Bed Bath and Beyond: Capital Structure Decision (HBR Case Study)
StockmarketIntroduction Bed Bath & Beyond (BBBY) was founded in 1971 by Warren Eisenberg and Leonard Feinstein. BBBY held its initial public offering in June 1992, on the NASDAQ exchange. The company utilizes the “big box” retail concept and focuses its product offerings around domestics merchandise and home furnishings. Since its IPO BBBY has been favored by equity investors and long considered one of the best performing retail companies. They have never missed an earnings estimate and have experienced a fortyfold increase in stock price from the original $17 per share IPO. The company introduced its ? rst superstore in 1985 and have since underwent large scale expansion operating 575 stores by the end of the ? scal year 2003. BBBY also owned and operated 30 Harmon stores and 24 Christmas Tree Shops stores by 2003. (See appendix four for SWOT analysis) The Problem Bed Bath & Beyond has always conducted business under the old fashioned premise that “cash is king, and debt is bad”. As of late their capital structure has become a big issue amongst investors. They are concerned that the current unlevered structure is not maximizing value and are wary of the risks associated with the companies large and growing cash balances.
Currently BBBY is facing the issue of trying to decide wether their current capital structure is optimal moving into the future, and if not, what decisions they need to make to achieve optimization. The following analysis will outline the key factors in? uencing this decision and ultimately suggest a course of action. Case 2: Bed Bath & Beyond page | 1 Case Analysis Capital Structure BBBY? s capital structure is not optimal, as BBBY has a large cash position and they do not issue any debt nor do they pay any dividends during their operation. M&M proposition I states that the value of ? m is independent to its capital structure and therefore the mix between debt and equity is irrelevant. However assumptions under the M&M proposition are unrealistic in the real world, so the idea that an optimal capital structure is unattainable is discarded. Achieving the optimal capital structure depends on the mixture of debt to equity, depending on the amount of debt, it can help maximize the value of the ? rm while minimizing WACC. Another reason BBBY should consider taking on some debt is that they have more than enough cash to cover their expenses.
Issuing debt can act as a positive signal to investors that they are able to make timely payments and are ? nancially stable. The tradeoff theory of capital structure states that a value-maximizing ? rm will balance the value of interest tax shields and other bene? ts of debt against the costs of bankruptcy and other costs of debt, to determine an optimal level of leverage for the ? rm (KISGEN, 2006). One potential reason why BBBY may not be taking advantage of the tax shields could be that they want to stay ? exible in the industry and avoid costs of ?nancial distress. According to Exhibit 8 from the case, Pro Forma 2003 of BBBY with 40% debt to total capital, the interest coverage ratio is 22. 519 ($644,836/28,635) and the debt to equity ratio is around 66. 67% ($636,328/954,492), which coincides with AA credit rating and the default rate, which Case 2: Bed Bath & Beyond page | 2 is 1. 31% (Exhibit 7A). From Exhibit 2 in the case, we can ? nd BBBY? s total assets on Feb. 29, 2004 are $2,865,023 and taking the value of 15% and the bankruptcy cost for BBBY is approximately $5629. 8 (Heitor Almeida, 2004).
Meanwhile, from Exhibit 8, the taxes on Pro Forma 2003 is $237,237, which is $12,838 ($250,075-237,237) less than actual 2003, which results in the tax bene? t generated from issuing debt is -$15,797 ($12,838-28,635). It is obvious to conclude that, with the implication of tradeoff theory, the pro forma 40% debt to total capital in 2003 is not the optimal leverage ratio for BBBY. The pecking order theory argues that ? rms will generally prefer not to issue equity due to asymmetric information costs. Firms will prefer to fund projects ? rst with internal funds and then with debt, and only when internal funds have been extinguished and a ?rm has reached its debt capacity will a ? rm issue equity (KISGEN, 2006). In 2003 10-K, BBBY management con? rmed itscommitment to ongoing expansion and stated its intention to use internally generated funds to ?
Nance its expansion, which clearly implies pecking order theory is rooted in BBBY capital structure, and is the reason why BBBY keeps a large cash position (Artur Raviv, 2007). Agency Theory & Costs Keeping a large sum of money on hand may be advantageous in uncertain economic conditions, and ? nancial crises. However, this can lead to potential con?ict between managers who do not act in the interest of shareholders, such as empire building and over-investment problems. Debt helps discipline management because they must pay interest payments or risk bankrupting of the ? rm. It also helps reduce Case 2: Bed Bath & Beyond page | 3 wasteful investments as manager have less cash on hand to invest, in other words managers must be careful how they use the money of the ? rm. Debt creates a con? ict of interest between the shareholders and creditors though, such as the possibility of expropriating wealth from creditors to shareholders and the underinvestment problem so this must be monitored.
The Cost of Financial Distress & Debt BBBY? s current cost of ? nancial distress is essentially zero because they have no debt on their books. The bond class default rate of AAA bonds to BBB bonds, 0. 52% and 6. 64% respectively, were used to estimate default rates based on different capital structures. The most problematic key ratio on the list is BBBY? s “operating income to sales” at roughly 14%, which is low for the industry (see Appendix one for more details), and the highest and most consistent ratio was their EBIT and EBITDA interest coverage ratios, which are considered to be the two most important ratios.
With this in mind, the default rates outlined (see Appendix one) should be a close estimate of what BBBY would face when they take on debt. Direct costs associated with ? nancial distress are historically small. The indirect costs, such as loss of suppliers, customer, and leases can be quite substantial. Using the high side of an industry estimate, 20% of total assets, to reasonably account for what BBBY could lose due to ? nancial distress. For the optimal D/E ratio of 0. 60 we have a present value of ? nancial distress equal to $127,432,000 and a present value of tax shield of $400,362,000.
As we move to a higher D/E ratio we see the marginal cost of ? nancial distress and marginal bene? t of the tax shield converge. Case 2: Bed Bath & Beyond page | 4 Repurchasing Shares The decision to repurchase shares and take on debt is overall positive news to the shareholder? s. They will receive a special repurchase capital gain and enjoy an increased upside on returns due to the increased beta of the company. The total capital structure of the company shifts from being totally equity funded to being 38% Debt and 62% Equity ($600 Million and $990 Million respectively).
This also improves the WACC from 33. 75% to 28. 85% (see Appendix one), which will allow Bed Bath and Beyond to take on lower positive NPV projects and increase their options. Earnings per share (Appendix two) will improve due to the share buyback and the net income reducing effect of the new interest expense. Return on assets also improves due to the reduction in cash used to fund the share repurchase. The overall value of the ? rm will improve as the new tax shields that were generated outweigh the cost of ? nancial distress that faces them, from taking on the 600 million in debt.
In Conclusion We would suggest Bed Bath & Beyond do a mixture of two things: 1) Issue debt in the amount of 600 million dollars 2) Hold a one-time share repurchase of 1 billion dollars (approximately 27 million shares) ? nanced by 400 million in cash and 600 million from the proceeds of the debt issue. 3) Assume an optimal capital structure of 60% debt/equity. It is our belief that this will be the best method for BBBY moving into the future. The one time large scale share buyback would improve the WACC and boost the EPS by decreasing the amount of shares outstanding.
The market value of the ? rm would Case 2: Bed Bath & Beyond page | 5 increase and at the 60% ratio the value of the tax shield gained by issuing debt will far outweigh the cost of ? nancial distress. (See Appendix Three) Their old way of making ? nancial decisions has served them well in the past and has consistently made BBBY one of the top performing retail companies. But as times change businesses must adapt and evolve to meet demands of markets and investors. Case 2: Bed Bath & Beyond page | 6 Works Cited Artur Raviv, T. T. (2007, 4 1). Bed Bath & Beyond: The Capital Structure Decision.