 More about baline katchine

Blaine Kitchenware
 Mid-sized producer of small Kitchen appliances.
 Family promoted, Victor Dubinski CEO.
 Captures 10% of $2.3bn US market.
 Competitive advantage such as “smart” technology
 Brand recognition
 2 times borrowed beyond seasonal working capital
need
Major Segments
Major Revenue

Food
preparation Cooking
appliances

Beverage making
appliances

2% market share
400000

300000

200000

100000
Cash & Securities
Net Debt
0
Blaine Home & Easy Living
-100000 Kitchenware Hearth System
Design
-200000

-300000
Main Problem
 Lacks of 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???
Dilemma of Buy Back
Dilemma

Buy Back
 Companies return cash to stockholders in the
form of dividends
 Stock buyback has emerged as an alternative
 Repurchase Open Market
Tender Offers Purchases
Privately
Negotiated R
epurchases
Capital Structure
380 – Ritwa Lokhandwala
Capital Structure
 Capital Structure of a firm refers to the combination
mix of debt and equity i.e., sources of funds, which
a company uses to finance its overall operations
and growth
 A firm's capital structure is then the structure of its
liabilities
 Usually a company more heavily financed by debt
poses greater risk, as this firm is relatively highly
levered.
 It is monitored by debt to equity ratio
Example
 A corporation that sells $30 billion in equity and
$70 billion in debt is said to be 30% equity-
financed and 70% debt-financed. Thus, firm's ratio
of debt to total financing, 70% is referred to as the
firm's leverage.
Capital Structure

Capital Structure

Debt- Capital Equity-Capital

Specific short- Preferred

Long-term debt term debt(bond Equity(or Common Equity
issued) retained
earnings)
Capital Structure
 Equity Capital: This refers to money put up and
owned by the shareholders. Equity:
 Contributed capital, which is the money that was
originally invested in the business in exchange for
shares of stock or ownership
 Retained earnings, which represents profits from past
years that have been kept by the company and used to
strengthen the balance sheet or fund growth,
acquisitions, or expansion.
 An example: A speculative mining company vs.
proctor & Gambler
Capital Structure
 Debt Capital in a company's capital structure refers
to borrowed money that is at work in the business.
 The safest type is generally considered long-
term bonds because the company has years, if not
decades, to come up with the principal, while
paying interest only in the meantime.
 Other types of debt capital can include short-term
commercial
 The cost of debt capital in the capital structure
depends on the health of the company's balance
sheet
Capital Structure
 Other Forms of Capital:
 There are actually other forms of capital, such as vendor
financing where a company can sell goods before they have
to pay the bill to the vendor, that can drastically increase
return on equity but don't cost the company anything.
 This was one of the secrets to success of Wal-Mart.
 Wal-Mart has often able to sell Tide detergent before
having to pay the bill to Procter & Gamble, in effect, using
PG's money to grow his retailer.
 The cost of other forms of capital in the capital structure
varies greatly on a case-by-case basis and often comes
down to the talent and discipline of managers.
Good Capital Structure
 Firstly, the good capital structure will result in a low
overall cost of capital for the company

 Secondly, the only variation in capital structure we

will consider is in the overall amount of borrowings
which firms use.
Assumptions and Definitions
 To examine the relationship between capital structure and
cost of capital the following assumptions are commonly
made:
 There is no consideration of income tax, corporate or personal.
However we consider the implications of tax in some cases.
 We assume firm’s policy of paying all of its earning as dividends
i.e., 100% dividend ratio is assumed.
 Investors have identical subjective probability distributions of
operating income for each company.
 It is assumed operating income remains same over period of time.
 It is assumed that there is no transaction cost incurred if the firm
changes its capital structure instantaneously.
Assumptions and Definitions
 Assuming, debt is perpetual:
Cost of Debt = Annual interest charges/Market value of debt
rD = I /D
 Assuming, 100% dividend payout ratio and earnings constant:
Cost of Equity = Equity earnings/Market value of equity
rE = P/E
 Thus, Capitalization rate of the firm = Operating income/Market
value of equity
rA = O/V = O/ (D+E)
 Capitalization rate of the firm = Weighted average cost of capital
rA = rD(D/D+E)+ rE(E/D+E)
 what happens to these rates if D/E changes
Calculation of Capital Structure
Net income approach
 This approach, the cost of debt, Rd and the cost of
equity, Re, remain unchanged when D/E varies

 The constancy of Rd and Re with respect to D/E means

that Ra, the average cost of capital, measured as
Ra=Rd [D/D+E] + Re[ E/D+E]

D=market value of debt

E=market value of equity
Net income approach:- graph

From the graph it is clear that as D/E increases, Ra decreases because the
proportion of debt, the cheaper source of finance, increases in the capital
structure.
Net operating income approach
 According to the net operating income approach,
the overall capitalization rate and the cost of debt
remain constant for all degrees of leverage
 Ra and Rd are constant for all degree of
leverage. Given this the cost of equity can be
expressed as:
Re=Ra+(Ra-Rb)(D/E)
Net operating income approach
 The critical premises of this approach is that the
market capitalizes the firm as a whole at a discount
rate which is independent of the firm’s debt-equity
ratio
 As consequences the division between debt and
equity is irrelevant.
 An increase in the use of debt funds, which are
apparently cheaper, is offset by an increase in
equity capitalization rate
Net operating income approach
Traditional proportion
 Rd remains constant up to a certain leverage then
rises increasingly

 Re rises gradually up to a certain degree at a

constant rate

 Ra decreases up to a certain point then remains un

affected and finally rises beyond the point
Traditional proportion:- graph
Traditional proportion
Implication:
 Cost of capital depends upon capital structure

 Optimal capital structure minimizes cost of capital

 Before optimal point:

Real marginal cost of debt < real marginal cost of Equity
 After optimal point:

Real marginal cost of debt > real marginal cost of Equity

MM Proposition I
 The value of firm is equal to its expected operating income
divided by the discount rate appropriate to its risk class. It is
independent of its capital structure.
 V=D+E=O/R
 V= market value of firm
 E= market value of equity
 D= market value of equity
 O= expected operating income
 R= discount rate applicable to the risk class to which the
firms belongs
 MM invoked an arbitrage argument to prove this
proposition.
MM Proposition II
 The cost of equity capital for a levered firm =
Re=Ra+(Ra-Rd)(D/E)

 Expected return on equity= Expected return on

assets +[expected return on assets – expected
return on debt] debt-equity ratio
MM Proposition II graph
FEATURES OF APPROPRIATE
CAPITAL STRUCTURE
 FEATURES

Combination at that level of debt – equity proportion

where the market value per share is maximum and
the cost of capital is minimum.
FEATURES

Capital structure should have the following features

 Profitability
 Risk
 Flexibility
Importance of Capital Structure

 Decision Making
 Calculate Cost of Capital or WACC

 To Reduce Risk

 To Adjust according to Business Environment

 Idea Generation of New Source of Fund

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%(For 10 year
Treasury Bond)
 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
 To Reduce Risk

 When we make capital structure before actual

getting money from money supplier, we can do many
adjustments for reducing our overall risk.

 For a new business, there will be lower rate of return

than the profits.

 But if the ROI is high in the initial years itself, then

the future financing can be done using debt options.
To Adjust according to Business
Environment
 If government of India cuts off his relation with China,
from where Company X is getting its fund, it will
definitely tough for us to get more money from China.
 But proper planning of capital structure of future
sources will be helpful for us to enlarge our area for
getting money.
 In finance, it is called manoeuvrability. It means to create
mobility of sources of fund by including maximum
alternatives in planned capital structure.
 Suppose, if RBI increases the interest rate, it means your
cost for getting debt will be high, at that time, you can
choose any other cheap source of fund.
Idea Generation of New Source of
Fund

 Good planning of capital structure will

make versatile to finance manager for getting
money from new sources.
BKI’s Capital Structure & Policies
BKI’s Capital Structure

 Conservative financial policies

 Only two borrowings

 Debt free
Cash and securities : $ 230,866,000
Total Debt :$0
Net Debt : $ (230,866,000)

 Strong liquidity
BKI’s Capital Structure
 Largest Uses of Cash
 PayDividends
 Acquisitions
BKI’s Capital Structure

 Average Capital Expenditure = $10 million

 After-tax operating cash flow more than 4 times
Market Capitalization
Current Stock Price = $16.25

Average Outstanding Shares = 59,052,000

Market Capitalization = Current Stock Price *

Average Outstanding Shares

= $ 959,596,000
Special Dividends
 In case the company plans to give out outstanding
shares, the amount of the dividends paid per share
would be:
 In case
 Excessive earnings
 Restructuring
Debt Ratio
 Defined as the ratio of Net Debt to Equity

For BKI the debt ratio was

 (230,866,000)/959,866,000

 -24.06%

Whereas,
Industry Average was 17%
How Appropriate is it?
Threats
1. Take over threat

 Attract hostile takeover

• Enterprise value = 729 million

• Market capitalization = 959

million
Risks
2. Re-investment risks

• Capital misallocation

• Invest in some wrong /

weak projects
Dividends ?...
3. Inappropriate policy

• Consistent increase in the pay-

out ratio

• Management’s goal is to
maximize share-holders value.

• Should use the cash in more

attractive investments.

• Investors expect the dividends

to continue
Share Repurchase – Advantages
 Get rid of surplus cash.
 Decrease the cash carrying cost.
 Reduce the risk of unattractive re-investments.
 Increase buying cost of hostile take-overs.

… thus by discharging cash BKI can decrease its asset

and equity on book and there-by increase its ROE.
Difference from Proposal
Difference Between Proposed sketched of Case Study
and Special Dividends Of 4.898/share.

 Proposed Sketch: Buyback Of Share

 Option 1: Buyback Of Shares

 Assumptions: Buyback price for share 18.5$.

 Option 2: Pay Special Dividends of $4.39/share

Advantage Of Buyback Over Special
Dividends
 Share repurchase will decrease the number of
share outstanding and increase the family
ownership.

 From investors’ perspective, instead of being

passively given dividend which subject to income
tax, they have more flexibility to choose when they
want to sell their shares at premium price.
Cont..
 In addition, share repurchase might send a signal to
the market that the share is undervalued thus
boosting the share price
Conclusion
ROE and Earnings/Share both are highest in case of
Buyback. Therefore company should go for
buyback.
Thank You
Have a nice day 