Victor Dubinski, CEO of Blaine Kitchenware, Inc. had recently been made aware that a group of private equity investors made inquiries about a possible acquisition of Blaine. Dubinski knew that the family had absolutely no interest in selling, but he was still perplexed about how the private equity group could unlock some inherent value within their company. They wanted to use the cash on Blaine’s balance sheet and new borrowings to purchase all of Blaine’s outstanding shares at a price higher than its current stock price. After some thinking, he began to think about how he could complete a repurchase decision himself and thus stave off an unsolicited takeover.
Blaine’s current capital structure and payout policies
Blaine Kitchenware, Inc’s current capital structure is not appropriate. The incentive for investors and shareholders should be increasing the value of their investments through projects, increasing Earnings per Share (EPS), and the lowering of costs of capital. The simplest way that the firm can effectively increase the value for investors is by minimizing the Weighted Average Cost of Capital (WACC) through an optimal combination of debts and equity. The WACC is the cost of debts and equity used by the firm to run the business. The more debt they use will increase their debt-to-equity ratio, which will then lower their WACC.
Blaine Kitchenware, Inc. is a public limited company and issues shares, they have an established capital structure model in place. In 2006, Blaine Kitchenware used 100% equity in their capital structure and took on zero debt. By using this structure, the value of the firm does not increase because they are not utilizing the advantage of the “interest tax shield”. Because Blaine has chosen to finance projects through equity only and not taken the advantage of taking on debt, the WACC is not minimized and the firm’s value is not fully maximized. The interest expenses on debt are tax deductible, which give an advantage to the firm. If Blaine took on debt, the value of the firm would increase and shareholders would benefit more because of the interest tax shield. Since the firm has not paid any interest expense, this causes the firm to pay more taxes and that ultimately decreases their net income and EPS of the firm. On the
other hand, dividends being paid out are not tax deductible and the act of paying dividends does not increase the value of the firm.
Should Dubinski recommend a large share repurchase to the Board?
After reviewing the options before the company, our team suggests that Dubinski should recommend the share repurchase to the Board by partially using cash & securities and the remaining by taking on debt. However, this decision does have several advantages and disadvantages to the firm. Some of advantages would be: that by borrowing for the repurchase it would provide the firm with an interest tax shield, healthy borrowing would increase the firm’s overall value, using up Blaine’s debt capacity would discourage the takeover attempt, while paying out dividends is not tax deductible, paying interest on loans is, and finally Blaine could slow down its acquisition activities and increase their current margins.
Along with these advantages, there are still a good amount of disadvantages that include: Producing more interest expenses and increasing management risk, which also increases the chance of financial distress, Blaine has no former debt experience and the family members may not agree on how to handle it, the market may interpret such a move as a negative indication or see it as a less attractive investment, and finally they would be buying...