Case Study - Financial Overview and Strategic Activities (2004–2006)

1. About the Case 1.1 Few Facts About the Case • • • • In 2006, Most of the revenues collected from US Wholesalers and Retailers. Cash securities decreased from $286mn in 2004 to $231mn in 2006. Largest uses of cash included Dividend payment and parts of acquisitions. Company issued new shares in connection with some of its acquisitions. During 2004-2006, Compounded annual returns are summarized as follows: Compounded Annual Returns BKI 11% S&P500 10% Peers 16% In 2006, ROE of Blaine was significantly below that of its publicly traded peer companies: ROEBlaine 11% Mean ROE 25.90% Median ROE 19.50% 2. Do you believe Blaine's current capital structure is appropriate? Why? Why not? • • • • • • Blaine is an all-Equity firm. It has only obtained long-term financing twice in its history beyond seasonal working capital needs (first during World War II and second time during the first oil shock of 1970). As the company's financial posture was conservative, being unlevered may have been popular during the early twentieth century. However, according to Modigliani and Miller Model, there are advantages of maintaining a certain amount of debt as it adds value to the company in the form of a tax shield provided by the tax-deductible interest on the debt. Therefore, companies find it prudent to maintain some amount of long-term debt on their balance sheets. Although high levels of debt can be risky as there are distress costs associated with high leverage, it is widely accepted that a medium level of leverage can add significant value to a company. As we see later, calculating cost of equity using CAPM, we get: (Calculating Cost of Equity) R (ALL EQUITY FIRM ) = 5.54% 3. The New Proposal: Unlevered to Levered Blaine wants to raise $50 million new debt @6.75% and use $209 million of cash from its balance sheet to repurchase 14 million shares @$18.5 per share with an intension to reduce share capital and increase debt equity ratio. Number of shares bought back (000s) Buyback price per share Debt value (000s) Interest rate 3.1. 14000 $18.5 50000 6.75% Income Statement for the FY 2007 Operating Results (000s) 2004 2005 2006 2007 Without Debt With Debt Revenue 2,91,940.00 3,07,964.00 3,42,251.00 3,52,518.53 3,52,518.53 Less: Cost of Goods Sold 2,04,265.00 2,20,234.00 2,49,794.00 2,52,050.75 2,52,050.75 Gross Profit 87,676.00 87,731.00 92,458.00 1,00,467.78 1,00,467.78 Less: Operating Expenses 18,306.00 18,836.00 18,598.00 20,798.59 20,798.59 EBITDA 69,370.00 68,895.00 73,860.00 79,669.19 79,669.19 Less: Depreciation and Amortization 6,987.00 8,213.00 9,914.00 9,412.24 9,400.49 EBIT 62,383.00 60,682.00 63,946.00 70,256.94 70,268.69 Less: Interest on Debt - - - - 3,375.00 Plus: Interest Income 15,719.00 16,057.00 13,506.00 29,447.05 29,415.71 Earnings Before Tax 78,102.00 76,738.00 77,451.00 99,703.99 96,309.41 Less: Taxes 24,989.00 24,303.00 23,821.00 39,881.60 38,523.76 Net Income 53,113.00 52,435.00 53,630.00 59,822.39 57,785.64 Less: Dividends 18,589.00 22,871.00 28,345.00 20,937.84 20,224.98 Reserves 34,524.00 29,564.00 25,285.00 38,884.56 37,560.67 2004 2005 2006 Average Effective Rates for 2007 Explanation/Assumptions Revenue Growth 3.20% 5.50% 11.10% 6.60% 3% Manager's expecting top line growth of 3% for FY 2007 Gross Margin EBIT Margin/Operating Margin 30% 28.50% 27% 28.5% 28.5% Average growth expected 21.40% 19.70% 18.70% 19.93% 19.93% Average growth expected EBITDA Margin 23.80% 22.40% 21.60% 22.60% 22.60% Average growth expected 32% 40% Future tax rate expected to rise to the statutory rate of 40% 16.97% 16.97% Average growth expected 44% 35% No acquisitions would be made in 2007 Effective Tax Rate 32% Net Income Margin 18.20% Dividend Payout Ratio 3.2. 35% 31.70% 30.80% 17% 15.70% 43.60% 52.90% Calculating Cost of Equity Cost of Equity Rf (90 days) 4.91% Assuming 90 days Maturity period Rm (AA) β (Blaine) Cost of Equity 6.04% 0.56 5.54% Assuming Blaine as Moody's AA Assuming Beta of 2006 continues 3.3. Calculating Cost of Debt Cost of Debt Borrowing rate Tax rate Cost of Debt 3.4. 6.75% 40% 4.05% Value of Equity 3.4.1. Equity and Cash Calculation Equity Opening Balance Opening Share Capital Less: Buyback (Share Capital) Closing Share Capital Retained earnings Less: buy back (RE) (@17.5%) Without Debt 488363 59052 0 59052 429311 0 With Debt 488363 59052 14000 45052 429311 245000 Add: Current year RE 38,884.56 37,560.67 4,68,195.56 2,21,871.67 Closing Reserves and Surplus Cash Inflows = After-tax operating cash flow + Interest Income - Interest Expense Without Debt With Debt 230866.00 230866.00 0.00 209000.00 Add: Cash Inflows 69234.64 67186.14 Less: Dividends Closing Cash and Cash Equivalents 20937.84 20224.98 279162.80 68827.16 Cash and Cash Equivalents Opening Balance Less: Buyback 3.4.2. Balance Sheet (FY 2007) Assuming all other liabilities and assets stay constant for FY 2007 as for FY 2006. 3.4.2.1. Scenario 1 (Without Debt) Balance Sheet (2007 - Without Debt) Liabilities and Shareholder's Equity (000s) Assets (000s) Share Capital 59052.00 Cash and Cash Equivalents Reserves and Surplus 468195.56 Accounts Receivable Accounts Payable 31936.00 Inventory Accrued Liabilities 27761.00 Other Current Assets Taxes Payable 16884.00 Property, Plant and Equipment Other Liabilities 4814.00 Goodwill Deferred Taxes 22495.00 Other Assets Total Liabilities and Equity 3.4.2.2. 631137.56 Total Assets 279162.80 48781.00 54874.00 5157.00 164908.76 38281.00 39973.00 631137.56 Scenario 2 (With Debt) Balance Sheet (2007 - With Debt) Liabilities and Shareholder's Equity (000s) Assets (000s) Share Capital 45052.00 Cash and Cash Equivalents Reserves and Surplus 221871.67 Debt 50000.00 Accounts Receivable Accounts Payable 31936.00 Inventory Accrued Liabilities 27761.00 Other Current Assets Taxes Payable 16884.00 Property, Plant and Equipment Other Liabilities 4814.00 Goodwill Deferred Taxes 22495.00 Other Assets 48781.00 54874.00 5157.00 164920.51 38281.00 39973.00 Total Liabilities and Equity 420813.67 420813.67 Total Assets Value of Equity = Share Capital + Reserves and Surplus Value of Equity (000s) 3.5. Share Capital + Reserves and Surplus 266923.67 Value of Debt Value of Debt (000s) 50000 68827.16 3.6. Calculating Weighted Average Cost of Capital Weighted Average Cost of Capital Equity/TA Debt/TA RWACC 0.84 0.16 5.31% Therefore, Cost of Capital for the new proposed model is, RWACC = 5.31% 3.7. Ratios Ratios EPS ($) ROE Interest Coverage Debt Coverage Company's Cost of Capital Without Debt 1.01 11.35% 0 0 5.54% With Debt 1.28 21.65% 20.82 5.25 5.31% Without Debt With Debt 59052.00 45052.00 0.00 3375.00 0.00 10000.00 527247.56 266923.67 These have been calculated using the following data: Current number of shares outstanding (000s) Interest Obligation Principal payment (assuming equal payment over 5 years) (000s) Book Value of Equity 3.8. Calculating Firm Value Assuming stock price remains same at $16.25. Using: Firm Value = Value of Equity + Value of Debt - Cash Balance Firm Value Value of Equity (Market Capitalization) Without Debt With Debt 959596 732095 Value of Debt 0 50000 Cash Balance 279162.80 68827.16 Firm Value 680433.20 713267.84 A repurchase of 14 million shares would reduce the outstanding shares to 450.52 million (Equity and Cash Calculation). The EBIT is adjusted for the interest on debt, interest income and taxes to calculate the net income. The resulting net income is lesser than the net income before the share repurchase decision (without debt component). However, the earnings per share have increased from $1.01 per share to $1.28. Therefore, the repurchase program has allowed the company to earn more income on each dollar of its outstanding equity capital. The return on equity increases to 21.65% from 11.35%. Cost of Capital also decreases from 5.54% to 5.31%. Firm Value also increases by $32.8 million ($680433.2 million to $713267.8 million). The additional debt is not expected to cause any bankruptcy concerns, as the company enjoys a comfortable interest coverage ratio of almost 21 times. Therefore, the repurchase program is expected to improve the company's operating results. 4. As a member of Blaine’s family, would you be in favor of this proposal? Would you be in favor of it as a non- family member? 4.1. Calculating Change in Holdings in the Firm Value Without Debt 59052 With Debt 45052 36612.24 62% 22439.76 36612.24 81.27% 8439.76 Promoter's POV Share of promoters in Firm Value Increase in holdings 421868.58 488199.44 66330.86 Non-Promoter's POV Share of non-promoters in Firm Value Buyback Amount Total Value Increase in Holdings Value per share 258564.62 0 258564.62 112538.49 259000 371538.49 112973.87 13.33 Total number of shares Number of shares held by promoters Percentage held by promoters Remaining number of shares 11.52 From Promoter’s point of view, there is a noted increase in the holdings ($66.33 million). Hence, it is beneficial and they would be in favor of it. From Non-promoter’s point of view, there is an increase in holdings resulting in increased value per share from $11.52 to $13.33. This seems favorable for the short term, but as the percentage of shares held by nonpromoters decreases significantly, they won’t be able to influence future decisions. Hence, the repurchase decision may not be favored by non-promoters if they want to hold the stocks for a long time.