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Group 7: Blaine Kitchenware Inc.

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

INTRODUCTION TO THE CASE


Vasvi Gakkhar

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 Blaines 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 familys ownership interest, and the companys 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 shareholders 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)Stockholders 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, promoters 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 Shareholders 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 companys 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

Operating Results: Revenue Less: Cost of Goods Sold Gross Profit

Forecasted Earning Statement


2004 2005 2,91,940 2,04,265 87,676 25,293 62,383 3,07,964 2,20,234 87,731 27,049 60,682 62,383 15,719 78,101 24,989 53,112 60,682 16,057 76,738 24,303 52,435

2006

2007

3,42,251 3,52,518 2,49,794 2,55,575 92,458 28,512 63,946 63,946 13,506 77,451 23,821 53,630 66,979 96,943 29,964 66,979

Less: Selling, General & Administrative Operating Income EBIT Plus: Other Income (expense) Earnings Before Tax Less: Taxes Net Income

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 Family 38% : Market float For 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 taken Shares 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 million 3. (Less) Cash and Cash Equivalents and market securities = $224.309 million 4. 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 Capital
WACC = [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= 0 Re = 5.972 Debt = (230,866) Debt/ Value = -.31 Therefore 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.