Corporate Financial Policy – Case Study: Bed Bath Beyond (BBB)

Introduction

The capital structure of a firm is a crucial element for any business, it entails the relationship between the multiple sources of capital used to finance the operation and acquisition of assets of an entity (Pandey and Singh 164). The common sources of financing are debt, preference share capital, equity capital, retained earnings, and cash surpluses. The majority of firms aim to have a proper mix of the different sources, having a proper capital structure is one of the challenges that company executives such as the Chief Executive Officer (CEO) and Chief Financial Officer (CFO) face. According to Pandey and Singh (164), a proper mix of debt and equity financing is considered as the desirable practice by the majority of organizations’ stakeholders.

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The issue of an optimal capital structure has been of great interest to scholars. Guner (85) discusses some of the theoretical positions that have been developed in an attempt to improve the knowledge on the topic. Modigliani and Miller (MM) are two scholars who developed the irrelevance theory, they claimed that the capital structure of the firm had no bearing on its market value (Guner 85). The value of a company is determined by its operating income rather than how leveraged a business is.

Kraus and Litzenberg contradicted MM when they stated that the tradeoff between leverage and costs was instrumental in the capital structure and their statement laid the foundation for the trade-off theory (Guner 85). Myers and Majluf also contributed to the topic, through the pecking order theory (Guner 85). They argued the choice for funds should be a hierarchical process; internal funds should be considered first, then debt and the last option should be equity. Modern theories have been developed since the optimal capital structure is still an area that has no authoritative stand on the topic.

Bed Bath & Beyond (BBBY) is a firm that is facing the optimal capital structure problem. The company’s superior financial performance has led to the business having excess cash in its balance sheet. Many financial analysts consider having excess funds to be a problem since it creates an opportunity cost for the company, by holding cash, an entity fails to spend on new investments, reward its shareholders through more valuable dividends, and affects the return on equity owed to shareholders (Picard).

Company Profile and Background

The company was formed in 1971 by Warren Eisenberg and Leonard Feinstein, it was a small store that sold bed linens and bath accessories (Raviv and Thompson). Over time, the firm expanded and its product offering grew to kitchenware, household accessories, and small electric appliances. In 1987, the name Bed Bath & Beyond was adopted in order to portray its wide array of products and services (Raviv and Thompson).

Description of the BBBY Excess Cash Problem

In 2004, the Cash, Cash equivalents, and Short-term securities were valued at $867 million; this was a 40% increase from the 2003 figure. The company cash was also estimated to be $400 million more than the firm’s needs to fund growth and operations. Financial analysts are of the opinion that there is a deterioration on the Return on Equity (ROE) because the interest on investments has reduced (Raviv and Thompson). The firm did not pay dividends and it does not have a significant long-term debt.

BBBY’s debt culture and share repurchase culture exacerbate the issue; the business is not known for share repurchases and it considers holding cash to be better than acquiring debt (Raviv and Thompson). The firm’s attitude has the potential of dissuading investors since they are of the opinion that cash should not be sitting on the company’s balance sheet; the money should be invested or placed into shareholders hands through a share repurchase program. The entity does reinvest the cash in expansion and operations but the cash value is too high, and therefore, a lot of money is not used.

The excess cash has raised queries about the capital structure of BBBY. To improve on the return on equity and earnings per share, the firm can repurchase its shares, and therefore, reduce the number of outstanding shares that exist. To carry out the strategy, the company can use its excess funds and combine it with debt in order to have the necessary funds required and to improve its debt to equity mix in a bid to have an optimal capital structure. Issuing a one-time special dividend is another option. A taxation policy had eliminated some of the disadvantages of paying out dividends making this route a viable option. The next section will examine the factors to be considered in choosing a capital structure and the three options will be analyzed.

Factors to Consider in Developing an Optimal Capital Structure

The capital structure of a company is determined by both micro and macro factors; micro variables are internal issues and macro variables are external issues that influence the decision-making process of an organization. According to Pandey and Singh (170), micro factors entail the characteristics of an individual firm that can affect the capital structure, they are management style, financial flexibility, and the entity’s growth rate. Macro factors, on the other hand, are the economic aspects that affect multiple companies since they influence a country’s economic activities; they include the tax policy, business risks, and the capital market conditions.

Macro Factors that affect Capital Structure

Business Risk and Debt

The business risk refers to any adverse and uncertain event that may occur during the normal business operations of BBBY. The company can experience the following issues that negatively affect its bottom line; theft, data breach, damage to inventory, and entry of a new competitor into the market are some of the risks that BBBY can face.

In considering the use of debt, two capital structure theories give a conflicting stand. The Pecking Order theory posits a negative correlation between income and advantage, a firm should use its internal reserves to fund its assets and operations first, and turn to debt next (Serghiescu and Vaidean 1450). A company similar to BBBY, which has excess cash, should not acquire debt since it has enough internal resources to fund its capital needs. The Tradeoff theory suggests a positive correlation between profitability and debt (Serghiescu and Vaidean 1450). The more profit a firm makes, and the higher the levels of debt are, the more income is exempt from taxation due to the debt-tax shield. BBBY’s debt is less than 1/3 (104,669 / 399,470) of its net earnings as per 29 February 2004. It means more than 2/3 of the company’s income incurs a tax expense of 38.5%.

BBBY can benefit from the debt tax shield if it repurchases its shares using $400 million in excess funds and $636.328 in debt. The interest charge of 4.5% will be tax deductible. To calculate the debt tax shield, the taxable expense is multiplied by the tax rate.

BBB Debt Tax Shield = Interest Expense * Tax Rate

= (636,328,000*0.045) * 38.5% = 11,024,382.6

Tax Exposure

The impact of taxes on the capital structure is dependent on the tax shield. Interest payment on debt is tax deductible in some jurisdiction while dividend payments are not. A company can choose debt over equity financing since the interest payments will reduce the amount of income that the firm is supposed to remit taxes on.

Market Conditions

The prevailing market conditions have an impact on interest rates, and therefore, they affect the debt and equity. Changes in the macroeconomic conditions affect the dynamics of a firm’s debt ratio. A company will adjust its debt ratio based on whether the market is good or bad and also depending on its levels of debt. Research shows that highly leveraged firms with low credit risks will avoid using equity during bad market conditions, the businesses will postpone adjusting their debt ratio until the situation changes or the credit risk becomes too high (Botta et al. 3). On the other hand, companies that are over-levered will issue equity regardless of the prevailing market situation due to their poor credit ratings (3).

BBBY can adjust its debt ratio since the current market conditions are favorable. The interest rates on bonds are low, therefore, reducing the cost of capital. By taking on debt, the company will be adjusting its debt to equity ratio in an attempt to achieve its target of an optimal capital structure.

Micro-Factors that Affect the Capital Structure

Financial Flexibility

One of the issues that CFOs consider when deciding whether to raise capital through debt is the ability of the executives to maintain financial flexibility. Once the debt is issued, the company will have a financial obligation, which reduces a certain level of financial flexibility that the entity has had. Firms maintain financial flexibility in an attempt to keep their debt capacity for future investments. It is also maintained so that debt can be minimized to avoid financial distress brought by debt obligations.

Growth Rate

Depending on the direction of growth, a firm’s management can decide to use equity or debt in financing operations and assets. Debt has been used in firms that have a negative growth rate to reduce the agency costs of managerial discretion. The interest obligation reduces the executives’ financial flexibility, and therefore, debt is used as a managerial check. On the other hand, high-growth companies may avoid debt since it increases the debt holders’ stake over the entity’s assets.

Capital Structure Options

BBBY’s excess Cash and Cash equivalent and its Short-term Securities are growing at a significant rate. The funds grew by 44% between the year 2002 and 2003 and by 40% between the year 2003 and 2004. According to Raviv and Thompson (4), the value is projected to grow to $3 billion in the next three years. The table below shows the value of Cash, Cash equivalent, and Short-term Securities and the growth rate.

Table 1: Cash, Cash Equivalent, and Short-term Securities

Cash and Cash Equivalent plus Short-Term Securities

Year

2002

2003

2004

Cash and Cash Equivalent

429,496

515,670

825,015

Short-Term Securities

0

100,927

41,580

Total

429496

616,597

866,595

Growth Rate

44%

41%

Source: Author (2018)

Figure 1: Cash, Cash Equivalent, and Short-term Securities Growth Trajectory

Source: Author (2018)

The Decision to Keep the Money

The decision to hold onto money or spend it is dependent on the benefits that accrue to the business when it has large cash reserves and the downside of holding onto funds. Holian cites three reasons money is held, transaction, speculative, and precautionary motives (27). By analyzing the cash flow statement of BBBY, one can identify how the firm uses its cash, and therefore, have an insight into why the firm would hold on to its reserves.

Table Two: Cash Flows

BBB’s Cashflow Statement

Year

2002

2003

2004

Net cash flow from operating activities

337,956

419,317

548,442

Net cash flow from operating activities

-173,541

-357,359

-292,479

Net cash flow from operating activities

25,753

24,216

53,382

Source: Author (2018)

Figure Two: Cash Flow Trends 2002-2004

Source: Author (2018)

BBBY uses the largest portion of its cash on operations, therefore, the firm can hold funds for transactional motive. It also spends on investments; the company has purchased securities in all the three years, the values were $51,909, $368,008, and $361,013 (all in thousands) for the years 2002, 2003, and 2004 respectively. Acquisitions are another avenue through which cash was invested. Therefore, the speculative motive is a reason for holding onto cash. Lastly, the business spends the least amounts of money on financing activities; the entity has recouped $74,597 in the form of exercise on stock options. The low debt held by the business means the company does not spend much money on paying interests on loans.

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The downsides of holding excess reserves can adversely affect the value of the company. Wieczorek-Kosmala et al. (7) argue that holding large amounts of liquid assets negatively affects the return on equity. Investors would prefer the firm to utilize its cash instead of holding onto it, they view large cash balances as a managerial inefficiency whereby the business fails to invest or issue a share repurchase and reward the shareholders. As the CEO, I would advise the business against keeping large cash reserves.

The Decision to Pay it Out

BBBY has an option of reducing its large cash reserves by issuing a one-time special dividend. Special dividends are normally issued when a firm has posted a good return and they are significantly larger than normal dividends. A one-time special dividend is seen as a way of sharing an entity’s wealth with the shareholders. They are also used to rearrange a firm’s capital structure.

Cash dividends can be used to change the capital structure since it reduces the shareholder’s equity and total assets. The dividend is paid from the retained earnings, and therefore, it reduces the paid-up capital. The effect is the proportion of leverage increases in the capital structure, thus reducing the cost of capital of the firm. The Weighted Cost of Capital (WACC) account for proportions of common equity, preferred stocks, and debt in an organization’s capital. Debt is cheaper since there is the aspect of the tax shield.

By issuing $400 million worth of dividends, BBBY will reduce the total shareholders’ equity by 20% (400,000 / 1,990,820). This will increase the debt to equity ratio from 43% (874,203 / 1,990,820) to 55% (874,203 / 1,590,820). The change in the debt to equity ratio will, thus, alter the capital structure of the firm. However, the disadvantages of issuing a one-time special dividend dissuade me from proposing this option. The issue of the special dividend has been associated with temporary benefits as compared to the other options; short-term growth is experienced in the case of a special dividend as opposed to the long-term benefits to shareholders when share repurchase is carried out (Wesson 6).

Share Repurchases through an LBO

BBBY can use a Leveraged Buyout (LBO) to repurchase its shares and reduce the amount of outstanding share capital thus altering its capital structure. An LBO is a financing transaction that enables a firm to buy back some of its stock by using debt financing. The company can use its excess $400 million and combine it with a debt of $636.3 million to repurchase its shares.

The objective of using an LBO is to decapitalize the balance sheet by reducing excess cash and increasing the debt portion. It is also used to improve the earnings per share (EPS), Return on Equity, and the Price to Book ratio. The values are enhanced since the count of outstanding shares reduces, and thus, the number of shareholders who have a stake in the income of the firm reduces. Despite the improvement of the above ratios, the repurchase does not signify better operational or financial performance, and therefore, this measure can be misleading (Cohn et al. 490).

LBO’s have the potential to accrue various value-enhancing benefits to companies. According to Cohn et.al (470), several studies have shown that firms that used the LBO approach had improved their net operating profits. Such results occur due to certain benefits such as a reduction in agency costs due to increased managerial efficiency brought about by enhanced oversight since debt has an interest obligation. The tax cost reduction associated with the debt tax shield also enhances the value of the firm, the amount saved increases the cash flow of the entity.

The following calculations show the benefit of the tax shield and the bond ratings associated with increasing the debt ratio:

BBBY Debt Tax Shield = Interest Expense * Tax Rate

= (636,328,000*0.045) * 38.5% = 11,024,382.6

To get the present value of the tax shield, we discount the above value with the WACC of BBB. To acquire the value, we identify the market value of equity, cost of equity, the market value of debt, and the cost of debt.

Market Value = Outstanding Shares * Share Price

= 300,278 * 14.2 = 4,263,947.6

Cost Of Equity = Risk Free Rate + Beta * Risk Premium

= 3.5 + 1.08 * 5 = 8.9

Market Value of Debt = 636,328

Cost of Debt = (Risk Free Rate + Credit Spread) * (1-Tax Rate)

= (3.5 + 4.5) * (1-0.385) = 4.92

WACC = 4,263,947.6/4,900,275.6 * 8.9 + 636,328/4,900,275.6 * 4.92 (1-0.385)

WACC = 7.74 + 0.39 = 8.13

PV of Tax Shield = 11,024,382.6 / 0.0813 = $135,601,262

Source: (Reuters 2018, Grabowski et al.).

Bond Rating Based On Leverage Ratio

Leverage Ratio

Bond Rating

Reasons

20%

Aaa-Aa

The firm has a low debt risk

40%

A

The firm has a low debt risk

60%

Ba

The debt ratio is high exposing the firm to a high risk

80%

Caa-C

The debt ratio is high exposing the firm to a high risk

Source: Author (2018)

From the analysis of the tax shield and bond rating, it is evident that the firm will save money if it used an LBO to repurchase its shares, however, the higher the leverage ratio the lower the firm’s rating will be. However, I would recommend the above approach since the company would be able to increase its shareholders return on equity and also escalate its cash flow through the tax costs savings. BBBY is not significantly geared, and therefore, any additional debt does not add to the financial distress.

Conclusion

The capital structure of a firm is important, and thus, the decision on whether to use debt, retained earnings, or equity is vital. Various theoretical models such as the pecking order and tradeoff theory have been developed, but there is no conclusive authority on the optimum mix of debt, retained earnings, and equity. From the case study, different factors that have an impact on the capital structure decision have been identified. BBBY financial performance has been positive and the company has excess cash reserves. Conducting an LBO is the better option of utilizing the funds.

Works Cited

Botta, M and Luca, C. Macroeconomic and Institutional Determinants of Capital Structure Decisions, Working Paper, no. 38, Università Cattolica del Sacro Cuore, Dipartimento di Economia e Finanza (DISCE), Milano, 2016.

Cohn, J, Mills, L, and Harrington, J. “The Evolution of Capital Structure and Operating Performance after Leveraged Buyouts: Evidence from U.S. Corporate Tax Returns.” Journal of Financial Economics, vol. 111, 2014, pp.469-494.

Grabowski, R, Nunes, C, and Harrington, J. “Duff & Phelps’ U.S. Equity Risk Premium Recommendation Decreased from 5.5% to 5.0%, Effective September 5, 2017.” Duff and Phelps, 2017, https://www.duffandphelps.com/insights/publications/cost-of-capital/us-equity-risk-premium-recommendation-2017

Guner, A. “The Determinants of Capital Structure Decisions: New Evidence from Turkish Companies.” Procedia Economics and Finance, vol. 38, 2016, pp.84-89.

Holian, M. Principles of Economics. Hong Kong: The Open University of Hong Kong, 2015.

Wieczorek-Kosmala, M, Dos, A, Blach, J, and Gorczyńska, M. “Working Capital Management and Liquidity Reserves: The Context of Risk Retention.” Journal of Economics and Management, vol.23, no.1, 2016, pp.6-20.

Pandey, A and Singh, M. “Capital Structure Determinants: A Literature Review.” African J. Accounting, Auditing, and Finance, vol. 4, no. 2, 2015, pp.163-176.

Picard, R. “Too Much Cash Becomes a Really Serious Business Problem.” Forbes, Forbes, 2011, https://www.forbes.com/sites/robertpicard/2011/08/08/liguidity-is-creating-short-term-investment-challenges-for-many-companies/#7a860d4d5729

Raviv, A and Thompson, T. “Bed Bath & Beyond: The Capital Structure Decision.” Kellogg School of Management, Northwestern University, 2007.

Reuters. “Bed Bath & Beyond Inc.” Reuters, Reuters, 2018, https://www.reuters.com/finance/stocks/overview/BBBY.OQ

Serghiescu, L and Vaidean, V. “Determinant factors of the capital structure of a firm- an empirical analysis.” Procedia Economics and Finance, vol. 15, 2014, pp.1447 – 1457

Wesson, N. An empirical model of choice between share repurchases and dividends for companies in selected JSE-listed sectors. 2015. Stellenbosch University, Ph.D. Dissertation. Stellenbosch University https://scholar.sun.ac.za