Case 30: Discussions 1.

Dobrynin plays the role of the financial entrepreneur, exploiting inefficiencies in investment valuation and corporate finance. She see s to profit by restructuring firms !ith "la#y financing$ or too much cash and unused debt capacity relative to the %lo!& ris s faced by the firms. 'y pressuring directors and managers to adopt more efficient policies, she hopes to reap an investment gain. (he larger issue is !hether or not )rigley is inefficiently financed. *f so, ho! much capital structure change !ill bring it to more efficient operation+ ,a. - recapitali#ation based on a dividend !ill have no effect on the number of shares outstanding. 'ut !ith a repurchase, the number of shares !ill change materially. *f !e ad.ust the current stoc price only for our estimate of tax benefits, the repurchase price !ould be /01.13. )rigley currently has ,3,.2 million shares outstanding. -t that price, 23.411 million shares !ill be repurchased %/3 billion5/01.13&, leaving 133.030 million shares outstanding. ,c. )ith the addition of the ne! debt, )rigley6s share price should 7uic ly and fully reflect the changes in investors6 perceptions stemming from the repurchase once the company publicly discloses its intentions. 8ne !ay to frame the issues is9immediately upon the announcement9the stoc price should change to reflect the follo!ing: :ost; recapitali#ation e7uity value < :rerecap. :resent value e7uity value = Debt tax shields < /10.34 /01.13 < /10.34 = Tc Debt 0.2 ? %/3,000& = /1,,00 or = /1.105sh :resent value of distress;related costs Challenging to observe + Signaling, incentive, > clientele effects @nobservable +

The effect of the present value of debt tax shields: *t sho!s that adding /3 billion in debt to )rigley6s capitali#ation and returning a li e amount to shareholders !ill add /1., billion in e7uity value due to tax effects. (he tax benefits are estimated assuming that )rigley commits to maintain the /3 billion in debt in perpetuity. (he net revised value per )rigley share is /01.13. Debt gro!s from #ero to /3 billion. -ssets gro! by /1., billion, e7ual to the present value of the debt tax shields.

,b. 'oo e7uity becomes negative as a result of the large payout under the dividend or share repurchase. Aar et value of e7uity declines by /1.3 billion, the result of the payout of /3 billion, !hich is offset by the benefit of the debt tax shields %/1., billion&. Bote that the accounting values give no attention to the value of debt tax shields and to the possibility that the mar et value of fixed assets may be greater than the historical value. ,f. @nder the share repurchase, the shrin age in shares outstanding might alter the influence of control groups. *n some tax environments, investors may have a preference for capital gains %triggered by a repurchase& as opposed to dividend income %!hich might be taxed more aggressively. 3. 'eginners !ill often turn to boo values as the basis for determining the !eights of capital for use in the !eighted;average calculation. C7uity accounts for 3DE of )rigley6s boo value of capital before the recapitali#ation. 'ut the boo value per share is /1.2D, 1 less than one;tenth of )rigley6s current share price of /10.34. (his huge disparity is the possibility that boo values are bac !ard;loo ing and ignore important economic considerations, such as the value of brands, intellectual property, and customer franchise as !ell as the debt tax shields. *n contrast, finance theory and best practice rely on the firm6s current mar et value as a guide to compute the capital !eights. 'efore the recapitali#ation, )rigley6s mar et value of e7uity accounted for DDE of its capital. -nd, after the recapitali#ation, that ratio fell to 43E. (he increase in leverage !ill imply a change in )rigley6s cost of capital. WACC before recapitalization )rigley6s prerecapitali#ation )-CC is 10.DE. (he cost of e7uity assumes a ris ;free rate of 1.01E for ,0;year @.S. (reasuries %case Cxhibit 4&, a ris premium is assumed 4E %or 1E&, and uses )rigley6s current beta of 0.41 %case Cxhibit 1&. 4. WACC after recapitalization (he increase in leverage !ill affect )rigley6s )-CC in at least three !ays: 1. Cost of debt: )rigley6s debt rating !ill change from --- %consistent !ith no debt& to a ''5' rating reflecting the higher ris . (he postrecapitali#ation credit rating is a matter of .udgment. *t is highly instructive to guide students through a rating exercise for )rigley6s pro forma recapitali#ation. (his re7uires computing the range of measures included in case Cxhibit 0 and determining !here in the ratings range the firm !ould fall., Comparing
1 C7ual to /1,,40,,34 ,3,,221 shares. , Fatio definitions are given in case Cxhibit 0, but the ratings agencies rely entirely on boo values.

)rigley6s pro.ected results to the benchmar s given in case Cxhibit 0 suggests that ''5' is a reasonable call. (urning to the yields by credit rating given in case Cxhibit 4, one can interpolate bet!een '' %1,.43E& and ' %12.00E& to obtain a cost of debt. (he cost used in the remainder of this analysis is 13E, 'lan a Dobrynin6s choice.3 Gields rise almost linearly across the investment;grade spectrum %--- to '''& and then rise curvilinearly at lo!er debt ratings9this hints at the problem that !e !ill encounter in estimating the cost of e7uity. ,. Beta: Gou should unlever )rigley6s current beta of 0.41, assuming the current values of boo debt and the mar et value of e7uity. (his gives an estimate of the unlevered beta of 0.41, reflecting the fact that )rigley has almost no debt. 2 (his beta then needs to be relevered to reflect the addition of /3 billion in debt. @sing the formula produces a levered beta of 0.34. -ll in all, this is not much of a change. )hy+ (he ans!er is t!ofold: first, the mar et value of )rigley6s e7uity is so large that /3 billion more in debt does relatively little to change the debt5e7uity ratio. Second, the levered beta formula is a linear model that accounts for debt tax shields but not the costs of financial distress. (hus, the curvilinear relationship bet!een ris and yield observed in case Cxhibit 4 is not reflected in the estimate of the levered beta. 3. Capital weights based on the market value of equity and the book value of debt : (hese !ere calculated earlier as 43E e7uity and ,,E debt. 'est practice and finance theory re7uire the use of long;term target !eights in calculating )-CC. -re those !eights the long;run target capitali#ation for )rigley or a short;run pea that !ill gradually change as )rigley repays its debt+ Hor the sa e of simplicity and the illustration of extreme change, the balance of this note !ill assume the 435,, percentage mix. Felevering beta to reflect the ne! mix of capital and other!ise assuming similar ris ;free rate and e7uity;mar et ris premium !ill yield an estimated cost of e7uity for )rigley of 11.4E. )e could d!ell on the modest increase of 30 basis points in the cost of e7uity. (his reflects the impact of the higher debt tax shields and does not incorporate the costs of financial distress relative to the levered beta as discussed earlier. -nother !ay is to compare the estimated cost of e7uity !ith the cost of debt. -ssumed at 13E, the cost of debt does incorporate a financial ris premium %as reflected in the changed credit rating&. Get the e7uity, !hich has a .unior claim on the assets of the firm, bears a lo!er cost. -gain, the paradox is explained by the fact that the estimated cost of e7uity ignores costs of financial distress. Combining the costs of e7uity and debt !ith the revised capital !eights yields a postrecapitali#ation )-CC of 10.D1E9virtually unchanged from the prerecapitalization
3 :essimistic analysts !ill lean to!ard a ' rating and I D of 12.00E. (his produces a postrecapitali#ation )-CC that is materially !orse than the prerecapitali#ation )-CC, and that proves to be a further disincentive to implement the recap. 2 Hor comparison, you might unlever the betas for )rigley6s peers %see case Cxhibit 1& and ta e the average. (his gives an average unlevered beta of 0.14. (he reasons for the difference in the unlevered betas are difficult to assess under the best of circumstances and virtually impossible given the abbreviated information in the case. Hor more advanced analysts, !e can assign the comparison of )rigley and its peer group9the competitive implication of lo!er capital cost for its peers.

W CC. (he company is manifestly ris ier in financial terms. )hy doesn6t the estimate of )-CC reflect this+ 'asically, the tax benefit of using more debt is virtually offset by the higher cost of e7uity, but most importantly, the estimate of the levered beta postrecapitali#ation fails to reflect costs of financial distress. Costs of financial distress revisited *f !e give )rigley a ''5' rating postrecapitali#ation. Some may !ish to argue that )rigley deserves a higher credit rating based on an assessment of its business and industry, as !ell as on reasoning from general no!ledge. (he firm has a dominant mar et position in an annuity business. *f on this basis one concludes that the present value of the expected costs of financial distress is small, then a )-CC of 10.D1E may not be unreasonable. @nder the assumptions based on a put option, the value of the put option on /3 billion in )rigley debt !ould be /0.30 million. *nserting this into the calculation offered earlier reduces the share price by /0.03,. :ost; recapitali#ation e7uity value < :rerecap. e7uity value < /10.34 /01.11 < /10.34 :resent value = Debt tax shields = Tc Debt 0.2 ? %/3,000& = /1,,00 or = /1.105sh :resent value of distress;related costs :ut option value J /0.03, million or J /0.00012 Signaling, incentive, > clientele effects @nobservable +

'y this estimate, the effect of the costs of financial distress is negligible. )ould )rigley6s current investors !elcome the recapitali#ation+ Surely a 0E increase in share price !ould be good ne!s, but does this compensate sufficiently for the increase in financial ris + 2.d Effect of recapitalization on reported earnings per share *f time permits, the instructor could explore the impact of the proposed recapitali#ation on )rigley6s reported financial performance. C'*(5C:S analysis is a method for exploring the sensitivity of earnings per share %C:S& to changes in C'*( %earnings before interest and taxes&. Case Cxhibit 3 gives a template for your analysis. (his compares the status 7uo C:S %assuming no recapitali#ation& !ith an C:S after the addition of /3 billion in debt and dra!s on data in case Cxhibits , and 3. (he focal point for this analysis is the operating income of /112 million, !hich is the value for the year ,001 %see case Cxhibit ,&. (he pro forma interest expense assumes /3D0 million at an interest rate of 13E. Bo ad.ustment is made for any possible amorti#ation of the debt. (he ey issue is !hat !ill be the expected C'*( next year and thereafter. *f one assumes /112 million, the issuance of /3 billion in debt reduces the expected C:S from /1.33 to /0.21 !ith

repurchase, or /0.3, !ith dividend. (his results simply from increased interest expense and the variation in the number of shares outstanding. Clearly, shareholders should brace for much !orse C:S results after the recapitali#ation. -t C'*( values of /112 million and above, the repurchase produces higher C:S values than does the dividend;based recapitali#ation. Does the !orsening C:S matter+ - !ide range of research in financial economics suggests that investors see through reported C:S to base their investing decisions on cash flo!. 1. -nalysis sugg e s t s that the reca pit ali#a tion !ill crea t e retur n s on the order of DE9this figure is not larger simply bec a u s e )rigley is relativ ely richly; value d alre a d y. -s sho!n in cas e Cxhibit 1, )rigley trad e s at a price5 e a r nin g s multiple that is ma t e ri ally larger tha n its peer s. Kevera g e d reca pit ali#ation s hav e the gre a t e s t impac t on value !hen the targ e t firm is trading at depr e s s e d value s. -lso, given the very larg e ass e t value und erlying the debt, the costs of financial distr e s s app e a r to be negligible. 8ther effects, including signaling, inves t m e n t , and client el e consid e r a tio n s , are mor e difficult to gau g e but prob a bly bala nc e out to a mildly positive set of consid er a tio n s . Feport e d earning s per shar e !ill be dilute d significantly, but as argu e d abov e, C:S may not be a sufficient me tric to guide corpor a t e financial decision; ma ing. 8n thos e groun d s , it !ould app e a r that a lever a g e d reca pit ali#a tion !ould be attr a c tiv e.