Assignment #1 Bed Bath & Beyond Case

Financial Decisions
Larissa Veri de Arruda Mattos Antonio Ascar, Carolina Camargo, Daniel Loureiro, Daniel Medeiros,
FINC -442
Jean Paul Cordahi and Larissa Mattos

Problem Statement:

BBBY has been growing more than 20% per year due to the

opening of new stores and same store growth. Although

this growth has been financed with cash from operations, BBBY was carrying a growing

excess cash position of $400M, well above the typical 2% of sales. In early 2004, in order

to improve a deteriorating return on Equity (ROE), boost earnings per share (EPS), and

maximize shareholders wealth, BBBY began to explore the possibility of leveraging its

capital structure.

Facts and Assumptions:

BBBY has been carrying cash excess. In 2003 the cash position was 18.5% of Sales,

significantly higher than other retailers (Sonoma is 6% and Target 1.5%). Moreover BBBY

was able to honor its short term obligations (Cash and short term investment exceeds the

current liabilities by $97,061) and there is no indication of operation/business risk that

would require such amount of cash. Some of the business risks are detailed on exhibit 4.

Besides reducing cash excess, BBBY can also benefit from a leveraged capital structure.

However to have a more proper view of the true capital structure we created scenarios

considering the current operating lease as capitalized lease. By just adjusting the lease

method we realized that in 2003 BBBY already has a 45% debtto-total capital ratio. The

present value of the capital lease is $ 1,643,025 and in our analysis it will be considered a

long term liability (Lease Obligation) and would incur in an interest expense of $73,936

(4.5% discount rate). See Exhibit 2 for detail on the lease capitalization.

In order to analyze the different debt-to capital scenarios besides considering the

capitalized lease we compared the NPV of unleveraged company ($10,983,598) with the

leveraged NPV (NPV Unleveraged + NPV Tax Shield - NPV Cost of Distress). The main

assumption were: same tax rate of 38.5%, blended interest rate 4.5% , probability of

default based on S&P rating calculations - Cases #1 & #2 - rating AA, Case #3 - rating A

and Case #4 -rating B ) - (see Exhibit 3).

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Assignment #1 Bed Bath & Beyond Case
Financial Decisions
Larissa Veri de Arruda Mattos Antonio Ascar, Carolina Camargo, Daniel Loureiro, Daniel Medeiros,
FINC -442
Jean Paul Cordahi and Larissa Mattos

Finally the cost of distress was estimated between 10%

and 25% depending on the leverage ratio; for Cases #1 &

#2, 10% distress was considered, 15% for Case #3 and

25% for Case #4. For the base case, the company inventory is around $915M for 2003 and

in case of distress the company can liquidate part of its inventory to cover its obligations.

In addition, the company could, if needed, liquidate the inventory in certain locations with

lower gross

margins and close down such locations, thus significantly limiting the impact of distress.

On the flipside, accounts payable days are high (56 days) and in case of distress, suppliers

may want to decrease significantly this period, which then puts even much more pressure

on the company's working capital. Another point that has both advantages and

disadvantages is the lease agreements on the stores. Although leasing provides more

flexibility to close and relocate when needed, and demands less financing when company

is growing, in case of distress, lack of ownership and assets puts BBBY in a more exposed

position.

Analysis

Our initial baseline considered case #1 & #2 was zero leverage, Case #3 has 40%

leverage and Case #4, 80%. However, considering the Lease Obligation as part of the

debt, at zero leverage the company has a debt to total asset ratio of 45% in Case #1

and 51% in Case #2. Also, given the additional debt of $636.328MM in Case #3 and of

$1.27B in Case #4, the actual leverage ratios are now, respectively, 70% and 90%.

Additionally, in Cases #2, #3, and #4, we have assumed a share repurchase using both

$400MM in excess cash and the proposed debt, should the case apply (#3 & #4).

However, in Case #1, we did not use the excess cash. Comparing cases #1 & #2, we

found as a result of this analysis that indeed BBBY has excess cash which, when used for a

cash repurchase, boosts the ROE by around 8 percentage points.

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Assignment #1 Bed Bath & Beyond Case
Financial Decisions
Larissa Veri de Arruda Mattos Antonio Ascar, Carolina Camargo, Daniel Loureiro, Daniel Medeiros,
FINC -442
Jean Paul Cordahi and Larissa Mattos

As expected there are increasing gains from the Tax Shield

in the leverage firm cases. The lease capitalization brings

additional $632,565 in the unleveraged scenarios (case #1

and #2), $ 877,552 case # 3 and $1,121,516 in case #5. As for the distress cost in case

#1 and #2 BBBY would be exposed to $247,651, $ 560,453 in case #3 and $1,317,465 in

90% leverage firm.

Overall acquiring new debt reduces the total value of the company from $11,368,512 in

case # 1 x $11,300,696 in a 70% debt-to-capital company x $9, 66,133 in a 90% debt

case. Moreover a change in the capital structure reduces EPS from current $1.35 x $1.24

(cases #2 and #3) x $1.26 in case #4.

Recommendations:

We recommend not contracting debt, but still using the $400K in excess cash to

repurchase stocks. The arguments we would present BBBY management for this option we

believe best balance the shareholders profitability and the companys value. This is the

option that maximizes the firm's value, as it is the one that create an NPV of $11.368.512

(exhibit 2), the highest NPV of the firm along with the option of no debt and no stock

repurchase. But using the excess ash to repurchase stock, BOBBY's ROE improved from

33% to 41%, making shareholders happier, with no significant increase in risk, as BBBY will

still be a AA company.

Another possible actions the BBBY could take to leverage up the firm and have a more

aggressive capital structure is to start paying dividends. This would make BBBY more

leveraged and increase the shareholders profitability. Also A share repurchase by the

company would signal to the shareholders that shares are undervalued and therefore, the

price per share would probably increase. On the other hand, if the capital structure of the

firm changes and the firm becomes more levered, the share price may be affected given

the tradeoff between tax shield and cost of distress.

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Assignment #1 Bed Bath & Beyond Case
Financial Decisions
Larissa Veri de Arruda Mattos Antonio Ascar, Carolina Camargo, Daniel Loureiro, Daniel Medeiros,
FINC -442
Jean Paul Cordahi and Larissa Mattos

Exhibit 1 - Pro Forma 2003 Results for AlternativeCapital Structures ($ in thousands)

Actual 2003 Case #1 Case #2 Case #3 Case #4

Unleveraged -
Without capitalized Unleveraged - With Unleveraged - With
Lease capitalized Lease capitalized Lease 40% Debt To 80% Debt To
No Repurchase With Repurchase Total Capital (d) Total Capital (d)

Sales $ 4,477,981 Sales $ 4,477,981 $ 4,477,981 $ 4,477,981

Operating Profit 639,343 Operating Profit 639,343 639,343 639,343
Interest Income (a) 10,202 Interest Income (a) 10,202 5,493 5,493
EBIT 649,545 649,545 649,545 644,836 644,836
Interest Expense (b) 73,936 73,936 102,571 131,086
Profit Before Taxes 649,545 575,609 575,609 542,265 513,750
Taxes (c) 250,075 221,610 221,610 208,772 197,794
Profit After Tax 399,470 353,999 353,999 333,493 315,956

Cash and Equivalents (e) $ 866,595 $ 866,595 $ 466,595 $ 466,595 $ 466,595

Excess Cash (given) $ 400,000 $ 400,000 $ 400,000 $ 400,000 $ 400,000
Total Debt - $ 1,643,026 $ 1,643,026 $ 2,279,354 $ 2,913,026
New Debt $ - $ 636,328 $ 1,270,000
Lease Obligations - $ 1,643,026 $ 1,643,026 $ 1,643,026 $ 1,643,026
Shareholders' Equity 1,990,820 1,990,820 1,590,820 954,492 320,820
Total Capital 1,990,820 3,633,846 3,233,846 3,233,846 3,233,846
D/TC 45% 51% 70% 90%
Total Repurchase Amount -> can only use cash and- new debt to buy this - 400,000 1,036,328 $ 1,670,000
Common Stock Price (4/30/04) $ 37.00 $ 37.00 $ 37.00 $ 37.00 $ 37.00
Market Value of Common Stock 10,983,598 -
Shares Repurchased 0 - 10,811 28,009 45,135
Total Outstanding Share 296,854 296,854 286,043 268,845 251,719
Debt/(Debt +Equity) 45% 51% 70% 90%
Interest Coverage 8.79 8.79 6.29 4.92
EPS 1.35 1.19 1.24 1.24 1.26

NPV Unleveraged $ 10,983,598 $ 10,983,598 $ 10,983,598 $ 10,983,598 $ 10,983,598

Debt Rating n/a AA AA A B

ROE 33% 33% 41% 68% 201%

NPV Tax Shield $ 632,565 $ 632,565 $ 877,552 $ 1,121,516

Total Cost of Distress $ (1,098,360) $ (1,098,360) $ (1,647,540) $ (2,745,900)

NPV Cost of Distress $ (247,651) $ (247,651) $ (560,453) $ (2,438,981)

Increasein Value $ 384,914 $ 384,914 $ 317,098 $ (1,317,465)

NPV Leveraged $ 11,368,512 $ 11,368,512 $ 11,300,696 $ 9,666,133

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Assignment #1 Bed Bath & Beyond Case
Financial Decisions
Larissa Veri de Arruda Mattos Antonio Ascar, Carolina Camargo, Daniel Loureiro, Daniel Medeiros,
FINC -442
Jean Paul Cordahi and Larissa Mattos

Exhibit 2 - Excerpt fromBed, Bath and Beyond's 2003Annual Report RegardingOperatingLeases

Amount
Fiscal Year (in thousands) Pv using 4.5% (debt rate)
2004 $ 273,934 $ 262,138
2005 $ 285,298 $ 261,256
2006 $ 283,051 $ 248,037
2007 $ 274,325 $ 230,038
2008 $ 265,991 $ 213,445
Thereafter $ 1,344,563 $ 428,112
Total future minimum lease payments: 2,727,162
Present Valueof Lease $ 1,643,026

2003 LeasingInterest $ 73,936

Exhibit 3 Standard & PoorsThree-Year Median Key Industrial Financial Ratios, 2000-2002
Expenses for all operating leases were $251.0 million, $219.8 million and
$178.7 million for fiscal 2003, 2002
AAAand 2001,AArespectively.
A BBB BB B CCC Current 40% Debt 80% Debt
EBIT Interest Coverage (x) 23.4 13.3 6.3 3.9 2.2 1.0 0.1 8.8 22.519 11.28322
EBITDA Interest Coverage (x) 25.3 16.9 8.5 5.4 3.2 1.7 0.7 9.8 25.32 12.69
FFO/Total Debt (%) 214.2 65.7 42.2 30.6 19.7 10.4 3.2
Free Operating Cash Flow/Total Debt (%) 156.6 33.6 22.3 12.8 7.3 1.5 (2.8) n/a n/a
Return on Capital (%) 35.0 26.6 18.1 13.1 11.5 8.0 1.2 6% 36% 10%
Operating Income/Sales (%) 23.4 24.0 18.1 15.5 15.4 14.7 8.8 n/a n/a
Long-Term Debt/Capital (%) (1.1) 21.1 33.8 40.3 53.6 72.6 78.3
Total Debt/Capital (%) 5.0 35.9 42.6 47.0 57.7 75.1 91.7 40% 80%
AA A B
Number of Companies 6 20 121 224 279 264 56
Average Default Rate, past 15 years* 0.52% 1.31% 2.32% 6.64% 19.52% 35.76% 54.38%

Exhibit 4: BBBY Business Risks

More intense competition can create a price war and deteriorate margins

Demand is co-related with economy

Growing assortment brings more complexity to manager larger number of suppliers

Limited growth of number stores in US. Cannibalization between stores will increase with
the number of stores

Fit of business model with international expansion

Change in consumer behavior to online

Decentralized inventory management can get out of control and impact current operation
efficiency