Case 2

Mr Dubinski is the CEO of Blaine Kitchenware, Inc. (BKI). BKIs shareholders are mostly
family members descended from the firms founders. The interests of the family are strongly
represented at Blaines board. A private equity group wants to takeover BKI by buying the
firms common stock. The family does not want to lose control over the company. A banker
suggested to Dubinski that BKI could borrow money to buy back most of the outstanding
shares themselves and pay off the debt over time with future earnings. Dubinski now has to
make a decision. This paper examines the current capital structure of BKI, the advantages
and disadvantages of a repurchase, the changes in the capital structure after a repurchase
of 14 million shares and the perspective of the shareholders on the repurchase.

In 1994 BKI completed an IPO after which the family owned 62% of the shares outstanding.
BKI has already paid for all the acquisitions either in cash or in stock. The company has no
long term debt and they have a large amount of cash and cash equivalents. BKI is currently
over-liquid and under-levered. Their capital structure is not appropriate, because it causes
unnecessary costs. The excess of capital decreases the efficiency of its leverage. BKI does
not entirely use their funds to invest. Since they are equity-financed and do not have debt,
there is no tax shield. The lack of a tax shield increases the cost of capital. Which comes at
the cost of the shareholders. BKIs payout policies are not appropriate as well, because a
surplus of capital also lowers the return on equity. The shareholders get a lower dividend.
Their payout policy was 11% per year while shareholders of other firms within the same
industry earned 16%. This makes other corporations within the industry more attractive.
However, the main policy of BKI is to maximize the value of the shares and not high
dividends. To maintain this policy and keep shareholders satisfied BKI can reduce the
amount of shares by repurchasing their own shares.

A repurchase of shares has its advantages and disadvantages. An advantage can be a

lower cost of capital due to the use of the tax-shield. An increase in the amount of debt can
affect the capital structure in a way where the amount of taxed income will be lower.
Furthermore, the return on equity per share will increase. Return on equity is calculated by
net income divided by shareholders equity. The shareholders equity decreases, because the
amount of shares decreases. This means that the net income is divided by a smaller number
which will generate a higher return.
A disadvantage of repurchasing shares can be financial distress, because the amount of
long term debt increases. Second, the timing of the purchase. Although stock prices
increase initially, the price may come down on the moment the repurchase is finalized,
meaning that the company may pay too much for their own shares.
Taking these advantages and disadvantages into account, Dubinski should recommend a
large share repurchase to Blains board. The asset beta will decrease because Ra is
decreasing. When the Beta becomes less than one, it means that the security is less volatile
than the market which is a positive outcome for BKI. Besides, Blains board consists mostly
of family members. The family wants to keep control over the company and by the stock
repurchase the family will own relative more shares. This means their control over the
corporation will increase. However, if the control of the family increases, this means that the
control of the other shareholder decreases.
The proposed repurchase of buying 14 million shares back would affect BKI in several ways.
As the calculations show, BKI will benefit from the repurchase. First, the return on equity.
The return on equity shows how much profit a firm makes with the money that was invested
by the equityholders. What might happen if a repurchase occurs is already discussed above.
The expectation is that the return on equity would increase and it did by approximately 1%,
from about 11 % to almost 12%. BKI wanted to repurchase the share, because they were
under-levered and over-liquid. The equity holders did not benefit from the firms equity. After
the repurchase the earnings per share have increased by 8,79% from 0.91 to 0.99. Which
means the investors can benefit more from the companys earnings.
We also expected the cost of capital to decrease because of either the tax shield and lower
cost of debt. Both cost of capital and weighted average cost of capital have decreased by
over 1%. The cost of capital from 17.47% to 16.21% and the weighted average cost of
capital form 17.47% to 15.89%. These calculations show that BKI will benefit from the
repurchase. The earnings per share will increase, while the cost of capital will decrease and
as discussed below, the family will get more ownership. BKI will be less under-levered and
less over-liquid.

When a company is owned mostly by family members, it is important for them to keep an
certain amount of ownership and control. Thus, a member of Blaines controlling family will
be in favor of the repurchase proposal, because the proposal will give the family a larger
percentage of ownership. One main attraction of the repurchase for the family was the
increased ownership. Before the proposal the family owned 62% of the shares. This will be
81% after the repurchase. The increased ownership will give the family more control and will
make it easier for the board to set future dividends.
A shareholder who is not part of Blaines controlling family could be a shareholder who
maintains their share after the repurchase or a shareholder who sells their share. In both
cases they will be in favor of the repurchase proposal, because the earnings per share and
the stock price will increase after the repurchase. This will benefit both groups of
shareholders. It is important, though, for the remaining shareholders to keep in mind that
their control over the company will decrease as the amount of shares they have decreases.

A repurchase of stock for a company should be a well considered decision. Several financial
and non financial factors need to be taken into account and the timing of the stock
repurchase is important. BKI needs a restructure of their capital structure and this paper has
shown that BKI and their shareholders will benefit in several ways from a repurchase. With
all of this in mind, it is recommended for BKI to perform the stock repurchase.