1.

Executive summary

This memo´s purpose is to recommend an optimal capital structure for Bed,

Bath and Beyond at the implementation of a program the use the USD 400 mil-
lion excess in cash and a leveraged (@4.5%) share repurchase program. The
first part is a review of the financial indicators of the company and their perfor-
mance as well as their future obligations to present the business risk of the
company. Second, an analysis of the pros and cons of the share repurchase pro-
gram and the impact of different scenarios. Finally, a recommended action to
maximize the wealth of the company minimizing the cost of capital.

The recommendation is to implement a share repurchase program with a D/E of

40%., for the following reasons:

 Maximize the MV equity considering the tax shields effects and the bank-
ruptcy risks increasing the return on equity for the shareholders.
 Secure the future commitment of cash of the company, and
 The sign to the capital markets about this new capital structure.

2. Company performance

Bed, Bath and Beyond is competing in the retail industry in USA with net sales
of $4.5 billion and a net income of $399 million for Fiscal year 2003. It is one of
the top-performing public companies. This success could be attributed to the
following factors:

 Good customer experience leading to high store productivity

 Decentralized store control
 High margins
 Low-cost structure

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The company is the largest superstore domestic retailer, although its market
share was estimated at 4 percent. Their competitors are department stores,
mass merchandisers, superstore competitors and specialty stores. The compa-
rable data of the industry present a 5-yr-CAGR between -9.8% and 28.5%.
Bed, Bath and Beyond present the highest 5-yr-CAGR and with that growth
maintain their 4% percent participation of the market. The EBIT margin of the
company is also the highest as a result of their strategy of low-cost structure
and high margins in their products, especially with their own brand. So, in this
competitive market the strategy decision for differentiation in products and ser-
vices has generated these high-performance return indicators. These phenome-
nal financial results have created an excess of cash in the company.

The company presents operating leasing expenses in 2003 of $251.0 million.

These several leasing are committed obligations of the company. The present
value of these obligations will be of $1,255.0 million. The effect on the balance
of this obligation would be a D/E to 38% and will create distress on the credit
rating of the company. These operating leasing will reflect on the P&L of the
company in time and so far, the company is able to create cash flow to pay
these expenses.

The shareholders have the second highest return on stock of the industry, but
the cash of the company is not generating the returns that should be, and some
market analysts are looking this as a risk of the company, because the money
could be less productive. Another point is that the company hasn’t paid divi-
dends since going public, so the market could read this as an inefficient sign of
the managers as they keep non debt and is much less than their competitors
that gain some advantage with debt in their capital structure.

3. Share repurchase program

The share repurchase program is thinking in a financial environment of low in-

terest rates and excess of cash in the company. The company shows less lever-

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age capital structure than their competitors and even their acquisitions were
made in cash. Is important that the company maintains their competitive ad-
vantage as well as being efficient in the use of the cash to maximize the wealth
of their shareholders.

The advantage of debt in the real world is that creates tax shields that increase
the shareholders returns, specially with low interest rates in the debt market
and growing opportunities in the retail segment and the current financial posi-
tion of the company provides a good opportunity to increase debt. In the other
hand an increase in debt of the company will affect their credit rating. The opti-
mal capital structure should be that the company increase debt until de value is
maximized between the difference of tax benefits and the bankruptcy costs.

In this case, the scenarios present the different market value equity for D/E ra-
tios shown in table 1.

Table 1.- Scenarios of capital structure for different D/E

(Express in US million)

D/E 0% 20% 40% 60% 80%

Interest rate 4.50% 4.50% 4.50% 4.50%
Interest expense 14 29 43 57
Total BV debt (D) 318 636 954 1,273
Cash used in repo 400 400 400 400
Total $ Repo 718 1,036 1,354 1,673
PV (Tax shield) 122 245 367 490
Stock price paid 37 37 37 37
# shares repo 19,410 28,009 36,608 45,207
taxes 38.50% 38.50% 38.50% 38.50% 38.50%
Total MV equity 10,984 11,083 11,106 10,943 10,436

% Bankruptucy cost 17% 17% 17% 17%

Long Term debt / Capital 20% 40% 60% 80%
Average default rate 0.52% 1.24% 6.59% 21.85% 56%

The D/E that maximize the market value equity is 40%. This result is generated
by the combination of tax benefits and bankruptcy costs. The tax shield for ever
scenario is going up when the D/E ratio increase, but it also increases the aver-

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age default rate of the company because of the higher long-term debt / capital
ratio.

In the 40% D/E ratio, the company will be taking debt of $636 million and a to-
tal repo of $1,036 million. Creating a market value equity of $11,106 million
and increasing the earnings per share to $1.40 per share.

The cash held for the company will be $425 million plus the cash net cash pro-
vided by the operating activities, which last year represented $548 million. With
this cash creation the company would cover their future investments and finan-
cial obligations, including their operating leases.

This new capital structure will affect the credit rating of the company, but it will
be the same as their competitors on average because so far Bed, Bath and Be-
yond have not taken any debt and had low credit risk, but this was inefficient
form a capital structure point of view and the financial markets will see this pro-
gram as a good sign for the share value.

4. Recommendation

The company should implement the share repurchase program for $400 million
and debt structure of 40% D/E. However, the company should keep an eye on
their future cash creation and keep the optimal capital structure and analyzing
other methods to structure capital as a dividend policy or a one time pay divi-
dend to the shareholders.

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