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• justin_zelin

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Question 1:

Do you believe Blaine’s current capital structure and payout policies are appropriate? Why or why not? First, Blaine Kitchenware Inc’s current capital structure is not efficient. The incentive for any public company and Board of Directors should be the increase the value of firm through projects, increased earnings per share value, and the lowering of costs. One way many firm’s effectively increase the value of the firm is to minimize the weighted average cost of capital. The weighted average cost of capital is the costs of a firm in the form of debt and equity. Since Blaine Kitchenware is a public company and issues shares, they have an established capital structure model. In 2006, Blain Kitchenware incurred no debt thus taking on one hundred percent of equity in their capital structure. By taking on no debt, the value of the firm is unlevered and the firm does not gain the advantage of the interest tax shield. It is because Blaine Kitchenware Inc has chose to finance projects by the selling of shares and has not made use of debt issuance that the firm’s value is not fully maximized and the weighted average cost of capital is not minimized. If Blaine Kitchenware Inc took on debt, the value of the firm would rise and shareholders would benefit more as the firm would have the interest tax shield as in Exhibit 11. Our advice would alter the amounts in both debt and equity (thus leaving the firm’s assets unchanged ) such that they use the financing from the debt to purchase their company’s shares back. As the firm incurs more debt, they take on the payment of interest. This payment of interest lowers both the firm’s taxable income and their amount paid due to taxes. After deducting the necessary 1 The difference between the unlevered payment to shareholders and levered payment to shareholders and bondholders is the interest tax shield. In principal, the interest tax shield is the tax saving attained by a firm from interest expense.

depreciation amounts, changes to net working capital, and capital spending, the total amount paid to shareholders and bondholders would be greater (whereas the current situation, the bondholders are not being paid at all as they do not currently exist). The more debt a firm uses, the lower the weighted average cost of capital. This is because the higher the debt-to-equity ratio, the lower the weighted average cost of capital as shown in Exhibit 2. This notion suggests the optimal choice of capital structure composition is to choose one hundred percent debt as the more debt the firm takes on, the higher the value of the firm becomes due to the value of the tax shield. However, this is not the case. At low levels of debt, the probability of bankruptcy and financial distress is low, and the benefit from debt outweighs the cost. On the other hand, at high levels of debt, the possibility of financial distress is an ongoing problem for the firm so the benefit from debt may be more than offset by the financial distress costs. The key is to choose a level of debt between these extremes, a notion more distinguished by the static theory of capital structure. The static theory of capital structure says that a firm borrows 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 which is illustrated in Exhibit 3. The key thing we derive from Exhibit 3 is that there is the theoretical value of the firm (measured by the value of the unlevered firm plus the product of corporate tax and the amount debt) and the actual value of the firm. The actual value of the firm reaches a climax then quickly begins to decline further below the value of an unlevered firm. This is where Blaine Kitchenware needs to be very careful in choosing the amount of debt to take on.

The convincing of the Board of Directors to take part in debt financing stands as the problem now. Although the static theory of capital structure provides the assurance that the value of the firm will increase by taking on enough debt to maximize the value of the interest tax shield, 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. However, if the members of the Board disagree to the issuance of debt, the shareholders can adjust the amount of financial leverage by borrowing and lending on their own (homemade leverage). Overall, the benefit of taking on debt outweighs the circumstances of not taking on debt (although being more risky). Blaine Kitchenware Inc will have to calculate the minimum earnings before interest and taxes required to take full advantage of debt financing where both the weighted average cost of capital will be minimized, the value of the firm will be maximized, and earnings per share will be increased as demonstrated in Exhibit 4.

Exhibit 1: Value of Firm Relative to Debt and Taxes

Value of Firm

Value of Levere d Firm

Interest Tax Shield

Value of Unlevere d Firm

Total Debt

Chosen amount of Debt

Exhibit 2: The Cost of Equity and the Weighted Average Cost of Capital with Taxes

Cost of Capital (%)

Re

Ru WACC Rd x (1 – Tc)

Debt/Equity Ratio

“Re” is the Cost of Equity: the return that equity investors require on their investment in a firm. “Ru” is the Unlevered Cost of Capital: the cost of capital of a firm with no debt. “WACC” is the Weighted Average Cost of Capital: the weighted average costs of debt and equity. “Rd x (1-Tc)” measures the interest tax shield rate. We use this rate to multiple with amount of debt in a firm’s capital structure.

Exhibit 3: The Static Theory of Capital Structure

Value of Firm

Financial Distress

Max Firm Value

Value of Unlevere d Firm

Present Value of Tax Shield

Optimal Amount of Debt

Actual Firm Value

Total Debt

Exhibit 4: Financial Leverage, EBIT, and EPS

EPS

Advantage of Debt

With Debt

Without Debt

EBIT Required Disadvant age of Debt

The use of debt does not provide benefit to earnings per share until the EBIT passes the indifference point (the blue circle). The indifference point illustrates the point of required EBIT before the EPS grows faster than without debt. When taking on debt,

the minimum required amount of EBIT is at this point. If forecasted EBIT does not exceed this amount it is not beneficial to shareholders to take on debt (EPS will suffer).