Bed Bath & Beyond: PRAC CORP FIN MODEL

The Capital Structure Decision GROUP 3

Executive Summary – Situation Overview.

• Investors are expressing concerns over the company holding excessive cash reserves
• The substantial cash balance could signify an underinvestment or no investment opportunities, and could eventually
lead to a deterioration of return on equity
• Managements are considering a recapitalization of the company, and weighting between share repurchasing and
issuing a special dividend

Facts & Assumptions

• BBBY’s current cash balance is reported to be $400 million more than its operational requirements
• Based on the current financial performance and position, BBBY exhibits strong liquidity and solvency ratios, alongside
its healthy profitability, making it appealing to potential lenders (see Appendix A).
• We project that the company's credit rating would align with a AAA classification, in accordance with the benchmarks
set by Standard and Poor’s Three-Year Median Key Industrial Financial Ratios (see Appendix B).

Recapitalization: Range of Alternatives

Action Description Benefits Considerations

• Use excess cash of $400 • Positive signal to investors • Forego the benefits of tax
million for a share repurchase • Potentially boost the share shield and low interest rate
Share Repurchase a price environment
• Increase EPS and ROE

• Use excess cash of $400 • Positive signal to investors • Investors may respond in
million for a special dividend • Take advantage of the varied ways
Special Dividend b • Decrease EPS
elimination of dividend tax

• Recapitalize company capital • Exploit tax shield benefits • May not fully optimize the
structure to reflect a 40% • Leverage the current low- potential tax shield
$636.6 million
debt proportion interest rate climate for advantages
Bond Issuance
• Use excess cash of $400 and strategic financial • Increase firm’s risk
& Share Repurchase c
borrowed funds to repurchase operations
shares • Increase EPS and ROE

• Increase company’s leverage • Potentially enhance tax • Escalate costs related to

ratio to an 80% debt and 20% shield benefits financial distress
$1.27 billion equity • Possibly result in a lower
Bond Issuance • Use excess cash of $400 and credit rating for the firm
& Share Repurchase d borrowed funds to repurchase • Shareholders would
shares demand higher required
rate of return

• Optimize benefits arising from • Take advantage of the • Investors may respond in
the recent change in tax elimination of dividend tax varied ways
Bond Issuance policy related to dividend • Decrease EPS and ROE
& Special Dividend e payment.

a,b,c,d,e : Refer to Appendix C for a Detailed Analysis of Alternative Strategies

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Recommendation: Optimizing Leverage to Enhance Financial Positioning

• We advise that BBBY initiate a bond issuance of $636.6 million, and utilize the proceeds along with its surplus cash
for a share repurchase program. This move would change BBBY's capital structure from being equity-based to a new
capital structure of 40% debt and 60% equity.

• Our comprehensive analysis (detailed in Appendix C) indicates that by issuing bonds worth $636.6 million at a 4.5%
interest rate, BBBY could leverage the tax shield benefit, estimated to be near $250 million. Moreover, by using
the borrowed fund in combination with its available excess cash of $400 million, BBBY could potentially buy back over
28 million shares at the current market valuation of $37 per share.

o Although the analysis indicates that the company could potentially employ a capital structure of 80% debt to
increase its tax shield benefits and potentially boosting its ROE and EPS, this approach might jeopardize its
credit rating. As increase debt level could result in a comparatively lower credit rating given higher financial
obligations and risks. (see Appendix 4).

• This recapitalization strategy is projected to improve BBBY's basic Earnings Per Share (EPS) from 1.35 to 1.41
and increase the Return on Equity (ROE) from 20% to 40%. Thus, this financial restructuring aligns with BBBY's
goal of maximizing shareholder value.

• Despite the management team's concerns about potential impacts on credit rating, we suggest that recapitalizing the
capital structure to a 40% debt-to-capital ratio would likely place BBBY's credit rating within the AAA-AA range (see
Appendix B)

• Additionally, considering the prospects of future business growth and expansion, there is potential for BBBY to further
enhance its credit rating. This improvement can be achieved through the continuous improvement and sustainability
of its operations, thereby strengthening its financial stability and creditworthiness in the long term.
Appendix A: Financial Analysis

2002 2003 2004

Activity Ratio
Inventory Turnover 2.3 2.3 2.6
Account Payable Turnover 6.4 5.9 6.5
Inventory Days (days) 160 156 142
Account Payable Days (days) 57 62 56
Liquidity Ratio
Current Ratio 2.4 2.3 2.6
Quick Ratio 0.9 1.0 1.2
Cash Ratio 0.8 0.9 1.1
Solvency Ratio
Debt to Equity Ratio - - -
Debt to Asset Ratio - - -
Equity Ratio 66.4% 66.3% 69.5%
Profitability Ratio
Gross Profit Margin 41.2% 41.4% 41.9%
Net Profit Margin 7.5% 8.2% 8.9%
Return on Asset 13.3% 13.8% 13.9%
Return on Equity 20.1% 20.8% 20.1%

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Appendix B: Credit Rating Evaluation

Standard and Poor’s Three-Year Median Key Industrial Financial Ratios, 2000–2002

AAA AA A BBB BB B CCC

EBIT interest coverage (x) 23.4 13.3 6.3 3.9 2.2 1.0 0.1
EBITDA interest coverage (x) 25.3 16.9 8.5 5.4 3.2 1.7 0.7
FFO/total debt (%) 214.2% 65.7% 42.2% 30.6% 19.7% 10.4% 3.2%
Free operating cash flow/total debt (%) 157% 34% 22% 13% 7% 2% -3%
Return on capital (%) 35.0% 26.6% 18.1% 13.1% 11.5% 8.0% 1.2%
Operating income/sales (%) 23.4% 24.0% 18.1% 15.5% 15.4% 14.7% 8.8%
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%

BBBY's Approximate Credit Rating using S&P Key Industrial Financial Ratios

Use Excess Cash (internally) Bond Issuance & Share Repurchase Bond Issuance & Special Dividend
Base Case Share Repurchase Special Dividend
Debt to Capital 0% 0% 0% 40% 80% 40% 80%
Credit Rating Evaluation
EBIT interest coverage (x) AAA AAA AAA AA A AA A
EBITDA interest coverage (x) AAA AAA AAA AA A AA A
FFO/total debt (%) AAA AAA AAA AA BBB AA BBB
Free operating cash flow/total debt (%) AAA CCC CCC AA A AA A
Return on capital (%) AAA AAA AAA AAA AAA AAA AAA
Operating income/sales (%) CCC CCC CCC CCC CCC CCC CCC
Long-term debt/capital (%) AAA AAA AAA A CCC A CCC
Total debt/capital (%) AAA AAA AAA AA B AA B

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Appendix C: Alternative Capital Structure Analysis (Pro Forma 2003)
Use Excess Cash (internally) Bond Issuance & Share Repurchase Bond Issuance & Special Dividend
Base Case Share Repurchase Special Dividend
Debt to Capital 0% 0% 0% 40% 80% 40% 80%

Debt - - - 0.40 0.80 0.40 0.80

Equity 1.00 1.00 1.00 0.60 0.20 0.60 0.20

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

Operating profit 639,343 639,343 639,343 639,343 639,343 639,343 639,343
Interest income 10,202 10,202 5,493 5,493 5,493 5,493 5,493
% to Cash 1.2% 1.2% 1.2% 1.2% 1.2% 1.2% 1.2%
EBIT 649,545 649,545 644,836 644,836 644,836 644,836 644,836
Interest expense 4.50% - - - 28,635 57,270 28,635 57,270
Profit before taxes 649,545 649,545 644,836 616,201 587,566 616,201 587,566
Taxes 38.50% 250,075 250,075 248,262 237,237 226,213 237,237 226,213
Profit after tax 399,470 399,470 396,574 378,964 361,353 378,964 361,353

EPS—basic 1.35 1.40 1.34 1.41 1.44 1.28 1.22

EPS—diluted 1.31 1.36 1.30 1.37 1.39 1.24 1.19

Average shares outstanding—basic 296,854 286,043 296,854 268,845 251,647 296,854 296,854
Average shares outstanding—diluted 304,690 293,879 304,690 276,681 259,483 304,690 304,690

Cash and equivalents 866,595 866,595 466,595 466,595 466,595 466,595 466,595
Total debt - - - 636,328 1,272,656 636,328 1,272,656
Total repurchase amount - 400,000 - 1,036,328 1,672,656 - -
Shareholders' equity 1,990,820 1,590,820 1,590,820 954,492 318,164 954,492 318,164
Common stock price (4/30/04) 37 - - - - - -
Market value of common stock 10,983,598 - - - - - -
Shares repurchased - 10,811 - 28,009 45,207 - -
Total Capital (Debt + Equity - Excess Cash) 1,990,820 1,590,820 1,590,820 1,590,820 1,590,820 1,590,820 1,590,820

Dividend Payout - - 400,000 - - 1,036,328 1,672,656

Dividend Payout Ratio (%) - - 100.9% - - 273.5% 462.9%
DPS - - 1.35 - - 3.49 5.63
Dividend Yield (%) - - 3.6% - - 9.4% 15.2%

Excess Cash for Repurchase / Dividend 0 400,000 400,000 400,000 400,000 400,000 400,000

ROE 0.20 0.25 0.25 0.40 1.14 0.40 1.14

PV Tax Shield - - - 244,986 489,973 244,986 489,973

EBIT interest coverage (x) - - - 22.5 11.3 22.5 11.3

EBITDA interest coverage (x) - - - 24.7 12.4 24.7 12.4
FFO/total debt (%) - - - 72.9% 35.0% 72.9% 35.0%
Free operating cash flow/total debt (%) - - - 63.3% 30.3% 63.3% 30.3%
Return on capital (%) 37.7% 42.7% 42.4% 42.4% 42.4% 42.4% 42.4%
Operating income/sales (%) 14.3% 14.3% 14.3% 14.3% 14.3% 14.3% 14.3%
Long-term debt/capital (%) 0.0% 0.0% 0.0% 40.0% 80.0% 40.0% 80.0%
Total debt/capital (%) 0.0% 0.0% 0.0% 40.0% 80.0% 40.0% 80.0%