Bed, Bath & Beyond: The Capital Structure Decision

Advanced Corporate Finance

September 15
th
, 2014




















Short introduction:

BBBY was founded in 1971 by Warren Eisenberg and Leonard Feinstein. At first they opened
two specialty stores. In 1985 the company opened the first superstore. With some good
strategies BBBY differed from its competitors. The main factors were: Good customer
experience leading to high store productivity, decentralized store control, high margins and
low cost structure.

Question 1
D= Debt Interest rate=4.50%
E= Shareholders equity Corporate tax rate=38.50%
Excess cash($)= 400,000() Perpetual debt policy

Scenario 1 (35%) :

(D+E) ($)=1,990,820()-400,000=1,590,820
D/1,590,820=0.35
D($)=556,787
E($)=1,034,033

Rate for interest income is 10,202()/866,595()1,1773%
Interest income($)=866,595-400,00=466,595-
Interest expense($)=4.5%556,787=25,055
Operating profit($) 639,343
Interest income($) +5,493
EBIT($) = 644,836
Interest expense($) +(25,055)
Profit before taxes($) =619,781
(PV) tax shield($)=619,78138.50%=238,616
Scenario 2 (85%) :
(D+E) ($)=1,990,820-400,000=1,590,820
D/1,590,820=0.85
D($)=1,352,197
E($)=238,623

Rate for interest income is 10,202/866,5951,1773%
Interest income($)=866,595-400,00=466,595-
Interest expense($)=4.5%1,352,197=60,849
Operating profit($) 639,343
Interest income($) +5,493
EBIT($) =644,836
Interest expense($) +(60,849)
Profit before taxes($) =583,987
(PV) tax shield($)=583,98738.50%=224,835


() $ are in thousands
()See Exhibit 8 for the values
Question 2
Scenario 1 (35%)
In the previous question we found that the profit before taxes was $619,781.
The taxes are 38,5%, so 0,385*619,781= 238,616

Profit before taxes 619,781
Taxes -238,616
Profit after tax = 381,165

The cash and equivalents are calculated using the actual value
3
minus the $400 million cash.
The total debt is calculated in the previous question.
The total repurchase amount is calculated by adding the $400 million cash to the total debt.
The Shareholders equity is calculated by using the actual value
3
minus the total repurchase amount.

Cash and equivalents 466,595
Total debt 556,787
Total repurchase amount 956,787
Shareholders equity 1,034,033

The common stock price is given at $37, so the amount of shares that can be repurchased is the total
repurchase amount/the common stock price= 956,787/37= 25859.
New amount of shares outstanding 296854-25859= 270995
The new share price is: share price old+ PV Tax shield/outstanding shares
So 37+ 238,616/270995= $37.88
Scenario 2 (85%)
In the previous question we found that the profit before taxes was $1,352,197.
The taxes are 38,5%, so 0,385*1,352,197= 224,835

Profit before taxes 1,352,197
Taxes -224,835
Profit after tax = 359,152

The cash and equivalents are calculated using the actual value
3
minus the $400 million cash.
The total debt is calculated in the previous question.
The total repurchase amount is calculated by adding the $400 million cash to the total debt.
The Shareholders equity is calculated by using the actual value
3
minus the total repurchase amount.

Cash and equivalents 466,595
Total debt 1,352,197
Total repurchase amount 1,752,197
Shareholders equity 238,623

The common stock price is given at $37, so the amount of shares that can be repurchased
is the total repurchase amount/the common stock price= 1,752,197/37= 47357.
New amount of shares outstanding 296854-25859= 268845
The new share price is: share price old+ PV Tax shield/outstanding shares
So 37+ 224,835/249497= $37.90
(3) See Exhibit 8 for the values

Question 3).

BBBY had no long term debt on its balance sheet. BBBY stated its intention to use internally
generated funds to finance its expansion. They didn't pay dividends. It was estimated that
BBBY cash balance was $400 million higher than its ongoing requirements for growth and
operations.

Is a lot of cash a good thing?
Lots of cash can signal many things, good or bad. Each company has its own right amount of
cash level. A company must have enough cash to cover all their interests, capital
expenditures and expenses. Sometimes a bit more for emergencies. All the extra cash should
be going to the shareholders, like dividends or in BBBY's case through a share repurchase.

Large cash balance reduces shareholders value because they create reduced return on
capital.

Calculations (exhibit 8):

net income (actual)= 399,470
shares outstanding (basic; actual)= 296,854
net earning per share (basic)= 399,470/296,854= 1,35
stock price= 37
market value of stock= 296,854*37= 10,983,598

net income (pro forma)= 378,964
shares outstanding (pro forma)= 268,845
net earning per share (pro forma)= 378,964/268,845= 1,41
stock price (pro forma)= 1,036,328/28,009= 37
market value of stock (pro forma)= 268,845*37=9,947,265

The EPS increases (1,35 to 1,41).
The stock price stayed the same, 37. So the market value decreases (10,983,598 to
9,947,265).

The optimal capital structure:

The best debt to equity ratio that maximizes the value of the company.
E= 954,492
D= 636,328
Re=20,1% Rd= 4,5% ??
Wacc = E/E+D * Re + D/E+D * Rd
Wacc= 0.6*20.1% + 0.4*4.5% = 13.86% (this is with Pro forma 40% debt)

with 80% debt:

wacc stays the same, 13,86%. And total of debt and equity also the same.

D=1,270,000
E= 320820

Re= 13,86% + 1,270,000/320820 *(13,86-4,5) = 51%
Rd= 4,5%

If BBBY increases the amount of debt, the return on equity increases as well.


Question 4


According to exhibit 7A, S&P estimates a corporations bond rating by using a number of
key ratios, the most important being EBIT interest coverage. If BBBY were to use its
$400 million in excess cash to buy back shares, and were to lever up to a debt to capital
ratio of 35%, the values of debt D and equity E would be as follows:
( )
( )
The amount of interest due on debt, assuming BBBYs cost of debt remains 4.5%, would
then be:

The EBIT interest coverage (using S&Ps formula provided in exhibit 7B) is:

BBBYs return on capital (again, using the formula provided by S&P in exhibit 7B and data
taken from the balance sheet in exhibit 2) is:

( )

When comparing these values to the S&Ps key median figures in exhibit 7A, it can be
concluded that BBBYs EBIT interest coverage firmly indicates a AAA bond rating, being
25.28 compared to a AAA median of 23.4. However, return on capital is significantly lower
than the AAA bond median of 35.0, and is closer to an AA rating. Since BBBY has an
abnormally large profit margin it would be more prudent to estimate an AA bond rating in
the case of a 35% debt to capital ratio.
In the case of BBBY levering up to a debt to capital ratio of 85%, debt D and equity E
would become the following:
( )
( )
The amount of interest due on debt, still assuming BBBYs cost of debt remains 4.5%,
would then be:

The EBIT interest coverage (using S&Ps formula provided in exhibit 7B) is:

BBBYs return on capital remains the same at:

( )

These values, when compared to the median key ratios in exhibit 7A, would indicate a bond
rating between AA and A for BBBY.
Levering up increases interest expenses and therefore has an effect on BBBYs EBIT
interest coverage. The companys credit rating deteriorates, but not by much. This is
mainly due to a large profit margin and strong return on capital.
Not taking financial distress costs into account, the value of the firm will be at a maximum
when the value of the interest tax shield is maximized. Assuming the firm will keep on the
new debt permanently, and assuming an AA rating in the case of a 35% debt to capital ratio,
and an A rating in the case of 85% debt to capital ratio, BBBYs interest payments will be:


Since the debt is permanent, the PV of the tax shield can be calculated as a perpetuity:
()
Obviously, the interest tax shield because more valuable as more debt is taken on.
Therefore, not taking financial distress costs or agency costs into account, 85% would be
the preferred debt to capital ratio. Under this ratio, the PV of the interest tax shield will
be:

Therefore, the new market value of the levered firm will be:

Since the benefit of the tax shield will be noted by investors, share price will immediately
rise before the repurchase to:

Therefore, the amount of stock that BBBY can repurchase is:

Question 5

There are risks involved when a company is issuing too much debt. If the leverage ratio
falls below a certain percentage, rating firms could downgrade the bond rating. If the bond
has a relative low risk of default, the rating is considered investment grade. If the bond has
a relative high risk of default the rating is considered non-investment grade. If BBBYs
credit rating falls below investment grade, it will face bankruptcy costs, so it has to avoid
getting a low credit rating.
The investment grade for Standard & Poors are the credit ratings AAA, AA, A and BBB.
Non-investment grade are BB, B, CCC, CC, C, R, SD, D and NR.
The optimal leverage ratio for BBBY is 0.47, as Standard & Poors will still give an BBB-
rating.
Shareholders equity $1,990,820
Leverage ratio 0.47
Maximum amount of debt

Share price March 1, 2014 $41.01
Number of shares purchasable

Shareholders equity was $1,990,820 in February 2004. A leverage ratio of 0.47 implies
that BBBY could issue debt of 47% over $1,990,820. Total debt would then be $935,685.
Considering a stock price at March 1, 2014 of $41.01, the amount of shares BBBY could
repurchase is 22,816.
Although the leverage ratio for Standard & Poors credit rating BBB is 0.47, it may keep
their status of investment grade if it falls below this number, when other ratios are far
above BBB-rating. On the other hand, if other ratios are worse than BBB, the leverage
ratio may have to be A-rating or above.
To perform a sensitivity analysis, we calculated to amount of shares it can repurchase with
a leverage ratio for an A-rating and for a BB-rating.
A-rating
Leverage ratio = 0.426
Maximum amount of debt = $848,089
Maximum amount of shares = 20,680
BB-rating
Leverage ratio = 0.577
Maximum amount of debt = $1,148,703
Maximum amount of shares = 28,010