Question 1:

Do you believe Blaines current capital structure and payout policies are
appropriate? Why or why not?
First, Blaine Kitchenware Incs current capital structure is not efficient. The
incentive for any public company and Board of Directors should be the increase the
value of firm through projects, increased earnings per share value, and the lowering
of costs. One way many firms effectively increase the value of the firm is to
minimize the weighted average cost of capital. The weighted average cost of capital
is the costs of a firm in the form of debt and equity. Since Blaine Kitchenware is a
public company and issues shares, they have an established capital structure
model. In 2006, Blain Kitchenware incurred no debt thus taking on one hundred
percent of equity in their capital structure. By taking on no debt, the value of the
firm is unlevered and the firm does not gain the advantage of the interest tax
shield. It is because Blaine Kitchenware Inc has chose to finance projects by the
selling of shares and has not made use of debt issuance that the firms value is not
fully maximized and the weighted average cost of capital is not minimized. If Blaine
Kitchenware Inc took on debt, the value of the firm would rise and shareholders
would benefit more as the firm would have the interest tax shield as in Exhibit 11.
Our advice would alter the amounts in both debt and equity (thus leaving the
firms assets unchanged ) such that they use the financing from the debt to
purchase their companys shares back. As the firm incurs more debt, they take on
the payment of interest. This payment of interest lowers both the firms taxable
income and their amount paid due to taxes. After deducting the necessary
1 The difference between the unlevered payment to shareholders and levered
payment to shareholders and bondholders is the interest tax shield. In principal, the
interest tax shield is the tax saving attained by a firm from interest expense.

depreciation amounts, changes to net working capital, and capital spending, the
total amount paid to shareholders and bondholders would be greater (whereas the
current situation, the bondholders are not being paid at all as they do not currently
exist).
The more debt a firm uses, the lower the weighted average cost of capital.
This is because the higher the debt-to-equity ratio, the lower the weighted average
cost of capital as shown in Exhibit 2. This notion suggests the optimal choice of
capital structure composition is to choose one hundred percent debt as the more
debt the firm takes on, the higher the value of the firm becomes due to the value of
the tax shield. However, this is not the case. At low levels of debt, the probability of
bankruptcy and financial distress is low, and the benefit from debt outweighs the
cost. On the other hand, at high levels of debt, the possibility of financial distress is
an ongoing problem for the firm so the benefit from debt may be more than offset
by the financial distress costs. The key is to choose a level of debt between these
extremes, a notion more distinguished by the static theory of capital structure.
The static theory of capital structure says that a firm borrows up to the point
where the tax benefit from an extra dollar of debt is exactly equal to the cost that
comes from the increased probability of financial distress which is illustrated in
Exhibit 3. The key thing we derive from Exhibit 3 is that there is the theoretical
value of the firm (measured by the value of the unlevered firm plus the product of
corporate tax and the amount debt) and the actual value of the firm. The actual
value of the firm reaches a climax then quickly begins to decline further below the
value of an unlevered firm. This is where Blaine Kitchenware needs to be very
careful in choosing the amount of debt to take on.

The convincing of the Board of Directors to take part in debt financing stands
as the problem now. Although the static theory of capital structure provides the
assurance that the value of the firm will increase by taking on enough debt to
maximize the value of the interest tax shield, the board may feel uncomfortable
with the risk associated and potential financial distress involved. The good news is
that the family members are the majority shareholders and if they collectively
decide that debt financing is will better the firm then they can choose to do so.
However, if the members of the Board disagree to the issuance of debt, the
shareholders can adjust the amount of financial leverage by borrowing and lending
on their own (homemade leverage).
Overall, the benefit of taking on debt outweighs the circumstances of not
taking on debt (although being more risky). Blaine Kitchenware Inc will have to
calculate the minimum earnings before interest and taxes required to take full
advantage of debt financing where both the weighted average cost of capital will be
minimized, the value of the firm will be maximized, and earnings per share will be
increased as demonstrated in Exhibit 4.

Exhibit 1: Value of Firm Relative to Debt and Taxes

Value of
Firm

Value
of
Levere
d Firm

Interest Tax
Shield

Value of
Unlevere
d Firm

Total Debt

Chosen
amount of
Debt

Exhibit 2: The Cost of Equity and the Weighted Average Cost of Capital
with Taxes

Cost of Capital
(%)

Re

Ru
WACC
Rd x (1 Tc)

Debt/Equity
Ratio

Re is the Cost of Equity: the return that equity investors require on their
investment in a firm.
Ru is the Unlevered Cost of Capital: the cost of capital of a firm with no debt.
WACC is the Weighted Average Cost of Capital: the weighted average costs of
debt and equity.
Rd x (1-Tc) measures the interest tax shield rate. We use this rate to multiple with
amount of debt in a firms capital structure.

Exhibit 3: The Static Theory of Capital Structure

Value of
Firm

Financial
Distress

Max
Firm
Value

Value of
Unlevere
d Firm

Present
Value of Tax
Shield

Optimal
Amount of
Debt

Actual
Firm Value

Total Debt

Exhibit 4: Financial Leverage, EBIT, and EPS

EPS

Advantage
of Debt

With
Debt

Without
Debt

EBIT
Required
Disadvant
age of
Debt

The use of debt does not provide benefit to earnings per share until the EBIT passes
the indifference point (the blue circle). The indifference point illustrates the point of
required EBIT before the EPS grows faster than without debt. When taking on debt,

the minimum required amount of EBIT is at this point. If forecasted EBIT does not
exceed this amount it is not beneficial to shareholders to take on debt (EPS will
suffer).