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The Wm Wrigley Jr. Company: capital structure, valuation, and cost of capital

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Yarrow Lin

on 8 December 2014

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Transcript of The Wm Wrigley Jr. Company: capital structure, valuation, and cost of capital

The Wm Wrigley Jr. Company
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Aurora Borealis
Data associated with case
Zhixuan Chu / Yaxin Zhou / Yin Le
Qixiang Fan / Yiling Lin / Wen Lei

The Wm Wrigley Jr. Company: capital structure, valuation, and cost of capital
Background
World’s largest manufacturer and distributor of chewing gum
The industry was intensively competitive and dominated by a few large players
William Wrigley Jr. Company has a leading market share and no debt
Firm had been financed conservatively and in 2001and total assets of $1.76B
Stock price significantly outperformed the S&P 500 Composite Index and was running slightly ahead of the industry index
Blanka Dobrynin
A managing partner of Aurora Borealis LLC. She identifies opportunities for a corporation to restructure, invest in the stock of the target firm and then persuades management to restructure.
Market Value of Common Equity $13.1 billion
Borrowing Capability $3 billion Credit Ration between BB and B
Yield 13%
Revenue Growth Rate 10%
Earnings Growth Rate 9%
Total Assets(2001) $1.76 billion
Marginal Tax Rate 40%
Pre-tax Cost of Debt 13%
Market Risk Premium 7%
Shares Outstanding 232.441 million
Wrigley Family Ownership 21% of common stock and 58% class B common stock
Discussion
How to restructure
Reason of restructure
Due to the low interest rates, Aurora Borealis LLC. is suggesting Wrigley take on $3B in debt and use it to pay equivalent dividend or to repurchase an equivalent value of shares.
An “active-investor” hedge fund with an investment strategy focused on distressed companies, merger arbitrage, change of control transactions and recapitalization.
The problem of issuing debt
As the debt to equity ratio increases there is a trade off between the interest tax shield and bankruptcy causing the target capital structure.
V
Levered
=V
Unlevered
+tD-C
Bankruptcy and Distress
Issue Dividends or Repurchase Stocks?
The market value of levered versus unlevered firm
Levered(million) Unlevered(million)
EBIT $513.356 $513.356
Interest(13%) $390 $0.000
EBT(EBIT-Interest) $123.356 $513.356
Taxes(40%) $49.342 $205.342
EAT $74.014 $308.014
Total cash flow to
both stock and
bond holders
$464.014 $308.014
Impact on Share Value
Impact of Debt Rating
Assume that Wrigley could borrow $3B at rating between BB and B, to yield 13%.
Corporate debt obligations(10 year)
Yield
AAA
AA
A
BBB
BB
B
9.307%
9.786%
10.083%
10.894%
12.753%
14.663%
Beta Calculations
Impact on Cost of Capital
rf Beta i (Rm-Rf) Ri
0.0565 0.75 0.07 0.1090
0.0565 0.87 0.07 0.1174
0.0565 0.87 0.07 0.1174
0.0565 0.88 0.07 0.1181
CAPM
WACC
Unlevered
Recapitalized
Dividend
Recapitalization
Recapitalized
Buyback
Wd
0.000

0.229

0.229
0.297
Kd
0.9307

0.13

0.13
0.13
(1-Tm)
0.60

0.60

0.60
0.60
We
1

0.771

0.771
0.703
Ke
0.1090

0.1174

0.1174
0.1181
WACC
0.1090

0.1083

0.1083
0.1062
WACC is not substantially decreased. Because the tax benefit of using more debt is offset by the higher cost of equity. The estimate of the levered beta post recap fails to reflect costs of financial distress. The lower cost of debt in the weighted cost of capital is largely offset of the cost of equity (risk adjusted for leverage).
Impact on EPS
EPS Comparison
Before Recapitalization


Worst Case Most Likely Best Case
$1.19 $1.33 $1.46
Earinings per share
After Recapitalization
(Shares Repurchased)


Worst Case Most Likely Best Case
$0.19 $0.32 $0.45
Earinings per share
EPS Comparison
Before Recapitalization


Worst Case Most Likely Best Case
$0.24 $0.40 $0.57
Earinings per share
Market Value
of Equity
Old share price
Tax Shield(billions)
Adjusted Share Price
Share(Millions)
Repurchase Price
Share Repurchased
Adjusted Share(millions)
Market Value of
Equity(millions)
Debt(millions)

Unlevered
56.37

56.37
232.441
-

232.441

13.103
-

Recapitalized
Dividend
56.37
1.2
61.53
232.441
-

232.441

11.303
3.000
Recapitalized
Buyback
56.37
1.2
61.53
232.441
61.53
48.755
183.686

10.354
3.000
After issuing $3 billion debt, we can calculate the debt interest coverage ratio by EBIT/Debt Interest. The interest on the debt is $390 million as calculated above. The EBIT in 2001 is $513.356million. So debt coverage ratio is $513.356m/390m=1.316.
Unlevered Beta
U
E
=
1+(1-t)
D

E
U
E
=[1+(1-t)
D

E
]
Voting Interest Analysis
The repurchase of shares would increase the Wrigley family’s voter-control. Because the Wrigley family holds over 50%, there will be a significant change in the family’s voting control position in the company.
Signaling effects
Generally, recapitalizations may signal to public investors the (better informed) expectations of insiders. Revelations of how the insiders view the future may cause public shareholders to revise their expectations about the firm’s future. For instance, all other things being equal, a large increase in debt may suggest management’s confidence that the firm’s future operating earnings will be less risky than in the past. However, the direction and magnitude of the signaling effects on share value are impossible to gauge rigorously.
Clientele effects
A large change in leverage may cause some investors to bail out of the stock and others to buy in. This is similar to the phenomenon of clientele change related to major changes in dividend payout by firms. As with the dividend decision, the question becomes whether the change in leverage will move the firm’s shares into the hands of the investors who are willing to pay the most.
Conclusion
A.Agree to take
on $3 billion in debt
B.Choose to repurchase shares,
but remain same dividend
payout
repurchase
shares
dividend
payout
C.Increase in value of
company and market share increase
D.Voter-control
increases
What we think The Wm Wrigley Jr. Company should do?
Full transcript