CAPITAL STRUCTURE, VALUATION, AND COST OF CAPITAL

The Wm. Wrigley Jr. Company, for example

Introduction

Interest rates are at their lowest point in 50 years. Yet the use of debt financing by
corporations is declining – this happens anyway in a recession. And some deleveraging is
due to strategic changes in an industry, such as technological innovation or other
developments that increase business risk. But corporate deleveraging seems to have gone
too far. CEOs are missing valuable opportunities to create value for their shareholders. In the
extreme case, you have mature firms who use no debt at all. Take the Wm. Wrigley Jr.
Company, for instance.

Wrigley has a leading market share in a stable low technology business and at the date of
the case, Wrigley has been conservatively financed – carries no debt. If we could persuade
Wrigley’s board to do a leveraged recapitalization through a dividend or major share
repurchase, we could create significant new value.

Background

Blanka Dobrynin, managing partner of Aurora Borealis LLC, asked Susan Chandler, an
associate, to initiate the research for a potential investment in Wrigley. Aurora Borealis LLC
is an active investor hedge fund with about $ 3 billion under management and an invesment
strategy that focused on distresses companies, merger arbitrage, change of control
transactions, and recapitulations. Dobrynin is trying to buy a large stake in the company and
thereby force the management to reorganize the capital structure by raising the debt and
using it to pay the dividends or buy back the shares.

Equally, Dobrynin plays the role of the financial entrepreuner, exploiting inefficiencies in
investment valuation and corporate finance. Dobrynin seeks to profit by restructuring firms
with “ lazy financing” or too much cash and unused debt capacity relative to the low risks
faced by the firms. By pressuring directors and managers to adopt more efficient policies,
Dobrynin hopes to reap an investment gain.

In June 2002, Dobrynin is considering the possible gains from increasing the debt
capitalization of the Wm. Wrigley Jr. Company. Chandler noted that Wrigley’s market value
of common equity was about $ 13,1 billion. Based on the current capital market conditions,
Dobrynin and Chandler decided to focus on the assumption that Wrigley could borrow $ 3
billion at a credit rating between BB and B to yield 13 %.

Company Profile

Wrigley was the world’s largest manufacturer and distributor of chewing gum. The firm’s
industry, branded consumer foods and candy, was intensely competitive and was dominated
by a few large player. They that is Cadbury Schweppes plc, Hershey Foods Corp, Kraft
Foods Inc, Tootsie Roll Industries, Inc, and the Wrigley itself. (Exhibit 1)
Revenues had grown from 1999 to 2001 at an annual compound rate of 10% from $ 1,33 to
$ 1,61 on net EPS of common stock and earnings grown 9 % / year from $ 308,183 to $
362,986 on net earnings. (Exhibit 2)

As have been submitted above, Wrigley has been conservatively financed. At the end of
2001, it had total assets of $ 1,765,648 and no debt. (Exhibit 3)

Wrigley’s stock price had significantly outperformed the S & P 500 Composite Index and was
running slightly ahead of its industry index. (Exhibit 4)

In this case, we have the issue is whether or not, Wrigley is inefficiently financed? If so , how
much capital structure change will bring it to more efficient operation ?

Results of Chandler’s Research

: Estimating the Effect of a Leveraged Recapitalization

Wrigley would be proposed to borrow $ 3 billion and use it either to pay an equivalent
dividend or to repurchase an equivalent value of shares.

The actions could affect the firm’s share value, cost of capital, debt coverage, earning per
share (EPS), and voting control. Therefore need to evaluate the effect of recapitalization on
those areas. Financial data on Wrigley and its peer companies are presented. (Exhibit 5)

The evaluations according to Chandler, which are :

1. Impact on Share Value

The effect of leverage could be modeled by using the adjusted PV formula, which
hypothesized that debt increased the value of a firm by means of shielding cash flows
from taxes. Thus, the PV of debt tax shields could be added to the value of the unlevered
firm to yield the value of levered firm.

The marginal tax rate proposed was 40 % reflecting the sum of federal, state, and local
taxes.

2. Impact on Debt Rating

After assumption $ 3 billion in debt, what would be the debt rating for Wrigley and
whether the firm could cover the resulting interest payments ?

The assumption that Wrigley would borrow at a rating between BB and B. Was a rating
of BB/B likely ? The information on the average financial ratios associated with different
debt rating categories are presented. (Exhibit 6)

Wrigley’s pre tax cost of debt (r d) would be around 13 %. Assumption againts the capital
market information given in Exhibit 7.

3. Impact on Cost of Capital

The maximum value of the firm was achieved when the weighted average cost of capital
(WACC) was minimized.
 Estimate what the cost of equity (KE or rs ) and the WACC might be if Wrigley pursued this
this capital structure change. The projected cost of debt would depend on Chandler’s
assesment of Wrigley’s debt rating after recapitulation and on current capital market
rates. (Exhibit 7)

KE or rs could be estimated by using the capital asset pricing model (CAPM). Aurora
Borealis use to equity market risk premium (RP M) of 7.0 %. Wrigley’s β would also need
to be relevered to reflect the project recapitalization.

Whether analysis have covered everything?. Should Chandler take into account potential
cost of bankruptcy and distress or the effects of leverage as a signal about future
operations? More leverage would also create certain constraints and incentives for
management.

4. Impact on Reported Earnings per Share

Estimate the expected effect on EPS that would occur at different levels of operating
income (EBIT) with a change in leverage. The beginnings of an EBIT/EPS analysis are
presented in Exhibit 8.

5. Impact on Voting Control

Wrigley had 232.441 million share outstanding. A repurchase of shares would alter that
ammount. Their family controlled 21 % of the common shares outstanding and 58 % of
Class B common stock, which had superior voting rights to the common stock.

Assuming their family did not sell any shares, how would the share repurchase
alternative affect the family’s voting control position in the company ?

6. Conclusion

Easy for Chandler to run numbers the Wrigley, but difficult to drawing profitable insights.

Problem Statement

In this case we agree that problems which must be replied shall be as follows :

1. Estimate the potential change in value from re-leveraging Wrigley using adjusted present
value analysis.
2. Assess the impact on WACC, EPS, the credit rating of the firm, and voting control of the
Wrigley Family
3. Consider the merits of dividend or share repurchase as a means of returning cash to
shareholders.

Analysis

Wrigley would be proposed to borrow $ 3 billion and use it either to pay an equivalent dividend or
to repurchase an equivalent value of shares.

1. A recapitalization based on a dividen will have no effect on the number of shares

outstanding. But with a repurchase (buy back), the number of shares will change
materially. If we adjust the current stock price (P 0) only for our estimate of tax benefits,
the repurchase price would be $ 61,53 based on calculation as follow : (Exhibit 5)
 Post Recapitalization Pre Recapitalization The PV of Debt Tax
Equity Value of = Equity value of the + Shield per share
Levered Firm unlevered firm
$ 61,53 / share = $ 56,37 + 40 % x $ 3 billion
= $ 56,37 / share + $ 1,200 billion or
$1,200 b / 232,44 m
$ 5,16 / share

Wrigley currently has 232,44 millions shares outstanding. It’s planned that $ 3 billion will
be use to pay an equivalent dividend or to repurchase an equivalent value of shares with
calculation :
$ 3 billion / $ 61,53 = 48,757 million shares

183.683.296 share outstanding = 232.440.000 – 48.756.704

At that prices 48,757 million shares will be repurchased, leaving 183,68 million shares
outstanding.

2. Effect of recapitalization on WACC

Before recapitalization, Wrigley has no debt, so its capital structure is 100 % equity, and
at this point WACC = r s. Cost of equity (rs ) could be estimated by using the capital asset
pricing model (CAPM) that is :
rs = rRF + (RPM) β

Aurora Borealis use to equity market risk premium (RPM) of 7.0 %,

US Treasury Obligations for 20 yr has yield can be assumed as a risk free rate (rRF ) of
5,65 % (Exhibit 7),
Wrigley’s current β or βu of 0,75 (Exhibit 5)
rs = 5,65 % + (7 %) 0,75
rs = 10,9% = WACC pre recapitalization

After recapitalization, the increase in leverage will affect Wrigley’s WACC in at least 3
ways :

a. Debt Rating

Unlevered debt rating will change from AAA (conservatively no debt) to a BB / B

rating reflecting the higher risk.

From Exhibit 7, turning to the yields by credit rating on corporate debt obligations (10
year), firm can interpolate between BB (12,753 %) and B (14,663 %) to obtain a cost
of debt. Dobrynin, in this case, chosen the cost of 13 %.

b. Beta (β)

A stock’s beta is the relevant measure of risk for diversified investors. Both
theoritically and empirically, that beta increases with financial leverage. Therefore,
Wrigley’s β would also need to be relevered to reflect the project recapitalization.
 Relevering β to reflect the new mix of capital from the addition of the $ 3 billion in
debt.

Robert Hamada developes the following equation to specify the effect of financial
leverage on β :
β = βu [ 1+(1-T)(D/S)]
β = 0,75 [ 1+(1-40 %)(3.000 million / (61,53 x 183,68 million) ]
β = 0,87

A levered β is not much a change. Because first, from exhibit 5, the market value of
Wrigley’s equity is so large ( $ 13.103 billion ) so that $ 3 billion more in debt does
relatively little to change the debt / equity ratio. Second, the levered β formula is a
linear model that accounts for debt tax shields, but not the costs of financial
distresses.

A levered β and otherwise assuming similar risk free-rate and equity market risk
premium will yield an estimated cost of equity for Wrigley as follow :

rs = rRF + (RPM) β
rs = 5,65 % + (7 %) 0,87
rs = 11,7 %

The cost of equity increase of 80 basis points ( 10,9 % to 11,7 %) reflects the impact
of the higher debt tax shields and does not incorporate the costs of financial
distresses relative to the levered β.

c. Capital weight based on the market value of equity and the book value of debt.

These were calculated (assumpted) earlier as 80 % equity and 20 % debt.

Combining the costs of equity and debt with the revised capital weights yield a
postrecapitalization WACC :
WACC = wd ( 1 – T ) rd + we rs
WACC = 20 % ( 1 – 40 % ) 13 % + 80 % . 11,7 %
WACCL = 10,92 %

Postrecapitalization WACC almost unchanged from the Prerecapitalization WACC.

Wrigley is manifestly riskier in financial terms. The estimation of WACC doesn’t
reflect this matter. Basically, the tax benefit of using more debt is almost offset by
higher cost of equity, but most importantly, the estimated levered β
postrecapitalization fails to reflect incorporate the costs of financial distresses.

3. Effect of recapitalization on Reported Earnings per Share

An EBIT/EPS analysis is a method for exploring the sensitivity of earnings per share
(EPS) to changes in earning before interest and taxes (EBIT). In Exhibit 8, firm compares
the status quo EPS (assuming no recapitalization) with an EPS after addition of $ 3
billion in debt and draws on data in case Exhibit 2 and 3.
 Using debt results net income decline of 80 %, so D1 = $ 0,75 (1-0,8) = $ 0,15.
If one assumes $ 513,356 million, the issuance of $ 3 billion in debt reduces the
expected EPS from $ 1,61 to $ 0,40 with repurchase, or $ 0,15 with dividend. This
results simply from increased interest expense and the variation in the number of share
outstanding.

Clearly, EPS results is more worse after recapitalization, but at EBIT values of $ 513,356
million, the repurchase produces higher EPS values than does the dividend-based
recapitalization.

Total market value of equity before recapitalization (S) of $ 13.103 million but after
recapitalization (S1) = $ 61,53 x 183,68 million share outstanding = $ 11,302 million,
which is identical to the market value of equity if the the firm pays dividend instead of
repurchasing stock.

Conclusions

1. The current WACC of Wrigley is 10,9 %. Since it is all equity firm the WACC is same as
cost of equity. Raising $ 3 billion debt for repurchase of stock or dividend would change
the capital structure of the firm. In our case, the WACC after including the debt structure
almost remains the same (10,9 to 10,92). The reason of this change is the increase in
Beta (0,75) due to relevered at new debt level, which consequently brings the beta up
(0,87) to the same level at relevant debt ratios. Hence although re-levering show no
effect on value of the firm, the stock prices rises due to the repurchase. A possible
explanation for this would be the decreasing financial stability (riskier in financial terms)
and its ability to make profits in the future.

2. The dividend payout, in our case is an ongoing commitmet, as once the dividend is paid,
stockholders expect at least the same dividend in the future. The reduction in dividend in
future may dissapoint many of them and the stock price may drop significantly after an
announcement or in anticipation of any such announcements. Moreover, using debt to
payout the dividends would result in decrease the value of the firms.

3. A share repurchase is a temporary phenomenon and the company remains more flexible
in terms of its financial decisions in the future. An issue of urgency is control of the firm
and the management have to plan an appropriate utilization of the retained earnings and
the new debt, then the company should refrain from adding on additional debt.

FINANSIAL MANAGEMENT

CAPITAL STRUCTURE, VALUATION, AND COST OF CAPITAL

 The Wm. Wrigley Jr. Company

Lecturer:

Prof. Dr. Sukmawati Sukamulja, MM

GROUP 4 :

1. Sri Muniat
2. Eri Ardono Sutoyo
3. Metha Padmanaba
4. Yunus
5. Hanom

MM-AP14 MASTER OF MANAGEMENT

GADJAH MADA UNIVERSITY
2009