Case Bed, Bath & Beyond Essay

Advance Corporate Finance – Bed Bath and Beyond Case

Questions:
You are BBBY’s CEO, Steven Temares. It is April 2004 and you are about to decide what to do with the company’s excess cash:
– Keep it?
– Pay it out and issue debt?
You structure your analysis by answering the following questions:

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1. What is wrong with building up cash? Provide (at least two) reasons in favor and against keeping cash in the firm.

Against:
By paying out excess cash and issuing debt, BBBY could improve return to equity holders and raise earnings per share (by a share repurchase).

Leverage can increase a firm’s expected earnings per share. An argument is that by doing so, leverage should also increase the firm’s stock price. Because BBBY has no debt, they pay no interest, and because in perfect capital markets there are no taxes, BBBY’s earnings would equal its EBIT. If BBBY has new debt, they will have interest payments each year, so their earnings will decrease (EBIT – interest).

If BBBY uses the debt to repurchase shares, the number of outstanding shares will also fall. Because of this, the earnings per share can increase with leverage. This increase might appear to make shareholders better off and could potentially lead to an increase in the stock price. Besides this, BBBY faces the risk that the firm is not attracting investors. Investors want to maximize their returns and when the firm has a lot of cash, the investors may not be sure of the ability of BBBY to maximize the shareholder value. Another positive point about debt is the tax deduction.

In favor:
-Leverage increases the risk of equity even when there’s no risk that the firm will default. Thus, while debt may be cheaper when considered on its own, it raises the cost of capital for equity. -Cash can be a buffer in tough times.

-When a firm has a lot of cash, there is more money available to invest. As you can read in the case, BBBY invests in a lot of new shops and when they have a lot of cash, they can react quickly when there is an investment opportunity.

Consider the case in which BBBY uses its $400 million excess cash and borrowed funds (interest rate: 4.5%) in a share repurchase program. Corporate tax is 38.5%. Consider two scenarios for the debt to capital ratio: 40% and 90%.

2. Calculate the present value of tax shield under each scenario. Assume that the company uses a perpetual debt policy.

PV (Interest Tax Shield) = PV (x Future Interest Payments)
= x PV (Future Interest Payments)
= x Total debt

●Scenario with a debt to capital ratio of 40%
We found in exhibit 8 that the debt(D) is $636328
PV(Interest Tax Shield)= x D
= 0.385 x 636328 = $244986.28

You can say that the value of BBBY increases $0.385 for every dollar of new debt.

●Scenario with a debt to capital ratio of 90%
Levered shareholder’s equity= Shareholders equity – Excess cash
= 1990820 – 400000 = $1590820

Total debt = Levered shareholder’s equity x Debt to capital ratio
= 1590820 x 0.9 = $1431738

PV(Interest Tax Shield)= x D
= 0.385 x 1431738 = $551219.13

3a. Estimate the number of shares BBBY can repurchase under each scenario and at what price.

The price for which BBBY can repurchase the differs from the market price of the shares. If they were the same, there would be an arbitrage opportunity.

●Scenario with a debt to capital ratio of 40%
The number of shares BBBY can repurchase is already calculated and can be found in exhibit 8 (28009). The unlevered value can also be found in exhibit 8 (Market value of common stock). For the shares outstanding we used the average shares outstanding(basic) from exhibit 8.

Levered value= Unlevered Value + PV(Interest Tax Shield)
= 10983598 + 244986.28 = $11228584.26

Share price = Levered value / # shares outstanding
= 11228584.26 / 296854 = $37.83
●Scenario with a debt to capital ratio of 90%

Repurchase amount= Total debt + Excess cash
= 1431378 + 400000 = $1831738

Shares repurchased= Repurchase amount / Market value share
= 1831738 / 37 = 49506

Levered value= Unlevered value + PV(Interest Tax Shield)
= 10983598 + 551219.13 = $11534817.13

Share price = Levered value / # shares outstanding
= 11534817.13 / 296854 = $38.86

3b. Evaluate the decision from the perspective of BBBY’s shareholders: does the proposed repurchase program increase shareholder’s value? Provide some calculations to illustrate your answer.

The repurchase program increases the shareholder’s value. This is because of a rise in the price of the shares of the original shareholders.

●Scenario with a debt to capital ratio of 40%
Increase in share price=(11228584.26/296854)-37 = 0.825275253 Total increase in value = 0.825275253*296854 = 244986.26

●Scenario with a debt to capital ratio of 90%
Increase in share price=(11534817.13/296854)-37 = 1.856869471 Total increase in value = 1.856869471*296854 = 551219.13

The answers are both the same as the answers of question 2 (PV of the interest tax shield).

4. For both scenarios, estimate BBBY’s bond rating. Comment: does levering up deteriorate the company’s credit worthiness?
●Scenario with a debt to capital ratio of 40%
In exhibit 7A, we can see the debt to capital ratios for different bond ratings. We estimate the bond rating to be A, because the debt to capital rating for this rating is 42.6%, so this the closest to the 40% ratio of BBBY.

●Scenario with a debt to capital ratio of 90%
We estimate the bond rating to be CCC, because the debt to capital ratio in exhibit 7A for this rating is 91.7%, which is the closest to 90%.

Levering up does worsen the company’s credit worthiness because when the debt increases, the risk also increases. In exhibit 7A you can see that when the debt to capital ratio increases, the key industrial financial ratios worsen.

5. What would be the company’s optimal leverage ratio that would result in an investment grade credit rating? Perform sensitivity analysis with respect to BBBY’s leverage ratio.

In the case that a company gets an investment grade credit rating if the bond rating is in the top four categories, then BBB will be the lowest. The companies optimal leverage ratio would be the ratio which will result in the highest firm value. In this case we have to take a look which ratio maximizes the PV of the tax interest shield. If the firm takes a leverage ratio of 47% then:

This amount is higher than with a ratio of 40%, so the firm value is also higher.

Then if the ratio is 30%:

When the ratio is 30% the tax shield will be lower. A ratio of 47% will maximize the value of the firm under the constraint that the company wants to have an investment grade credit rating. There is no better ratio than 47% because when the ratio is lower the value of the firm won’t be as high as it can be, and when the ratio is higher than 47% the company will have a worse grade of investment. When the ratio is 47% the total interest that is being paid is also lower than the EBIT, so there are no further losses. It is also not possible to take an amount of debt in which the interest expenses equals the EBIT.

6. Make a recommendation to the board of BBBY with regard to the company’s optimal capital structure.

We calculated in question 5, that the optimal ratio is 47%. This is optimal, because it’s maximizes the firms value and the company has still a good investment rating. So our recommendation will be to hold on ratio of 47%.

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