The Lisbon MBA Católica | Nova – Executive 2021

Blaine Kitchenware: Capital Structure

Applied Corporate Finance Take Home Exam

Context

The analysis performed in this document is about Blaine Kitchenware, a mid-sized kitchen
appliance producer from the US. Initially a family-owned business, Blaine was founded in
1927 and was considered an innovative company that produced modern and easy to use
appliances. By 2006, Blaine had 10% market share in the US and is under the management
of Victor Dubinski (great-grandson of one of the founders).
In this report I would answer some questions that should advice Victor on the best alternatives
for important managerial decisions he has to make to keep Blaine a competitive company.

Case questions

1. Looking at simple performance metrics such as ROE it seems that the company is
performing below its peers. Do you agree? Is the firm's operating performance really that
bad? What are the causes for ROE under performance? How can you state whether or not
is this company adding value on a recurrent basis? Is the stock market really unhappy
about Blaine Kitchenware's performance?

I do not agree with the statement that Blaine is performing below its peers since looking at
the ROE alone we get a vision that includes operational performance yes, but that is also
impacted by how efficiently the management is generating money. If you look at other metrics
such as ROCE for example you see that Blaine is still below the average but above some of
the peers:

Blaine may not be the healthiest company of the industry . In the case of Blaine, as
stated in the case the idea of growth may be deceiving though since apparently the
company is not actually achieving organic growth but is rather growing through
acquisitions which should me an alarming signal to the company.

Looking solely to the ROE we mainly have an indication that Blaine does not have
an optimized capital structure. The reason why it has been declining through 2004-
2006 is shown be the measures of the table below:

ROE is declining because the increase in book equity (financing from equity) grows
at larger pace than the net income.
It is underperforming comparing to peers because others as shown in exhibit 3 have
considerably more debt (not being financed exclusively with equity) so the weight of
the net income on the book equity is larger.

Regarding the stock market perception about Blaine, if I am an investor that is not
specifically interested in kitchen appliances companies meaning that I will diversify
and invest in several types of companies, I don’t think Blaine is a company that will
make me unhappy as an investor. In terms of annual compounded returns Blaine is
actually above the S&P 500 index (11% vs 10%) and I believe this is actually an
interesting return rate. On top of that stock prices are close to all-time high.
However, comparing with peer companies returns given to investors are considerably
lower which means that the company is being too conservative and not acting in the
best interest of shareholders.

2. According to the case, this company terminated a "revolving credit agreement designed to
provide standby credit for seasonal needs". Do you think that is wise for a company not to
have such a safety net? What is your opinion about this company's net working capital
financing policy? Is it safe? Is it in the best interest of shareholders?

In my view these types of safety nets make sense when a company does not hold many cash
reserves and it is constantly investing the money generated by the business. As stated in the
quote, this credit line can be activated for seasonal needs to make sure Net Working Capital
Requirements are satisfied but, looking at Blaine they hold on Cash & Securities seven times
the value of their working capital requirements so, I agree with the CFO that paying for this
safety net in the current conservative strategy of the company seems like an unnecessary
cost that could be saved for other purposes.

In terms of net working capital financing policy, I consider Blaine’s approach to be extremely
conservative since they are relying too much on long term funds to finance the business. The
figure bellow represents well a seasonal company such as Blaine that employs to high volume
of long terms funds. Blaine actually uses for this exclusively equity, which is usually the most
expensive source of funding.

As stated before, I believe that in the current state of the company, the revolving credit lines
are superfluous but, if working capital policies changed in a way that some seasonal peaks
were maintained by some short-term borrowings then I would not recommend for the
company to terminate the agreement. By leveraging the company, a little bit additional
investments could be made to improve the company’s operation and strategy and the effects
of tax shields could be used.

Is this policy safe? I believe that this is a very safe policy and that is shown by the fact that
the company has the lowest equity beta of the market meaning that investors should expect
a lower risk from this unlevered company. We could state that some investors would be
interested in this type of company profile however, I believe that the profile should come from
the type of business and not from a company's financial policies. If an investor wants low risk,
he should invest in non-seasonal business such as utilities.
Looking at Blaine I think that with this capital structure they are not meeting the investors best
interests. Being a company in which the majority of shares are controlled by family members,
the conservative style of the family (and even some ego) may be blocking the potential that
the company has to generate returns to its shareholders. It is good to be safe yes, if you mean
to attract cautious investors but in Blaine’s case, I believe that they do not have a reasonable
balance in their financial policy that allows for investors to extract value in the most efficient
way.

3. The company's investment banker hinted that value could be "unlocked" at Blaine
Kitchenware by using the available cash and additional borrowings to buy back a
 significant portion of the company's equity. Would that be wise? Do you agree that the
company has excessive cash? Does the company have an inefficient capital structure?

I believe there is a fundamental flaw on the comment of the investment banker which is to
say that an operation like buying back shares would unlock value for the company. Buying
back share is an operation that may bring Earning Per Share up but will keep the intrinsic
value of the company flat. It may help management hit some interesting ratios but they do not
signify and increase in performance or value. Furthermore, and in Blaine’s case I believe this
is critical, using the extra money to buy back shares constitutes an opportunity cost of
investing in the company’s long-term health.

It is true that buy backs are not without impact - they may have an effect on share prices that
come from the changes in capital structure and they send a signal to investors that the
company will not use the money unwisely (for example an acquisition without actual
synergies). These considerations are generic but, they have to be applied in the context of
each company’s current state.
Buy backs usually make sense when management believes the stock price to be undervalued
and it is said that stocks are close to all-time high so, it would not make sense to perform this
operation now. I believe that the money should be used to improve and rethink the company’s
strategy for the future.

The cash is definitely excessive and its use in recent years in acquisitions although it has
been one of Dubinsky’s main strategies it is apparently not being very successful since the
acquisitions are not generating more organic growth.
Looking at industry peers the returns generated to shareholders are much more interesting
than Blaine’s and this tells us that the conservative approach is creating inefficiencies in the
capital structure that do not allow the extraction of all the potential of the business.
According to MM theory, Proposition II, in profitable firms that pay taxes, the financial leverage
boosts the value of the firm and the cost of capital can be reduced by the effect of tax shields.
So, this should be the way to go as other industry peers are doing – leveraging to unlock
additional value.

4. Assuming that family shareholders would welcome a distribution of cash to equity holders
analyse, from the perspective of the controlling shareholders represented in the Board as
well as from that of the small minoritary shareholders, the following alternatives:
a. substantial increase in the annual regular dividend

Substantial increase in annual dividends signals that manager are confident that they will be
able to continue paying the new, higher dividend level in the future. This type of shareholders
(minoritary) depending on their goals may happy because they will earn more money. Some
may think they would rather see that money reinvested in the business so that the enterprise
value could grow more in the future.
For controlling shareholders, that also manage the company, this is a move that may leave
them suffocated if they are not able to sustain grow to keep dividends at that higher level.
This strategy removes flexibility and may cause future problems in the relation of
management with shareholders if dividends have to be lowered again (they are currently very
high already in my opinion). Since the company had not been experiencing actual organic
growth and competition is believed to become fiercer because of Asian imports and private
labels, Blaine should not burn this cash paying more dividends and should instead bet on
improving the business to create more value.

b. special dividend

For minoritary shareholders receiving a special dividend is good because it means more
money in their pocket however taxation will be harder on them and it may appear as a bad
signal for long term investors if they see it as a hint that the company has ran out of ideas on
how to use cash to make the company further grow.
For controlling shareholders, this special dividend is a more flexible way to give back some
additional cash to shareholders since it is extraordinary and no future commitment is
necessary. It also shows financial health but without the burden of having to sustain that on
upcoming years. On the other hand, special dividends usually represent a reduction in stock
price since many minority shareholders will sell their stocks after receiving this dividend and
this impacts the valuation of the company and the wealth of shareholders in general.

c. share buyback

For minoritary shareholders a buyback is good because the ones that sell will convert that
ownership into money but for the ones that remain shareholders their already small ownership
will be further diluted.
For managing shareholders, share buyback also signal confidence but offer more flexibility
because they don’t create a tacit commitment to additional purchases in future years.
Additionally, this move increases the control they have over the company and reduces the
amount of money spent on dividends each year.

5. A more radical solution would be the one proposed by the bank: to borrow money to
conduct a "leveraged recapitalization". Assume that a bank is willing to lend up to $150
million for such transaction, using the company's property, plant and equipment as
collateral. The rates on the loan would be: 6.35% up to $50 million, 6.75% for a loan
between $50 and $100 million and 7.75% if the loan exceeds $100 million (and below
$150m). Propose a leveraged recapitalization involving the acquisition (at current market
price) of at least $200 million worth of shares. Explain why do you think your proposal is
beneficiary to shareholders? How much value (and why?) is created by it?

Although as stated before I do not agree that performing the buyback is the best option for
Blaine, that was the suggestion of the investment banker. For the purpose of this question, it
would actually be relevant to calculate what would be the return for shareholders of this
investment of $200 comparing a no debt scenario vs several level of debt scenarios. The
simulation performed assumes that the buyback is being performed in 2006 so the same tax
rate is used (30,8%).
According to the calculations performed the option of borrowing as much money as possible
to perform the buyback is the one that is in most interest to Blaine’s shareholders since it
takes advantage of the tax shields, from which additional value is appropriated by
shareholders. The chosen option (buyback $200 million worth of shares using $150 million of
debt and $50 million of cash) shows the highest ROIC* from the analyzed options and also
shows to take the most advantage of the effect of tax shield (tax benefit of $0.08 per share).

6. Compute the firm's weighted average cost of capital and the cost of equity before and after
your proposed transaction. What explains the difference?

The cost of capital of Blaine before the proposed transaction is unlevered so it corresponds
to the implied rate of return the company expects to get on its assets, without the effect of
debt. The WACC and the cost of equity are the same number in this case. To calculate this
metric, I assumed following information:

• Risk-free rate of return - 5.02% (10-year Treasury Securities as a good proxy to long
term return)
• Unlevered beta – 0.56 (from the case)
 • Market expected rate of return – considered to be 10% from the information of the
case

WACC = rE = rf + βE * (rm-rf) = 5.02% + 0.56 * (10% - 5.02%) = 7.81%

After the proposed transaction the cost of equity and the beta of equity should be higher
since now, with a leveraged firm (more risk) shareholders demand more return. In this
scenario, and taking into account the proposed loan of $150 million we need additional
information to reach the WACC value (now also considering debt):

• Total debt amount: $150 million

• Total equity amount: $288,363 million
• RD = 7.75%
• Tax rate = 30.8% (from the case)
• A reviewed βE calculated from the βE unlevered approximately equal to 0.76 using
the below formula:

Using the data above we can calculate the cost of equity (final value is calculated using non
rounded values):

E(re) = rf - βE * (rm-rf) = 5.02% + 0.76 * (10% - 5.02%) = 8.81%

Now that the company is leveraged the WACC also considers the effect of the cost of debt:

=WACC = 7.63%

According to what was expected the WACC after the transaction is lower than before since
borrowing money is cheaper than selling equity in the company and the cost of equity is higher
since now with leverage BIK became a riskier company so investors demand for a higher
return to invest.

7. Now assume that Easy Living Systems is planning to make an offer to buy 100% of the
equity of Blaine Kitchenware. Internal analysis shows that after the acquisition is
implemented, synergies will allow an increase of the EBITDA margin to 22%, while sales
are expected to grow at 4% annually. What is the maximum price Easy Living may pay per
each share of Blaine's stock? Please explain all assumption made.
The key to success in buying another company is knowing the maximum price you can pay
and then having the discipline not to pay a penny more. In this case Easy Living Systems
(ELS) that currently has a margin EBITDA of 12% and is evaluating the possibility to buy
Blaine to generate synergies that can elevate the EBITDA margin to 22% (this corresponds
to an increase of 10 p.p for ELS). The maximum price ELS should pay corresponds to the
incremental value the company may obtain by the synergies of buying BIK. The acquisition
premium should never exceed those synergies:

GainELS = Synergy – (PBIK – VBIK)

In this case I estimated a WACC for ELS considering a cost of debt of 7.75% (since their debt
is within the range given in question 5) and considering a tax rate of 40%. With this value I
estimated an alternative current enterprise value for the company. To estimate the value after
acquiring BIK I estimated an alternative EBITDA (that grew 22%), applied it a perpetual
incremental growth of 0.5% (on the case we can extract that the market is growing 3.5% so
the 4% stated in the question corresponds only to an incremental 0.5%). The WACC
considered was a weighted average of the ELS’s current WACC and the WACC of BIK. The
values obtained may be seen bellow:

The additional value created by the acquisition is given by the difference between the EV
after and before the acquisition which in this case is highlighted in green.

The set of data/assumptions used is summarized on the table below:

Finally, to estimate the acquisition premium ELS should pay in on the current market value of
BIK we divide the incremental value for the number of BIK shares which results in the value
of $4.44. Given this, ELS should not be willing to pay more than $20.69 for BIK shares.
Other relevant considerations for ELS are:

• They should evaluate what would could by other strategies to achieve this increase in
EBITDA margin and if the opportunity cost of buying BIK at this price is no larger than
what those strategies would cost.
• The estimation made assumed that the cost of capital of the company after acquisition
would not change much but his is an extreme assumption since looking at ELS cash
reserves it seems obvious that they would have to demand a very large amount of
debt thus changing the company’s cost of capital and equity beta. To sum up, buying
this company that is valuated in more than ELS’s price does not seem to be a very
reasonable decision.