Bed Bath and Beyond: Capital Structure Decision (HBR Case Study)

Topics: Finance, Corporate finance, Stock Pages: 7 (1591 words) Published: March 31, 2014
Introduction
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 first superstore in 1985 and have since underwent large scale expansion operating 575 stores by the end of the fiscal 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 influencing this decision and ultimately suggest a course of action.

Case 2: Bed Bath & Beyond

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Case Analysis
Capital Structure
BBBYʼs 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 firm 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 firm 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 financially stable.

The tradeoff theory of capital structure states that a value-maximizing firm will balance the value of interest tax shields and other benefits of debt against the costs of bankruptcy and other costs of debt, to determine an optimal level of leverage for the firm (KISGEN, 2006). One potential reason why BBBY may not be taking advantage of the tax shields could be that they want to stay flexible in the industry and avoid costs of financial 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

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is 1.31% (Exhibit 7A). From Exhibit 2 in the case, we can find BBBYʼs 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 benefit 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 firms will generally prefer not to issue equity due...

Cited: Artur Raviv, T. T. (2007, 4 1). Bed Bath & Beyond: The Capital Structure
Decision
Heitor Almeida, T. P. (2004, 10 1). How should we discount the costs of financial
distress
KISGEN, D. J. (2006, 6). Credit Ratings and Capital Structure. THE JOURNAL
OF FINANCE, LXI(3).
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