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1 Case analysis Bath, Kitchen ’n More Corporation Bath, Kitchen ’n More Corporation (BKM) is a major retailer of household bath and kitchen supplies in the South East of the United States. Bath, Kitchen ’n More Co. has been very successful in the retail business for over 20 years. For the fiscal year of 2012 they announced a net income of $316 million which represented a 15% growth in income over the previous year. In the past, BKM had consistently targeted a leverage ratio of 0.4 but now is considering moving to a more conservative target leverage of 20%. Furthermore, historically, capital budgeting decisions at BKM were straightforward: a project was accepted as long as the IRR was greater than 18%. Given the success in their retail business, the management of BKM is considering expanding into the production business. They see potential for growth in vertical integration and their 20 years in retail suggest kitchenware is a good starting point. Even though there are very well established brands in the kitchenware market, the management of BKM thinks that the popular wave of cooking shows on television generated an increase demand for affordable high-quality specialty kitchen products. They believe that their retail experience gives them an advantage to position themselves among well-known brands such as Rachael Ray or Martha Stewart in as little as 5 years. BKM has financial information for their manufacturing endeavor which is provided in exhibits 1 and 2. Revenue projections are highly reliable and are expected to grow at 3% after year 5. Some of the financial projections are missing in the exhibits mentioned above, but the management thinks that one can use information from comparable competitor firms to project the missing figures. The initial investment needed to enter the cookware manufacturing business, without working capital investment, is estimated to be $114 million. Additionally, the estimated cash needed as working capital is 2% of sales. The management of BKM is entertaining different options to finance their expansion if they decide to move forward with it. If the expansion takes place, the manufacturing part of the business would be part of a new division of the company, and it would be kept separate from the retail activities. If BKM chooses to move forward with the kitchenware expansion, they should expect to start their sales by the end of 2014.

2 Please, answer the following questions as if you were in charge of this project. 1. What is the cost of capital for BKM under the new targeted capital structure? One way of doing it was using CAPM. Note that D/V for the retail industry is the same as the targeted by the firm. Then, we do not need to un-lever and re-lever the retail industry beta to get the beta on equity. Using CAPM r e = 2% + 1.29 * 6% = 9.74% WACC = 9.7% *0.8 + 4%*0.2*(1-40%) = 8.3% 2. What is the cost of capital for the household products industry? Using CAPM one can find re for the household product industry. r e = r f + beta e * Risk Premium. Since the project is long-lived, one should use the yield of a long term govt bond and the market risk premium with respect to long term bonds, unless they make it clear that they believe the long term rate include risk premium and therefore is not a good approximation of the risk free rate. CAPM gives r e = 7.8%. Then, r a = 1/1.18 * 6.98% + 0.18/1.18 * 2% If we are looking for the WACC this is r WACC = 7.8%* 1/ 1.18 + 2%*(1-0.4)* 0.18/1.18

3 3. Estimate the planned capital spending for the expansion into the cookware business for the years 2013-2018. 4. Estimate the (unlevered) free cash flows for the expansion into the cookware business for the years 2013-2018. FCF = OCF – NCS – Change in NWC 2013 2014 2015 2016 2017 2018 EBIT 0 -10750 -7800 6200 36575 82250 EBIAT 0 -6450 -4680 3720 21945 49350 Depreciation 0 10000 10300 11300 12800 14000 OCF 0 3550 5620 15020 34745 63350 change in NWC 3,289 2,536 5,182 $8,658 $ 8,053 2,594 NCS 114,000 15,000 22,300 28,300 26,800 15,410 FCF (117,289.04) (13,986.30) (21,861.51) (21,937.53) (107.74) 45,345.99 NFA 114,000 119,000 131,000 148,000 162,000 163,410 Change in NFA 114,000 5,000 12,000 17,000 14,000 1,410 Depreciation 0 10000 10300 11300 12800 14000 NCS 114,000 15,000 22,300 28,300 26,800 15,410

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4 5. What is the NPV of the project if the management plans to use its targeted capital structure to finance it? Step 1: Compute appropriate discount rate. We can use WACC since D/V is constant and the only financial side effect we are considering is the tax benefit of debt. We can write r WACC = r a – 0.2*0.4* r d We can use the r a for the household industry since the project is in that industry (same systematic risk). Using this, one can get a WACC of 6.82%. Step 2: Compute TV using the growing perpetuity formula. TV = FCF in 2018 *(1+g)/(r-g) This gives TV=845,865.44 Step 3: Compute NPV using FCFs from Q4 + discounting TV is step 2 NPV = $463,053.43 6. What is the NPV of the project if the management plans to use internally generated funds to finance it? Step 1: Find the appropriate discount rate In this case, it is r a from Q5, i.e., r a =6.98%. Step 2: Compute TV using the growing perpetuity formula. TV = FCF in 2018 *(1+g)/(r-g) This gives TV = $811,866.85 and PVTV = $579,322.79. Step 3: Compute NPV using FCFs from Q4 + discounting TV is step 2 NPV =$434,263.95

5 7. BKM has the opportunity to borrow $100,000 to finance the project at an interest rate of 10%. The management would like to make only interest payments on the loan for the first 5 years and pay all principal at once on year 6. From year 6 on, BKM would finance itself following its targeted capital structure. Step 1: Compute Tax shields from 2014 to 2018 $100,000*0.10*0.40 = $4,000per year Step 2: Compute TV of tax shields Difference between TV in Q5 and TV in Q6. TV tax shields = $33,978.59 Step 3: Compute PV of Tax benefits (discounted at r d = 2%) PVTB = $49,629.30 Step 4: Compute NPV Get base NPV from Q6 and then add PVTB. NPV= $483,893.25 8. Should BKM expand? If you think they should, how should they finance their expansion? Q8 NPV Targeted capital structure $463,053.43 All Equity $434,263.95 Debt at 10% $483,893.25

6 EXHIBIT 1: BKM Kitchenware – PROFORMA FINANCIAL STATEMENTS Projected income statement (in thousands) 2013 2014 2015 2016 2017 2018 Sales $ 35,000 $ 50,000 $100,000 $175,000 $235,000 COGS 15,750 22,500 45,000 78,750 105,750 Gross profit 19,250 27,500 55,000 96,250 129,250 SG&A 20,000 25,000 37,500 46,875 56,250 Depreciation 10,000 10,300 11,300 12,800 14,000 Pretax operating income $ (10,750) $ (7,800) $ 6,200 $ 36,575 $ 59,000 Projected Balance Sheet Assets Cash $ 700 $ 1,000 $ 2,000 $ 3,500 $ 4,700 $ 4,841 Accounts receivables 2,877 4,110 8,219 14,384 19,315 Inventories 2,589 3,699 7,397 12,945 17,384 17,905 Total current assets $ 3,289 $ 7,575 $ 13,507 $ 24,664 $ 36,467 $ 42,061 Net plant and equipment 100,000 103,000 113,000 128,000 140,000 141,410 Other fixed assets 14,000 16,000 18,000 20,000 22,000 22,000 Total Assets $ 117,289 $126,575 $144,507 $172,664 $198,467 $205,471 Liabilities Accounts payable - 1,750 2,500 5,000 8,750 11,750 Net asset value $ 117,289 $124,825 $142,007 $167,664 $189,717 $193,721 Total current assets - A/P $ 3,289 $ 5,825 $ 11,007 $ 19,664 $ 27,717 $ 30,311

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7 EXHIBIT 2: Industry and market data Beta for the retail industry D/E for the retail industry Average growth for the retail industry Cost of debt for the retail industry Beta for the household products industry D/E for the household products industry Average growth for the household products industry Cost of debt for the household products industry Corporate tax rate Yield on short term US T-bills Yield on long term US government bonds Market risk premium (Rm – T-bills) Market risk premium (Rm – gov. bonds) 1.29 25% 11% 4% 0.98 18% 3% 2% 40% 0.5% 2% 6.5% 6%

8 FORMULA SHEET • Present Value of Annuity Future Value of Annuity • Present Value of Growing Annuity Future Value of Growing Annuity • Present Value of Perpetuity PV of Growing Perpetuity • Capital Asset Pricing Model (CAPM) Fundamental PE Ratio ( ) i f i m f r r r r β =+ − ( ) + = − 1 F b g PE r g • Cost of Levered Equity & Levered Equity Beta ( )   = + −     e a a d D r r r r E , ( ) β β β β   = + −     E A A D D E • Cost of Levered Equity & Levered Equity Beta – MM Version ( ) ( )   = + − −     1 e a a d C D r r r r T E , ( ) ( ) 1 E A A D C D T E β β β β   = + − −     • Weighted Average Cost of Capital Present value of distress costs ( ) 1 e d C E D WACC r r T D E D E     = + −     + +     𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = 𝑝𝑝∗𝐷𝐷𝐷𝐷 𝑡𝑡 + ( 1−𝑝𝑝 ) ∗𝑃𝑃𝑃𝑃𝐷𝐷𝐷𝐷 𝑡𝑡+1 1+𝑟𝑟 𝐷𝐷𝐷𝐷 • Firm Valuation with Mid-Year Discounting Equal installments ( ) 1/ 2 0 1 1 (1 ) (1 ) =   = + + +   + +   ∑ N t N t N t FCF TV Firm Value cash r r r 𝑥𝑥 = 𝑃𝑃 ∗ 𝑟𝑟 1− ( 1+𝑟𝑟 ) −𝑇𝑇 • Effective tax shield of debt ( ) ( ) * 1 1 1 1 C E D T T T T − − = − − ( ) * 1 1 C Df Ef T r T r − = − • Fisher Equation for nominal and real interest rate ( ) ( ) + = + × + 1 1 1 nominal real r r inflation 1 0 (1 ) 1 n CF FVA r r   = × + −   1 0 1 1 (1 ) n CF PVA r r   = × −   +                 + + − × − = n r g g r CF PVA 1 1 1 1 0 ( ) ( ) 1 0 1 1 n n CF FVA r g r g   = × + − +   − 1 0 CF PVP r g = − 1 0 CF PVP r =