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Blaine Kitchenware Corporate Finance

Essay by   •  January 25, 2019  •  Case Study  •  1,209 Words (5 Pages)  •  32 Views

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CASE III          Blain Kitchenware Inc.

2018

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Context[pic 3]

Blaine Kitchenware (BKI) is a mid-size producer of kitchen appliances. It has been fairly successful in its segment. BKI is now considering a capital restructuring exercise through the buyback of shares using surplus cash and debt and wants us to evaluate if such an exercise would be fruitful.[pic 4]

Recommendation:

Based on the analysis, it can be concluded that Dubinski can recommend the buyback based on the overall increase in the value of the firm due to the benefit received from the interest tax shield, a benefit that is received by equity holders and due to the utilization of surplus cash.

Analysis of current capital structure[pic 5]

Under the current capital structure, BKI has 59.05 million shares, whose current price is $16.25 per share. Further, BKI has $231 million in cash and no debt. Since BKI has no debt and extra cash, the firm has a lower equity beta (0.43) than the unlevered asset beta (0.56) (Table TN5) since there is no risk associated with cash and hence the risk borne by the equity holders is lower as compared to the operational risk of the business (which is shown by the asset beta or the unlevered beta). But by having such a capital structure, BKI misses out on the opportunity of getting an interest tax shield by the way to debt financing. This interest tax shield will actually enhance the value for the equity holders since the rate of return for debt holders is fixed and the tax benefit of interest is passed on to equity holders. Hence, the current capital structure is not optimal in lieu of the missed opportunity of having an interest tax shield.[pic 6]

Analysis of the buy-back proposal

Buying back of shares using surplus cash and debt financing can help in getting the interest tax shield.

One such proposal is to buy back 14 million shares at the price of $18.50 per share by using $209 million of existing cash and $50 million of debt. This would result in the net debt growing from -$231 million to $28.134 million. Further, the Net income reduces from $53,630 thousand to $41,626 thousand. This difference in the net income is due to the interest expense incurred in the case of capital structure with debt. The reconstruction of capital in this manner will lead to not only an effect on the liability side of the balance sheet due to reduction in the number of shares and the debt but also a decrease in cash on the asset side. Further, the interest payment and the tax benefit received from the interest payment will be reflected as part of the shareholders equity (surplus). Hence, the total assets decrease from $488,373 thousand to $279,363 thousand. The total of debt and shareholder’s equity (book value) reduces to 279,363 thousand from $488,363 thousand (tallying with the asset side). The market value of equity now is $833,425 thousand. Hence the Debt to equity ratio now is .06 (considering market value of equity and book value of debt). The new total value of the firm (market value) is $833,425 thousand. Debt to total value of the company ratio is 0.057. Both these ratios (D/E and D/Capital) were zero earlier since debt was zero. If the net debt was considered, both these ratios would have been negative since net debt = debt – cash. The total book value of the firm will be $279,363 thousand. The EPS has increased from $0.91 to $0.93 and the ROE has increased from 11% to 18.3%. This is because the net income is spread among fewer shares. Interest coverage ratio (EBIT/Interest) is 17.9 which is more than sufficient to cover the interest expense. The cash flow to debt holders is the interest paid which is $2,337 thousand (after tax). The cash flow to equity holders is $18,201 thousand (after tax) which is lower than the without buyback case in which cash flow to equity holders was $34,323 thousand. But this reduction is primarily owing to interest payment for debt. But since the EPS has increased, equity holders receive more per share after buy-back as compared to what they received earlier. [pic 7]

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