Case #1: Blaine Kitchenware, Inc.

Questions:

1. Do you believe Blaine’s current capital structure and payout policies are appropriate?

No. Both the capital structure and payout policies of Blaine Kitchenware are

inappropriate.

Why not?

Capital Structure

The current capital structure shows that the company is very liquid which indicates that it

is not making efficient use of capital.

The company has also invested heavily in marketable securities which are safer

investment options and offer low returns to investors.

The company has no debt which means that the cost of capital is high as debt interest is

usually tax allowable as shown in the tax calculation where the interest expense is

subtracted before the tax liability is computed. On the other hand, returns on equity are

distributed after tax hence not tax allowable increasing the cost of capital.

Payout ratio

The payout ratio is inappropriate and unsustainable as part of the source of the dividends

is cash reserves.

It is also high given the decrease in the net income margin from 18.2% in 2004 to 15.7%

in 2006 which shows it is not sustainable to pay high dividends as income reduces.

Paying dividends from cash is also not a good use of capital.

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 The high payout is due to an increase in the number of share rather than the dividend per

share, which have grown modestly, hence the high payout is unsustainable as it will

reduce the cash reserves given that it’s arising from an unsustainable source.

2. Should Dubinski recommend a large share repurchase to Blaine’s board? What are the

primary advantages and disadvantages of such a move?

Dubinski should recommend a large share repurchase.

Advantages

It is better use of the excess cash the company currently has which is not generating

adequate return compared to competitors. We are informed that the annual return from

both dividend and capital gains of 11% is lower than that achieved by the competitors of

16%. This could also be due to the 164 million dollars invested in marketable securities

which offer lower returns.

It will help increase the return on equity on the remaining shares as the return will now be

distributed over a fewer number of shares.

The value of the remaining shares should, therefore, improve as the higher return will

make them more valuable.

Some Blaine Kitchenware investors might be happy to realize a capital gain if dividends

are taxed and they will pay no tax on the capital gain.

It will help unlock value in Blaine’s strong balance sheet as capital will now be used

more efficiently.

Disadvantage

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 It can also be seen as a sign of weakness by investors, who may think that the company

has no ideas or innovative projects with which it can generate a higher return that lives up

to my expectations.

In addition, investors invest in a company with the intention of being exposed to a certain

type of risk (and hopefully a certain return). The company is essentially forcing some

investors to sell their shares and invest elsewhere.

3. Consider the following share repurchase proposal: Blaine will use $209 million of cash

from its balance sheet and $50 million in new debt-bearing interest at the rate of 6.75% to

repurchase 14 million shares at a price of $18.80 per share. How would such a buyback

affect Blaine? Consider the impact on, among other things, BKI’s earnings per share and

ROE, its interest coverage and debt ratios, the family’s ownership interest and the

company’s cost of capital.

Earnings per share

By buying back shares, the earnings per share should increase as the future earnings will

now be spread over fewer shares.

Return on equity

The return on equity will initially reduce as the company repays it debt but on the long-

term the returns should improve as the earnings will be spread over a lower equity value.

We are also told the returns reduced due to dilutive acquisition hence reducing the

number of shares should increase the returns.

Interest coverage

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Interest coverage ratio is used to determine how easily a company can pay interest on its

outstanding debt. It is calculated as the earnings before interest and taxes divided by the

interest expense

Earning before interest ∧taxes ( EBIT )

The interest to be paid is

Annual interest =6.5 %∗50,000,000=3,250,000

The interest coverage will reduce as before no interest was being paid but it will still be

manageable given the company’s previous earnings before interest and tax.

Debt ratios

It measures the percentage of funds provided by other sources other than equity.

Total liabilites
Debt ratio=
Total Assets

The debt ratio would increase from the current ratio of 20%. This should help reduce both

the cost of capital and effective tax rate as the company will now be paying less taxes as

tax will be calculated on the income after paying the interest expense.

Family ownership

Family ownership in Blaine Kitchenware would reduce leading to loss of control of the

company.

Cost of capital

The cost of capital will reduce as debt capital increases as debt is a cheaper source of

capital than equity as it is tax allowable. This means the interest expense is deducted

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 before calculating the tax. This would be beneficial as the tax is expected to increase to

40% in the future. By having debt, this would reduce the effective tax rate.

4. As a member of Blaine’s controlling family, would you be in favor of this proposal?

Would you be in favor of it as a non-family shareholder?

Controlling family

The controlling family would be against this proposal as it means we lose control of the

company which has been in the family for close to a century. In addition, we are

informed that the family is well represented in the board and are likely to rebuff the offer

as they’ve done with earlier offers.

However, given the purchase price is higher than current share price this might encourage

some family members to sell their shares.

Non-family shareholder

As a non-family shareholder I would accept the offer. This is because:-

 The offer price is higher than the current share price.

 The returns have been lower compared to the industry.

 The lack of expertise in running the company’s as it’s passed down generations.

We are told that the current Chairman of the board inherited the position from his

uncle and has not changed much.

 Growth has also been slower as competition has increased leading to lower

returns. In addition we are told that current growth has been due to acquisition.

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5. How does the proposal sketched above differ from a special dividend of $4.39 per share?

A special dividend would only reduce the cash amount and cash equivalence but would

not change the capital structure hence it would not change anything. However, it has the

advantage of being a one-off and would not be expected in future.