Running head: BLAINE KITCHENWARE INC.

CASE ASSIGNMENT GROUP 7

Blaine Kitchenware Inc. Case Assignment Group 7

BUSMBA 515, Spring 2017

Jayne Dachlet, Peter Epstein, Gene Piccotti, and Matt Schwartz

Professor: Dr. Scott Roark

April 23, 2017

BLAINE KITCHENWARE INC. CASE ASSIGNMENT GROUP 7

Table of Contents
Capital Structure and Payout Policy............................................................................................
Advantages and Disadvantages of Repurchase...........................................................................
Evaluation of Share Repurchase Proposals.................................................................................
Benefits and Impacts to Ratios/Calculations...............................................................................
Recommendation............................................................................................................................
References.......................................................................................................................................

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BLAINE KITCHENWARE INC. CASE ASSIGNMENT GROUP 7

Capital Structure and Payout Policy

Blaine Kitchenware Incs current capital structure and payout policy is not optimal
because the company is under-levered and over-liquid. Blaines financial surplus works against
the efficiency of its leverage. In addition, the high dividend payout ratio (over 50%) isnt tax
deductible. BKIs financial surplus decreases the efficiency of its leverage. A surplus of cash
lowers the return on equity and increases the cost of capital which reduces their enterprise value
if they were ever to be bought-out.

Although the company is profitable, returns to shareholders are below average. This is
due directly to their net income and the amount of book equity. Additionally, BKIs ROE was
11% in 2006, which was below peers in their industry. This is problematic for the firm because
outside perspective of the firms value can be reduced. Furthermore, their payout ratio has also
been affected. From 2004 to 2006 the payout ratio has risen from 35% to 52.9%. This is due to
the amount of cash spent on common dividends. The companys dividend per share has risen
slightly over the past three years because of this, however, the company issued new shares with
some of its acquisitions. The number of shares then rose which reduced BKIs earning per
share. From 2004 to 2006 the earnings per share dropped from 1.29 to .91, a significant drop
for the previously invested shareholders. The average shares outstanding grew over 17
thousand shares.

Their 100 percent equity approach is financially conservative, yet without the debt
financing the company cannot take advantage of the tax shield and the reduction of overall
taxes. Although risk will increase when their debt increases, debt financing will lower the cost
of capital primarily due to tax reduction. Essentially, whereas debt financing involves more
risk, it leads to an optimal financial structure. To this point, Blaine Kitchenware Inc has chosen
to finance projects by the selling of shares and has not made use of debt. The firms value is not
fully maximized and the weighted average cost of capital (WACC) is not minimized.

The more debt a firm uses, the lower the WACC. This is because the higher the debt-to-
equity ratio, the lower the WACC. The key is to choose a level of debt up to the point where the
tax benefit from an extra dollar of debt is exactly equal to the cost that comes from the increased
probability of financial distress. Convincing of the Board of Directors to take part in debt
financing stands as the problem now because the board may feel uncomfortable with the risk
associated and potential financial distress involved. The good news is that the family members
are the majority shareholders and if they collectively decide that debt financing is will better the
firm then they can choose to do so. Overall, the benefit of taking on debt outweighs the
circumstances of not taking on debt (although being riskier). Blaine Kitchenware Inc must
calculate the minimum earnings before interest and taxes required to take full advantage of debt
financing where both the WACC will be minimized, the value of the firm will be maximized,
and earnings per share will be increased.

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BLAINE KITCHENWARE INC. CASE ASSIGNMENT GROUP 7

Advantages and Disadvantages of Repurchase

Advantages:
Large repurchase will give family greater shareholder ratio dilutions have occurred with
acquisitions (from 62% up to 90%); this provides greater ability to determine retained
earnings and dividend payout (which is unsustainably high at over 50%).

Tax-shield for interest on debt reducing the debt service net effect.

EPS will rise (from current $.91 up to $1.25 depending on proposal) creating greater
shareholder value.

ROI will rise creating a greater business value (from current 15.79% up to 35.94%, again,
dependent on proposal accepted).

WACC will fall which lowers expected returns from investors (from current 7.844 to
optimal 7.194); creating greater ability to take on riskier and potentially more profitable
projects.

Company is using a more modern approach to the use of leverage; adherence to founders
standards may not be satisfactory value for current family members (primary
shareholders) looking to enhance financial value; buy-in would be essential.

Disadvantages:
Immediate exposure to interest expense; during recessionary times, this magnifies losses
significantly.

Insolvency issues with greater debt the debtholders will have first consideration should
a liquidation become necessary, which can affect shareholder repayment.

Cash flows are effected by debt burden (payments to service the debt).

Debt rating will fall from current to Ba making further debt acquisition costlier due to
perceived greater risk (should future financing become needed).

Company culture of founding financial principles (no debt carried) may pervade among
family members (primary shareholders); consensus may have aversion to risk of
leveraging.

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BLAINE KITCHENWARE INC. CASE ASSIGNMENT GROUP 7

Evaluation of Share Repurchase Proposals

To evaluate Blaine Kitchenware Inc.s repurchase options, an analysis was done of the
companys capital structure (see Figure 1).

Figure 1. Evaluation of Three Repurchase Proposals. 2006 information cited from Blaine Kitchenware, Inc.:
Capital Structure by T. Luehrman and J. Heilprin. Copywright Harvard Business School

Additionally, the group considered Blaines weighted average cost of capital (WACC) by running
an optimal WACC analysis that demonstrated a 42.86% debt to equity ratio would yield the
optimal WACC 7.194% and therefore, create the greatest value for the firm (see Figures 2 and 3).

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BLAINE KITCHENWARE INC. CASE ASSIGNMENT GROUP 7

Figure 2. Blaines Optimal WACC

WACC

Figure 3. Blaines Optimal WACC Graphically

Benefits and Impacts to Ratios/Calculations

Blaine Kitchenware will enjoy the following effects from a share repurchase (see Figures 4 and
5):

With Proposal 1, there will be a 23.71% drop in shares outstanding; Proposal 2 adds an
additional 4.44% drop from Proposal 1 and a 27.09% drop from current year; Proposal 3
adds a 5.81% additional drop from Proposal 2, and a total 31.33% drop from the current
year.

EPS are affected by Proposal 1 by an increase of 4.83% from the current year; Proposal 2
adds an additional 12.35% from Proposal 1 and a 17.11% increase from current year;
Proposal 3 adds a 16.73% increase from Proposal 2 and a total increase in Proposal 3 of
37.48% from current EPS.

ROI in Proposal 1 is increased 92.85% from current; Proposal 2 enjoys a 7.36% increase
over Proposal 1 and a total increase of 107.04% from current years ROI; Proposal 3
increases ROI by 9.95% over Proposal 2 and a total ROI increase of 127.65% from
current.

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BLAINE KITCHENWARE INC. CASE ASSIGNMENT GROUP 7

Interest coverage begins at 19.52 with Proposal 1, an additional decrease of coverage of

48.33% occurs with Proposal 2 with Proposal 3 coming in at an additional 41.24% from
Proposal 2.

Debt ratio will increase considerably with all Proposals; Proposal 1 increases the ratio by
83.34% from the current ratio, Proposal 2s debt ratio would be 150.1% of current and
241.01% of current with Proposal 3.

Most importantly to family shareholders, the portion of shares outstanding increases

significantly with all three Proposals: Proposal 1 increases family ownership from 62%
currently to 81.27%, a 31.07% increase; Proposal 2 increases ownership to 85.04% up
37.16%; Proposal 3 increases ownership by 45.62% to a total of 90.28% ownership.

Figure 4. Blaine Kitchenware Inc. Ratios and Calculations

Figure 5. Percent Changes as a Comparison

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BLAINE KITCHENWARE INC. CASE ASSIGNMENT GROUP 7

Recommendation
Based on the group findings, Blaine Kitchenware, Inc. must move away from their
current strategy and move forward with a recapitalization option. To reiterate, there are numerous
financial issues facing the company that need to be reassessed. Although their conservative
approach to borrowing puts them in the unique position of not having debt, they have to change
this tactic as it will continue to negatively affect future income and the value of the firm. The
capital structure must be rearranged in order to take on the inherent advantages currently being
forfeited due to the firms lack of debt financing.

As the recommendation relates to the findings of the share repurchase proposals, this
group is inclined to recommend 2007 Proposal 2. This assertion is based on calculations which
outline Blaine Kitchenware, Inc.s optimized weighted average cost of capital (see figure 2). The
findings show that a 42.86% debt to equity ratio would yield the optimal weighted average cost
of capital, 7.194%, which would in turn establish the greatest value for the firm and allow them
increased autonomy at it relates to higher risk, higher profit projects. The Proposal findings also
demonstrate that it would result in a debt/equity ratio of 43.99% (see figure 4), the closest figure
to the percentage needed to establish the optimized WACC.

By moving forward with Proposal 2 the effects are incredibly advantageous to the overall
value of the business. The freedom and weight of decisions as they relate to the alarmingly high
dividend payout (over 52.9%) can be controlled at a higher degree by the family. Additionally,
significant increases in Return on Investment (107.03%) and Earnings per Share (17.58%) can be
realized, addressing two of Blaine Kitchenware Inc.s most pressing issues (see figure 4).

Furthermore, by taking on debt, the firm will then address the issues pertaining to being
over liquid and underleveraged. Although their previous strategy championed the idea of
no/minimal debt, the reality of the situation was they were not servicing shareholders by actively
maximizing the value of the firm. Proposal 2 increases year over year debt to equity to 43.99%.
This type of movement would see a decrease in their weighted average cost of capital and by
taking on debt financing, Blaine Kitchenware would be able to take advantage of tax shield
legislation and reduce taxable income with interest expense deductions; an oversight which
currently sees an adverse effect to net income.

References
Luehrman, T. A. & Heilprin, J. L. (2009, October 8). Blaine Kitchenware, Inc.: Capital Structure.
Harvard Business School Brief Case 94-040.