BED BATH & BEYOND
Suggested Study Questions
1. How would you characterize the business risk of Bed Bath & Beyond? Review their financial performance.
BBBY is special since they are selling products that are produced by name brand companies, and if any products needing repair could be sent directly back to the name brand company. Therefore, there are no switching costs for BBBY since they have no control on the quality of the products they sell. However, there fixed operating costs have been high and if management adds fixed operating costs to their business operations, without an increase in sales, the firm’s profit would decline and result in a loss, which ...view middle of the document...
Increasing to this capital structure would also reduce shareholders earnings per share.
BBBY will need to trade off business risk against financial risk. They operate in an industry with fairly low business risk however BBBY's operating leverage is high which could indicate a higher than industry business risk if they are not cognizant of managing their fixed costs. In addition, BBBY's debt to total asset ratio is higher than their industry. Both of these indicate a high business and financial risk. If BBBY were to recapitalize to 80% debt to total capital it would only increase their financial risk and reduce shareholders earnings per share. Therefore the recommendation for a capital structure for BBBY would be to add more than the 40% debt to total capital but not more than 80%.
2. Do you think Bed Bath & Beyond has too much cash? Should Bed Bath & Beyond lever up? Consider both the 40% and 80% debt-to-total capital proposals.
BBBY has too much cash even though it has used the cash for store growth and small acquisition. They should be focusing on using their cash to increase shareholder value.
If BBBY were to use $400 million in excess cash and $636.3 million in borrowed funds to repurchase it's shares they would increase their basic earnings per share from 1.35 to 1.41 and their diluted earnings per share from 1.31 to 1.37. If BBBY were to use $400 million in excess cash, and borrow $1.27 billion to repurchase their shares, the increase of the basic earnings per share would only be 0.3 while the difference from zero debt to 40% debt-to-capital ration is 0.6. And the diluted earnings per share would only rise to 1.4. in addition, the ROA and ROE of 40% pro forma are 13.32% and 23.82% respectively, whereas those of 80% strategy are 12.61% and 22.71%, which are slightly lower.
Repurchasing shares with a 40% debt to total capital ratio would increase shareholder value; however repurchasing shares with an 80% debt to total capital ratio would also increase shareholder value with higher level of risk. Increasing debt increases shareholder value to a certain point. As this pro forma shows, the point of diminishing return is somewhere between 40% and 80%.
Exhibit 8 Pro...