BOX's Business

BOX was a large producer of branded appliances primarily used in residential households. For the period 2012-2018 the industry posted modest annual unit sales growth of 1.8% despite positive market conditions including a strong housing market and product innovations. Competition from inexpensive imports and aggressive pricing by mass merchandisers limited industry dollar volume growth to just 2.5% annually over that same period. Under its CEO Liam Benjamin Steward's leadership, BOX operated much as it always had, with three notable exceptions. First, the company completed an IPO (Initial Public Offering) in 2011. This provided a measure of liquidity for founders' descendants who, collectively, owned 62% of the outstanding shares following the IPO. Second, beginning in the 2010s, BOX gradually moved its production abroad. Finally, BOX had undertaken a strategy focused on rounding out and complementing its product offerings by acquiring small independent manufacturers or the kitchen appliance product lines of large diversified manufacturers. Thus far, all acquisitions had been for cash or BOX stock.

BOX's Performance

During the year ended December 31, 2018, BOX earned net income of $8.25 billio n on revenue of $108.13 billion. Exhibits 1 and 2 present the company's recent financial statements. The company's 2018 EBIT margin of nearly 13.0% was average within the peer group. During 2012-2018, compounded annual returns for BOX shareholders, includ ing dividends and stock price appreciation, were approximately 13.1% per year. This was higher than the ASX S&P200, which returned approximately 7% per year. However, it was well below the 16% annual compounded return earned by shareholders of BOX's peer group during the same period.

BOX's Financial Policies

BOX's financial posture was conservative and very much in keeping with BOX's long-standing practice and, indeed, with its management style generally. In recent years the company's largest uses of cash had been common dividends and cash consideration paid in various acquisitions. Dividends per share had risen only modestly during 2012-2018. However, as the company issued new shares in connection with some of its acquisitions, the number of shares outstanding climbed up to approximately 1.27 billion by the end of 2018.

31/12/2018

Net income (000s) 8,248,000

Average number of shares outstanding (000s) 1,267,881

Effective tax rate (corporate) 36.397%

On a bright Friday afternoon, Liam sat in his office reflecting on a meeting he had with an investment banker earlier in the week. The banker, whom Liam had known for years, asked for the meeting after a group of private equity investors made discreet inquiries about a possible acquisition of BOX. Although BOX was a public company, a majority of its shares were controlled by family members descended from the firm's founders together with various family trusts. Liam knew the family had no current interest in selling - on the contrary, BOX was interested in acquiring other companies in the same industry - so this overture, like a few others before it, would be politely rebuffed. Nevertheless, Liam was struck by the banker's assertion that a private equity buyer could "unlock" value inherent in BOX's strong operations and balance sheet. Using cash on BOX's balance sheet and new borrowings, a private equity firm could purchase all of BOX's outstanding shares at a price higher than $114.33 per share, its current stock price. It would then repay the debt over time using the company's future earnings. The banker pointed out that BOX itself could do the same thing - borrow money to buy back its own shares. In the days since the meeting, Liam's thoughts kept returning to a share repurchase.

QUESTIONS

1. With the help of the Excel spread sheet provided, compute the market debt to equity (D/E) ratio for BOX. Then use it to find the current cost of equity (rE) and the pretaxWACC for BOX. Assuming the cost of unlevered equity (rU) is 12%. At present Liam is considering the following share repurchase proposal from the firm's CFO: the company could raise $12 billion new debt (on permanent basis) at a competitive rate of 3.25% to repurchase shares.

2. Compute the new market D/E ratio, rE, and the weighted average cost of capital of BOX in this scenario.

3. Compare your results in Questions 1 and 2. Explain the relationship between capital structure and the cost of capital with no taxes (as if in perfect markets). How would the weight average cost of capital (WACC) differ if the effect of taxes is incorporated? Justify. Assume that Liam was impressed by your discussion in Question 3. He now understands that interest is tax deductable and the firm could potentially benefit from issuing more debt. Liam decides to issue $12 billion of debt (on permanent basis) and use the proceeds to repurchase shares.

4. What is the present value of interest tax shield (ITS) of the new debt?

5.At the announcement of the repurchase, what is the new market value of the equity and the share price (assume no arbitraging)?

6.After the repurchase, how many shares are outstanding? How has this deal affected the total value of the firm?

7.