4041
OCTOBER 8, 2009
TEACHING NOTE
TIMOTHY A. LUEHRMAN
JOEL L. HEILPRIN
Blaine Kitchenware, Inc.: Capital Structure
In April 2007, Blaine Kitchenware’s CEO was considering whether to recommend a share
repurchase to the board of directors. Blaine was a mid-size producer of small kitchen appliances sold
primarily in North America. This case uses the possibility of a share repurchase—in essence a pure
capital structure adjustment—to introduce undergraduates and first-year MBA students to basic
capital structure theory. Students apply the static-tradeoff theory of optimal capital structure to
evaluate Blaine’s current capital structure and to formulate a recommendation for changes. Other
topics to be discussed include the effects of leverage on basic financial ratios, the relationship
between excess cash and leverage, and a comparison of dividends and stock repurchases. The case
may be taught in an 80- or 90-minute class as a first case on capital structure. It presumes familiarity
with basic financial statement analysis and works best if students are already familiar with Miller-
Modigliani Proposition 1 and the static-tradeoff theory of capital structure.1
A Specific Proposal
The case itself does not propose a specific repurchase, and instructors may, if they prefer, ask
students to develop their own proposals for discussion in class. However, beginning students will
struggle to develop a proposal on their own and have an even harder time defending it in class. It is
generally more productive with such students to set forth a specific proposal in the assignment
questions and ask them to analyze and critique it from Victor Dubinski’s perspective. The proposal
sketched in the assignment questions below is to have Blaine borrow $50 million at an interest rate of
6.75%, and to use the loan proceeds plus $209 million of its cash and securities to purchase (in a self-
tender) 14 million shares at $18.50 per share. Given just over 59 million shares outstanding and a
current stock price of $16.25, the proposal involves paying a 13.8% premium to buy back 23.7% of the
1 Blaine’s excess cash and the treatment of it as a non operating asset and “negative debt” may confuse some beginning
students; some instructors may wish to introduce this topic briefly in a session prior to the Blaine case.
,4041 | Teaching Note—Blaine Kitchenware, Inc.: Capital Structure
outstanding shares. The proposal is not meant to represent a “typical” self-tender—the premium is
low and the size is arguably sub-optimal—but rather a simple way to start a discussion.
The instructor may begin the class by sketching this proposal on the board and asking how many
students are in favor of it. Generally, very few students are supportive, for a variety of reasons
including these: the repo is too large, the premium is too large, the business is too risky, the
acquisition program is jeopardized, etc. None of these arguments should be analyzed closely at first,
but it is very helpful to have the students be skeptical of the proposal and to elicit the flavor of their
arguments against it. [Indeed, if the instructor discovers a majority of students are in favor of it, he or
she should modify the assignment questions the next time the case is taught, to make the dollar size
of the repo, and/or the premium offered, even larger.]
Financial Statement Analyses
The discussion should proceed next to some simple financial analyses. [“I can see you are mostly
against this idea, but let’s make sure we understand it.”] First, what effect does the proposal have on
Blaine’s balance sheet? There are three effects: Cash goes down by $209 million; debt goes up by $50
million; and equity goes down by $259 million. The net change on both sides of the balance sheet is
–$209 million. It is essential that students grasp this basic set of changes in the balance sheet. The
first part of TN Exhibit 1 shows Blaine’s EOY 2006 balance sheet before giving effect to the
repurchase but after accounts have been rearranged to isolate cash and operations on the left side and
“other” items have been netted. The rearranged balance sheet reveals Blaine’s basic capital structure
very starkly: it is an all-equity kitchenware firm with lots of excess cash. The other side of TN
Exhibit 1 shows the effects of the proposed repo as just discussed.
Once the balance sheet is understood, the instructor should ask about other effects of the repo.
How is leverage affected? No matter how students choose to measure it, leverage increases. Any
familiar balance sheet ratio (Debt/Equity, Debt/Capital, Liabilities/Assets, etc.) proposed by
students will show an increase in leverage. At this point, no one is likely to have considered BKI’s
large cash balance as “negative debt,” and this is fine for now. More important, students do need to
grasp that a “pure” share repurchase—in which shares are repurchased either by reducing cash-on-
hand or using proceeds from new borrowing and nothing else changes—is always and only a change in
capital structure. More specifically, it is an increase in leverage. The instructor may wish to point out,
or elicit, the point from students—that the effect of the repurchase on Blaine’s balance sheet is
equivalent to an extraordinary dividend (assuming the same financing from cash and debt).
Because the proposed repo strikes students as very large, the instructor should ask whether
Blaine’s pro forma leverage ratios are unreasonable. Using figures from TN Exhibit 1, we have a
post-repo debt/equity ratio of 22% and debt/capital is 18% (based on the modified historical balance
sheet). These do not seem unreasonable on their face, nor in comparison with the peers shown in
case Exhibit 3. Pursuing the point further, the instructor may ask about Blaine’s pro forma coverage
ratio. Annual interest on the new debt is $50 million x 6.75% = $3.375 million (shown in TN Exhibit
2). By comparison, 2006 EBIT is $63.9 million, implying pro forma interest coverage of nearly 19x!
Surely this is adequate? Many students become uncomfortable at about this point and lose their taste
for arguing against the repo. However, someone (still skeptical) will surely point out that 2006 was a
good year for Blaine and that coverage will not look nearly so good in a tough recession such as, for
example, that of 2008–2009.
Having broached coverage ratios, the discussion should proceed to a pro forma income statement,
shown in TN Exhibit 2. Students should be able to calculate the effect on 2006 results assuming the
repurchase had already been executed. EBIT is unchanged at $63.95 million; other income is zeroed
out because the excess cash is gone; interest expense is now $3.38 million. This yields pro forma
2 BRIEFCASES | HARVARD BUSINESS SCHOOL
, Teaching Note—Blaine Kitchenware, Inc.: Capital Structure | 4041
taxable income of $60.57 million as compared to the actual figure of $77.45 million, and net income
falls from $53.63 million to $41.94 million. Though net income falls due to the repo, earnings per
share rise from $0.91 to $0.93.2 Similarly, the repo boosts Blaine’s return on equity close to 18%, still
below the mean for the peers given in the case, but close to the peers’ median of 19% and much
higher than Blaine’s actual 2006 ROE of 11%.3
Another consideration mentioned in the case is the effect of a repurchase on the family’s control of
BKI. The family’s stake was diluted by the IPO in 1994, and has been further diluted more recently
by the issuance of shares to help finance acquisitions. In April of 2007, the family and associated
trusts still control BKI with an approximate 62% stake. However, it is possible that some family
members would tender into an offer of $18.50 per share, which could further reduce family control.
Even so, those who do not tender will see their percentage ownership rise. A holder of 10% of the pre-
repo shares, for example, will own 13.1% of the company following the repo. Similarly, given 62%
collective family ownership in 2006, if none of the members or associated trusts tendered, their
percentage ownership would increase to roughly 81%.
M-M Conditions and Proposition 1
Though the family may like the increased control, it does not necessarily make Blaine more
valuable (nor do the increases in EPS and ROE, necessarily—since the riskiness of the equity rises
with the increased leverage). Can we be confident that the proposed repo creates value?
TN Exhibit 1 is a good way to check students’ understanding of M-M Proposition 1—that
leverage does not affect firm value. By showing the effect of the proposed repurchase on BKI’s
balance sheet, TN Exhibit 1 also shows the absence of an effect on Blaine’s operations. The instructor
may ask, “After the repurchase, will Blaine have fewer/greater/different products? Different plants?
Customers? Patents?” If necessary, the instructor may ask students to imagine a homeowner who
has just refinanced a house worth $500K. In the refinancing, the owner took cash out and reduced
her equity from 40% to 20% (by taking out a larger loan). What happened to the value of the house?
Nothing—it is still the exact same house worth $500K. Students may point out that the homeowner
now has a larger loan and presumably larger monthly mortgage payments and tax deductions. The
instructor may use the point to move the discussion to the next topic—interest tax shields.4
Interest Tax Shields
The first of the M-M conditions to relax is the assumption of no taxes. BKI is a taxpayer and the
repurchase unambiguously reduces Blaine’s corporate taxes. The instructor should ask students to
quantify the tax savings. Most students will respond that the savings equal the interest deduction,
$3.375 million, times the tax rate of 30.8%, which equals $1.04 million.5 Capitalized as a perpetuity at
the cost of debt of 6.75%, this represents a present value of $15.4 million.6 However, on a per-share
basis, this is only about $0.26 per share ($15.4/59.052 = $0.26), which is far less than the premium
being offered in the proposed repo.
2 Some students are surprised that the rise in EPS is so modest. It is sensitive to the size of the premium paid for the
repurchased shares. In addition, the EPS figures in the text are computed based on average shares outstanding, rather than
end-of-period. The rise in ROE, computed based on end-of-year book equity, is more impressive.
3 For convenience, ROE figures are computed using end-of year equity, both in the text above and the table shown in the case.
4 The authors are grateful to a reviewer for suggesting this example and line of questioning.
5 A strong argument can be made for using Blaine’s marginal tax rate of 40%, rather than the effective rate, which would boost
all the following estimates of the present value of interest tax shields. Lacking information about Blaine’s overall tax situation,
many students will use 2006’s 30.8%.
6 The same $15.4 million may be computed as PV(tax shields) = ΔDt = $50.0(0.308) = $15.4.
HARVARD BUSINESS SCHOOL | BRIEFCASES 3
OCTOBER 8, 2009
TEACHING NOTE
TIMOTHY A. LUEHRMAN
JOEL L. HEILPRIN
Blaine Kitchenware, Inc.: Capital Structure
In April 2007, Blaine Kitchenware’s CEO was considering whether to recommend a share
repurchase to the board of directors. Blaine was a mid-size producer of small kitchen appliances sold
primarily in North America. This case uses the possibility of a share repurchase—in essence a pure
capital structure adjustment—to introduce undergraduates and first-year MBA students to basic
capital structure theory. Students apply the static-tradeoff theory of optimal capital structure to
evaluate Blaine’s current capital structure and to formulate a recommendation for changes. Other
topics to be discussed include the effects of leverage on basic financial ratios, the relationship
between excess cash and leverage, and a comparison of dividends and stock repurchases. The case
may be taught in an 80- or 90-minute class as a first case on capital structure. It presumes familiarity
with basic financial statement analysis and works best if students are already familiar with Miller-
Modigliani Proposition 1 and the static-tradeoff theory of capital structure.1
A Specific Proposal
The case itself does not propose a specific repurchase, and instructors may, if they prefer, ask
students to develop their own proposals for discussion in class. However, beginning students will
struggle to develop a proposal on their own and have an even harder time defending it in class. It is
generally more productive with such students to set forth a specific proposal in the assignment
questions and ask them to analyze and critique it from Victor Dubinski’s perspective. The proposal
sketched in the assignment questions below is to have Blaine borrow $50 million at an interest rate of
6.75%, and to use the loan proceeds plus $209 million of its cash and securities to purchase (in a self-
tender) 14 million shares at $18.50 per share. Given just over 59 million shares outstanding and a
current stock price of $16.25, the proposal involves paying a 13.8% premium to buy back 23.7% of the
1 Blaine’s excess cash and the treatment of it as a non operating asset and “negative debt” may confuse some beginning
students; some instructors may wish to introduce this topic briefly in a session prior to the Blaine case.
,4041 | Teaching Note—Blaine Kitchenware, Inc.: Capital Structure
outstanding shares. The proposal is not meant to represent a “typical” self-tender—the premium is
low and the size is arguably sub-optimal—but rather a simple way to start a discussion.
The instructor may begin the class by sketching this proposal on the board and asking how many
students are in favor of it. Generally, very few students are supportive, for a variety of reasons
including these: the repo is too large, the premium is too large, the business is too risky, the
acquisition program is jeopardized, etc. None of these arguments should be analyzed closely at first,
but it is very helpful to have the students be skeptical of the proposal and to elicit the flavor of their
arguments against it. [Indeed, if the instructor discovers a majority of students are in favor of it, he or
she should modify the assignment questions the next time the case is taught, to make the dollar size
of the repo, and/or the premium offered, even larger.]
Financial Statement Analyses
The discussion should proceed next to some simple financial analyses. [“I can see you are mostly
against this idea, but let’s make sure we understand it.”] First, what effect does the proposal have on
Blaine’s balance sheet? There are three effects: Cash goes down by $209 million; debt goes up by $50
million; and equity goes down by $259 million. The net change on both sides of the balance sheet is
–$209 million. It is essential that students grasp this basic set of changes in the balance sheet. The
first part of TN Exhibit 1 shows Blaine’s EOY 2006 balance sheet before giving effect to the
repurchase but after accounts have been rearranged to isolate cash and operations on the left side and
“other” items have been netted. The rearranged balance sheet reveals Blaine’s basic capital structure
very starkly: it is an all-equity kitchenware firm with lots of excess cash. The other side of TN
Exhibit 1 shows the effects of the proposed repo as just discussed.
Once the balance sheet is understood, the instructor should ask about other effects of the repo.
How is leverage affected? No matter how students choose to measure it, leverage increases. Any
familiar balance sheet ratio (Debt/Equity, Debt/Capital, Liabilities/Assets, etc.) proposed by
students will show an increase in leverage. At this point, no one is likely to have considered BKI’s
large cash balance as “negative debt,” and this is fine for now. More important, students do need to
grasp that a “pure” share repurchase—in which shares are repurchased either by reducing cash-on-
hand or using proceeds from new borrowing and nothing else changes—is always and only a change in
capital structure. More specifically, it is an increase in leverage. The instructor may wish to point out,
or elicit, the point from students—that the effect of the repurchase on Blaine’s balance sheet is
equivalent to an extraordinary dividend (assuming the same financing from cash and debt).
Because the proposed repo strikes students as very large, the instructor should ask whether
Blaine’s pro forma leverage ratios are unreasonable. Using figures from TN Exhibit 1, we have a
post-repo debt/equity ratio of 22% and debt/capital is 18% (based on the modified historical balance
sheet). These do not seem unreasonable on their face, nor in comparison with the peers shown in
case Exhibit 3. Pursuing the point further, the instructor may ask about Blaine’s pro forma coverage
ratio. Annual interest on the new debt is $50 million x 6.75% = $3.375 million (shown in TN Exhibit
2). By comparison, 2006 EBIT is $63.9 million, implying pro forma interest coverage of nearly 19x!
Surely this is adequate? Many students become uncomfortable at about this point and lose their taste
for arguing against the repo. However, someone (still skeptical) will surely point out that 2006 was a
good year for Blaine and that coverage will not look nearly so good in a tough recession such as, for
example, that of 2008–2009.
Having broached coverage ratios, the discussion should proceed to a pro forma income statement,
shown in TN Exhibit 2. Students should be able to calculate the effect on 2006 results assuming the
repurchase had already been executed. EBIT is unchanged at $63.95 million; other income is zeroed
out because the excess cash is gone; interest expense is now $3.38 million. This yields pro forma
2 BRIEFCASES | HARVARD BUSINESS SCHOOL
, Teaching Note—Blaine Kitchenware, Inc.: Capital Structure | 4041
taxable income of $60.57 million as compared to the actual figure of $77.45 million, and net income
falls from $53.63 million to $41.94 million. Though net income falls due to the repo, earnings per
share rise from $0.91 to $0.93.2 Similarly, the repo boosts Blaine’s return on equity close to 18%, still
below the mean for the peers given in the case, but close to the peers’ median of 19% and much
higher than Blaine’s actual 2006 ROE of 11%.3
Another consideration mentioned in the case is the effect of a repurchase on the family’s control of
BKI. The family’s stake was diluted by the IPO in 1994, and has been further diluted more recently
by the issuance of shares to help finance acquisitions. In April of 2007, the family and associated
trusts still control BKI with an approximate 62% stake. However, it is possible that some family
members would tender into an offer of $18.50 per share, which could further reduce family control.
Even so, those who do not tender will see their percentage ownership rise. A holder of 10% of the pre-
repo shares, for example, will own 13.1% of the company following the repo. Similarly, given 62%
collective family ownership in 2006, if none of the members or associated trusts tendered, their
percentage ownership would increase to roughly 81%.
M-M Conditions and Proposition 1
Though the family may like the increased control, it does not necessarily make Blaine more
valuable (nor do the increases in EPS and ROE, necessarily—since the riskiness of the equity rises
with the increased leverage). Can we be confident that the proposed repo creates value?
TN Exhibit 1 is a good way to check students’ understanding of M-M Proposition 1—that
leverage does not affect firm value. By showing the effect of the proposed repurchase on BKI’s
balance sheet, TN Exhibit 1 also shows the absence of an effect on Blaine’s operations. The instructor
may ask, “After the repurchase, will Blaine have fewer/greater/different products? Different plants?
Customers? Patents?” If necessary, the instructor may ask students to imagine a homeowner who
has just refinanced a house worth $500K. In the refinancing, the owner took cash out and reduced
her equity from 40% to 20% (by taking out a larger loan). What happened to the value of the house?
Nothing—it is still the exact same house worth $500K. Students may point out that the homeowner
now has a larger loan and presumably larger monthly mortgage payments and tax deductions. The
instructor may use the point to move the discussion to the next topic—interest tax shields.4
Interest Tax Shields
The first of the M-M conditions to relax is the assumption of no taxes. BKI is a taxpayer and the
repurchase unambiguously reduces Blaine’s corporate taxes. The instructor should ask students to
quantify the tax savings. Most students will respond that the savings equal the interest deduction,
$3.375 million, times the tax rate of 30.8%, which equals $1.04 million.5 Capitalized as a perpetuity at
the cost of debt of 6.75%, this represents a present value of $15.4 million.6 However, on a per-share
basis, this is only about $0.26 per share ($15.4/59.052 = $0.26), which is far less than the premium
being offered in the proposed repo.
2 Some students are surprised that the rise in EPS is so modest. It is sensitive to the size of the premium paid for the
repurchased shares. In addition, the EPS figures in the text are computed based on average shares outstanding, rather than
end-of-period. The rise in ROE, computed based on end-of-year book equity, is more impressive.
3 For convenience, ROE figures are computed using end-of year equity, both in the text above and the table shown in the case.
4 The authors are grateful to a reviewer for suggesting this example and line of questioning.
5 A strong argument can be made for using Blaine’s marginal tax rate of 40%, rather than the effective rate, which would boost
all the following estimates of the present value of interest tax shields. Lacking information about Blaine’s overall tax situation,
many students will use 2006’s 30.8%.
6 The same $15.4 million may be computed as PV(tax shields) = ΔDt = $50.0(0.308) = $15.4.
HARVARD BUSINESS SCHOOL | BRIEFCASES 3
