiving Systems Blaine Kitchenware Average
Beta Equity 1,03 1,24 0,96 0,92 0,67 0,96 0,96
Debt $ 372 293,00 $ 4 973 413,00 $ 972 227,00 $ 391 736,00 $ 177 302,00 $ 1 377 394,20 $ 391 736,00
Equity $ 475 377,00 $ 3 283 000,00 $ 2 109 400,00 $ 804 400,00 $ 94 919,00 $ 1 353 419,20 $ 804 400,00
Tax 40% 40% 40% 40% 40% 40% 40%
Unlevered Beta 0,70 0,65 0,75 0,71 0,32 0,63 0,70

After the calculation of the average unlevered beta of the industry, decided to calculate the WACC again to confirm the difference in
the cost of capital.

Blaine Kitchenware Comparable Firms

Equity $ 488 363,00 $ 488 363,00 Using the Equity Beta of the comparable firms the WACC is
Debt $ - $ - 9,2%, so in this case I would say that the minimum
Rf 5,0% 5,0%
acceptable return for a company in this sector needs to be
Be 0,56 0,70
above 9,2%, and in this case is true due to a ROIC of
MRP 6% 6%
19,82%.
Re 8,4% 9,2%
WACC 8,4% 9,2%

Detailed calculations in the excel sheet

3. Some analysts seem to infer that the company is undervalued. Based upon the information on Exb 3,
is Blaine really undervalued when compared with its peers? Please present your fair valuation of
Blaine’s equity.
The market to book value multiple indicates that in comparison with the average and the median, Blaine is in a
undervalued situation.
AutoTech Bunkerhill, EasyLiving Blaine
Home & Hearth Design XQL Corp. Average Median
Appliances Inc. Systems Kitchenware
MARKET/BOOK VALUE 1,63 4,26 2,51 4,93 4,41 3,55 4,26 1,96

To confirm if the company is undervalued we need to calculate the fair valuation of the company and compare with the
market captilazation at the time.
Get manage the calculations there was a number of assumptions that had to be made, to create the structure that
would lead us to the company future cash flows.
Besides values that were given in the case like the growth rate of 3% and the tax rate of 40%, metrics were based on
the average percentage of the historical data and in the case of NWC, the stability percentage when compared with
sales was the metric used to project future requeriments.
Assumptions 2004 2005 2006 2007 2008 2009 2010 2011
Revenue Growth Rate 5% 11% 3% 3% 3% 3% 3%
Gross Margin 30% 28% 27% 28,5% 28,5% 28,5% 28,5% 28,5%
Operating income 71% 69% 69% 69,8% 69,8% 69,8% 69,8% 69,8%
Depreciation Rate 8,3% 7,2% 7,7% 7,7% 7,7% 7,7% 7,7%
EB Tax rate 1,25 1,26 1,21 1,24 1,24 1,24 1,24 1,24
Tax rate 32% 32% 31% 40% 40% 40% 40% 40%
NWC $ 27 621,84 $ 26 128,11 $ 32 230,70 $ 32 153,10 $ 33 117,69 $ 34 111,22 $ 35 134,56 $ 36 188,59
NWC Sales 9% 8% 9% 9,1% 9,1% 9,1% 9,1% 9,1%

Detailed calculations in the excel sheet

3. Some analysts seem to infer that the company is undervalued. Based upon the information on Exb 3,
is Blaine really undervalued when compared with its peers? Please present your fair valuation of
Blaine’s equity.

2007 2008 2009 2010 2011

Revenue $ 352 518,79 $ 363 094,35 $ 373 987,18 $ 385 206,80 $ 396 763,00
Less: Cost of Goods Sold $ 252 011,16 $ 259 571,50 $ 267 358,64 $ 275 379,40 $ 283 640,78
With the assumptions that we mentioned Gross Profit $ 100 507,63 $ 103 522,85 $ 106 628,54 $ 109 827,40 $ 113 122,22
before, was possible to create an estimated Less: Selling, General & Administrative $ 30 325,90 $ 31 235,68 $ 32 172,75 $ 33 137,93 $ 34 132,07
Operating Income $ 70 181,72 $ 72 287,17 $ 74 455,79 $ 76 689,46 $ 78 990,15
income statement for the next years to get to Plus: Depreciation & Amortization $ 13 438,59 $ 12 402,59 $ 11 446,47 $ 10 564,05 $ 9 749,66
the value of EBIT. EBITDA $ 83 620,31 $ 84 689,77 $ 85 902,26 $ 87 253,51 $ 88 739,80
After this, it was reduced at the tax rate of 40%,
EBIT $ 70 181,72 $ 72 287,17 $ 74 455,79 $ 76 689,46 $ 78 990,15
to get to the NOPLAT. Plus: Other Income (expense) $ 16 696,77 $ 17 197,68 $ 17 713,61 $ 18 245,02 $ 18 792,37
The Free cash flow was caclulated reducing the Earnings Before Tax $ 86 878,50 $ 89 484,85 $ 92 169,40 $ 94 934,48 $ 97 782,51
Less: Taxes $ 34 751,40 $ 35 793,94 $ 36 867,76 $ 37 973,79 $ 39 113,01
CAPEX, that was considered to stay stable at Net Income $ 52 127,10 $ 53 690,91 $ 55 301,64 $ 56 960,69 $ 58 669,51
10M to keep the strategy used in the pass,
Depreciation and the change in NWC. EBIT $ 70 181,72 $ 72 287,17 $ 74 455,79 $ 76 689,46 $ 78 990,15
Less: Taxes $ 28 072,69 $ 28 914,87 $ 29 782,32 $ 30 675,79 $ 31 596,06
The next step was to bring the cash flows to net Earnings before Interest (NOPLAT) $ 42 109,03 $ 43 372,30 $ 44 673,47 $ 46 013,68 $ 47 394,09
present value using the wacc of the company Less: CAPEX $ 10 000,00 $ 10 000,00 $ 10 000,00 $ 10 000,00 $ 10 000,00
Less: Depreciation $ 13 438,59 $ 12 402,59 $ 11 446,47 $ 10 564,05 $ 9 749,66
(8,5%) in the next 5 years and the perpetuity Less: Change Working Capital $ 77,61 $ (964,59) $ (993,53) $ (1 023,34) $ (1 054,04)
after that. Free Cash Flow $ 45 470,01 $ 46 739,49 $ 47 113,47 $ 47 601,06 $ 48 197,78
Present Value FCF $ 41 923,30 $ 39 124,04 $ 36 926,34 $ 34 398,40 $ 32 112,87
Perpetuity $ 525 019,86 $ 787 995,50

Detailed calculations in the excel sheet

3. Some analysts seem to infer that the company is undervalued. Based upon the information on Exb 3,
is Blaine really undervalued when compared with its peers? Please present your fair valuation of
Blaine’s equity.

Enterprise Value: Net Debt: Market Cap:

709.504.810 - 230.866.000 940.370.810

In the end, my calculations got me to a fair valuation of 940.370.810, that comparing with the market capitalization has a
difference of around 2%. Having into consideration the assumptions that were taken that can be slightly changed without
affecting the base of the analysis I would say that my calculation confirm a correct valuation of the company.

With this, we can say that the company is not undervalued when compared with its peers since the market capitalization is in
the same values as the fair value of the company.
4. The company's investment banker hinted that value could be "unlocked" at Blaine Kitchenware by using the
available cash and additional borrowings to buy back a significant portion of the company's equity? Would that be
wise? Do you agree that the company has excessive cash? Does the company have an inefficient capital structure?

Unlocking value

The value creation comes from returning on the invested capital above WACC although, using a percentage of the available cash with
additional borrowed money to do a share buyback would increase some ratios that might increase the perceived actual value.
With the buyback the equity of the company would decrease, the ROE would increase and the EPS would also increase.
But, in my opinion, you can unlock more value if you get more return in proportion of the capital you invest and this need to be over
the wacc, that in this case will decrease due to the introduction of the cost of debt, which is lower than cost of equity.
Even in this scenario ROIC will be in a higher multiple compared with wacc but it would be only a ratio, because the real percentage of
ROIC would remain the same.

Excessive cash
Currently Blaine has a cash balance of 66M, plus 154M in marketable securities, and the average operating cash flow generated per
year is aprox. 45M (page 4 of the case). The CAPEX per year is around 10M and we know that this is a cyclical business that has
flutuations and a NWC of 32M. Combining all this, the company generates enough cash to the NWCR and CAPEX for the year.
Having this said, keeping more than 4 years of generated cash in the company I think is excessive and should be reduced.

Inefficient Capital Structure

The Capital structure is not efficient, mainly due to the zero debt present in the balance sheet showing that the company is not taking
advantage of the tax shields that can be generated with the interest coming from debt, but also the reduction in WACC by adding debt
to the structure.
5. Assuming that family shareholders would welcome a distribution of cash to equity holders analyse,
from the perspective of the controlling shareholders represented in the Board as well as from that of
the small minority shareholders the following alternatives:

This alternatives have different reactions on controlling shareholders and minority shareholders although, in some situations they produce a
good alternative for both sides. My analysis starts from the assumption that the minority shareholder is less worried about the future of the
company but is concerned about the future of the stock in terms of value and dividend distribution to shareholders.

Substanticial increase in the annual regular dividend

The increase in regular dividend is a decision that I would say is bad for both sides nevertheless, much worse in the perspective of the
controlling shareholders.
The minority shareholders see it has a way to increase the return since the dividend is higher, but they will pay taxes on this which means
that part of it will be loss. They also have to face the volatility of the stock price during the announcement and until the payout.
For the controlling shareholders is the same but in addition they must know that this decision will increase the payout rate even more
creating a situation were the value the company can capture is distributed to shareholders. In a long-term strategy this is not the best
decision because you are also committing to this level of dividends in the long term and if you can’t at least match this new level the stock
price will drop.

Special dividend

The special dividend maintains the tax payment obligation by every shareholder in this cash distribution and for the minority shareholders is
the same situation, but they will have “instant” cash in an out of the ordinary situation which is good. When they see this announcement,
the feeling is that the company is not able to apply the cash better than what they would, creating less confidence in the stock price long
term.
For the controlling shareholders, this decision would be just to extract cash from the company, with a tax reduction on the value that they
will get and no strategic thinking in the long term.
5. Assuming that family shareholders would welcome a distribution of cash to equity holders analyse,
from the perspective of the controlling shareholders represented in the Board as well as from that of
the small minority shareholders the following alternatives:

Share buyback

The share buyback option will not result in an instant cash distribution like the dividend ones mentioned before creating a larger difference
in perspective between controlling and minority shareholders.

Small minority shareholders

This group will face a situation where the buy pressor will be high which, in theory, drives the stock up in price increasing the potential gains
buy selling the stock avoiding taxation on this increase in value. This has a first issue for the minority shareholder in which he can only see
the benefit when he sells the stock, and if the price increases which in some situations doesn’t happen after the buyback due to external
factors related with the interpretation investors have about the stock.

Controlling Shareholders

The decision of share buybacks is by far the most interesting one for this group, not only because it increases their control, but also because
avoids immediate expenditures due to capital gains. The essence of the buyback is to reduce the shares outstanding, operation that is
crucial for the controlling shareholders that have been losing their power through share dilution, and with this mechanism they can regain
some of the share percentage in the company.
In terms of the company's financials this will reduce the global dividend spending, if the same is paid to each shareholder, due to the share
reduction. The payout ratio will also decrease if the company has the same results, and the share price is expected to increase. For the
controlling shareholders, this solution increase their controlling power, by increasing their percentage, avoids taxation on capital gains
preserving them in the share price and finally increases some of the performance metrics like ROE through the reduction of Equity.
6. A more radical solution would be the one proposed by the bank: to borrow money to conduct a "leveraged
recapitalization". Assume that a bank is willing to lend up to $150 million for such transaction, using the company's
property, plant and equipment as collateral. A loan of $50m would result on a A rating, $100m a rating of Baa and $150
a rating of Ba. Make a proposal on how much to borrow and how much and which alternative(s) you would use to
distribute that money to shareholders. Present a summary of the final balance sheet (just major items: Assets,
Liabilities and Equity).
The option of borrowing money, would be accepted with the intention of executing share buybacks in Book Equity $ 488 363,00
the available amount of shares at market price. The decision of the best option will be justified by Market Cap $ 959 596,00
indicators that need to be calculated, like the percentage of equity reduction, the dividends that Shares Outstanding 59052
wouldn’t be distributed the year after if the nominal value stays the same and the Interest/Tax shield Share par value $ 8,27
Share Mrket Value $ 16,25
created with the transaction.
Before Option1 Option 2 Option 3
EV $ 1 063 486,00 $ 1 063 486,00 $ 1 063 486,00 $ 1 063 486,00
With the increase in debt taken in each option
Total Debt $ - $ 50 000,00 $ 100 000,00 $ 150 000,00
is possible to see the changes in the balance
Total Liabilities $ 103 890,00 $ 103 890,00 $ 103 890,00 $ 103 890,00

ANSWER CONTINUES IN THE NEXT SLIDE

sheet major items.
Total Equity $ 959 596,00 $ 909 596,00 $ 859 596,00 $ 809 596,00
Number of Outstanding Shares 59052 55975 52898 49821 The change in shares outstanding based on
Reduction of shares 0% -5% -10% -16% the amount of shares bought at market price.

Controlling Shareholders 36612 36612 36612 36612 The reduction of shares outstanding from
Small Minority Shareholders 22440 19363 16286 13209 minority shareholders and the potential
Controlling Shareholders % 62% 65% 69% 73% increase in percentage of the controlling
Small Minority Shareholders % 38% 35% 31% 27% shareholders.

Global Dividend $ 28 344,96 $ 26 868,00 $ 25 391,04 $ 23 914,08 Future dividend reduction with the amount of
Dividend reduction $ - $ (1 476,96) $ (2 953,92) $ (4 430,88) share buybacks.

Rating A Baa Ba
Interest Rate 6,35% 6,72% 7,88% Interest to be paid for the transaction in each
Interest Expenses/Year $ 3 175,00 $ 6 720,00 $ 11 820,00 option and the tax shield generated with this,
Tax Shield $ 1 270,00 $ 2 688,00 $ 4 728,00
Final (Interest- Tax Shield - Dividend reduction) $ 428,04 $ 1 078,08 $ 2 661,12
Indicator of the effective cost after cutting
potential benefits.
6. A more radical solution would be the one proposed by the bank: to borrow money to conduct a "leveraged
recapitalization". Assume that a bank is willing to lend up to $150 million for such transaction, using the company's
property, plant and equipment as collateral. A loan of $50m would result on a A rating, $100m a rating of Baa and $150
a rating of Ba. Make a proposal on how much to borrow and how much and which alternative(s) you would use to
distribute that money to shareholders. Present a summary of the final balance sheet (just major items: Assets,
Liabilities and Equity).
Before Option 2
With decision to borrow 100M it is possible to highlight the following factors: EV $ 1 063 486,00 $ 1 063 486,00
Total Debt $ - $ 100 000,00
• Doing the buyback implies buying shares at market price which results in a reduction in Total Liabilities $ 103 890,00 $ 103 890,00
shares outstanding in 10%. A higher percentage have unexpected reactions by the Total Equity $ 959 596,00 $ 859 596,00
market and the share price would have a higher buy pressor causing a lot of instability; Number of Outstanding Shares 59052 52898
Reduction of shares 0% -10%
• This operation will increase the controlling shareholder percentage from 62% to 69%, Controlling Shareholders % 62% 69%
which is a good indicator for reduction of dilution; Dividend reduction $ - $ (2 953,92)
Interest Expenses/Year $ 6 720,00

• The reduction in number of shares will influence the global cost of a dividend Tax Shield $ 2 688,00

distribution, and since the dividend policy indicates that you should at least keep the Final (Interest- Tax Shield - Dividend reduction) $ 1 078,08

dividend from last year to confirm expectation in the company, at the same price the
next dividend will have a reduction of almost 3M; DECISION: Borrow $100M
• The tax shield generated by the interest paid in this operation is also considerable Final Balance Sheet
(considering a tax rate of 40%) and the benefits taken from the borrowing compared
with the cost of interest result in a 1M difference. Liabilities
203.890.000
• In the end the decision is based on the strategy of reducing the shares outstanding in a
considerable percentage (10% in this case), without changing dramatically the capital Assets
592.253.000
structure of the company. Equity
388.363.000
7. Compute the firm's weighted average cost of capital before and after your proposed transaction.
What explains the difference?

In the WACC calculation before the transaction, the weightage of equity will be 1 and the weightage of debt
will be 0, eliminating the second part of the equation, resulting in an 8,4% weighted average cost of capital.
This calculations, but also the ones that follow regarding the after transaction wacc, consider the equity as
the market cap, tax rate as 40%, risk free rate as 10y Treasury Securities and market risk premium as 6%.
Before Option 2
EV $ 1 063 486,00 $ 1 063 486,00 Difference between WACCs
Total Debt $ - $ 100 000,00
Total Liabilities $ 103 890,00 $ 103 890,00 This difference occurs due to
Total Equity $ 959 596,00 $ 859 596,00 the introduction of debt,
E/D+E 1,00 0,90 component of the capital
D/D+E 0,00 0,10 structure that has a lower cost
Tax 40,0% 40,0% compared with equity,
Rf 5,02% 5,02% confirmed by Re > Rd.
Be 0,56 0,56 In addition to this the cost of
MRP 6,0% 6,0% debt is reduced due to tax
Re = Rf + Be x MRP 8,4% 8,4% shield represented in the
Rd - 6,72% equation by (1 - T) creating a
WACC 8,4% 7,9% situation where has debt
increases, the cost of capital
The after transaction WACC, shown in the Option 2 calculations, uses the same principles said before and a
cost of debt related to a seasoned corporate bond with a Baa rate. This result in a wacc of 7,9%, substantially
decreases.
lower than the wacc before transaction.
8. If the company goes ahead with this transaction, is it a good idea to negotiate a line of credit for
working capital needs or should it keep the current policy of no credit lines and save on fees?

In case of Blaine the current capital structure and cash position enables the company to self
sustain the working capital needs, avoiding fees in possible credit lines generated for this
purpose.

The benefit of a credit line would be to face potential bad times with extra safety although,
since sales tend to track the overall macroeconomic activity, when bad times come the
probability of a cut in the credit line by the issuer is substantial.

This creates a scenario where the benefits of having a credit line open are less when
compared with the fees cost.

We shouldn’t depend on credit lines to support the working capital needs, giving
the current situation of good liquidity we should keep the policy of no credit lines
saving on the fees.
9. Suppose that in December 2006 the total amount of equity was divided between a $200 million shareholder loan
and $288,363 common equity. Assuming that you agree with the statement that this company has excessive cash,
what would be the advantages of this equity structure?

Balance Sheet

Liabilities
This new equity structure is better for the company since it has the same practical structure 103.890.000
but with different technicalities.

The Shareholder loan creates a platform to distribute cash to the shareholders, according Shareholder loan
Assets
with the interest rate of the loan, reducing the excessive cash in the company. 592.253.000 200.000.000

With this structure, the shareholder loans create interest that can be used to create a tax
shield saving money to the company.
Equity
288.363.000
THANK YOU