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The Wm. Wrigley Jr. Company: Capital Structure, Valuation and Cost of Capital
The Wm. Wrigley Jr. Company: Capital Structure, Valuation and Cost of Capital
COMPANY
Context
Interest rates reached the bottom in 50 years, the use of debt financing has fallen as a result.
CEO have taken this too far and missed valuable opportunities to create value for different
shareholders. Aurora Borealis LLC, acting as an activist investor, looked for companies that
could generate value through restructuring. They then invested heavily in the stock and began
persuading management to undertake the strategy.
They identified a mature company that currently holds no debt at all, the William Wrigley Jr.
Company. They believe that if they analyze the firm, they will be able to create additional
shareholder value by leveraging the firm for a dividend or share recapitalization.
Company
Wrigley is the world’s largest manufacturer and distributor of chewing gum. The industry was
consumer foods and candy, intensely competitive and dominated by a few large firms. Revenue
growth was 10% while earning grew at 9%, reflecting the introduction of new products and
foreign expansion. The company had 1.76 billion no debt, the stock significantly outperformed
S&P composite index and was running slightly ahead of its industry index.
With a market value of equity at 13.1 billion, Aurora estimated that they could borrow 3 billion
with a credit rating of BB/B to yield 13%.
The theorem assumed that there are no taxes and bankruptcy costs. The market is efficient,
and thus companies are access to symmetric information. In this case, capital structure cannot
affect the value of companies. However, WM Wrigley is subject to tax rate (40%) in the real
world. According to Modigliani-Miller model proposition Ⅱ, tax allows a deduction of interest,
which increases the value of companies. Individuals or corporations are able to reduce their tax
by adopting tax allowance such as interest rate and medical expenses. This is called tax shield.
2
Therefore, after the recapitalization, the market value of WM is by adding tax shield to pre-
recapitalization market value of WM.
From the table, WM can increase its market value to $14.3 billion from $13.1 billion by issuing
debt.
In the real world, firms might go bankrupt with a high leverage level. The costs of financial
distress or the bankruptcy due to the high leverage hevel erodes the value of the firm(Chart 1).
Likewise, the increasing amount of debt can increase the cost of capital at higher levels (Chart
2). Because of a large amount of debt, the cost of debt could rise due to the increased default
risk of the company’s bond. Hence, Susan Chandler is suggested to show the disadvantages of
the high leverage level and the hurdles of issuing bonds.
1
(n.d.). Modigliani-Miller Theorem (M&M) - Investopedia. Retrieved December 5, 2017, from
https://www.investopedia.com/terms/m/modigliani-millertheorem.asp
2
(n.d.). Tax Shield - Investopedia. Retrieved December 5, 2017, from
https://www.investopedia.com/terms/t/taxshield.asp
Chart 1. 3
Chart 2. 4
3
(2013, September 19). Capital structure 1 - SlideShare. Retrieved December 5, 2017, from
https://www.slideshare.net/RakeshKumar296/capital-structure-1-26337000
4
(2013, September 19). Capital structure 1 - SlideShare. Retrieved December 5, 2017, from
https://www.slideshare.net/RakeshKumar296/capital-structure-1-26337000
Investment Grade Non-Investment WM with debt
Grade
AAA AA A BBB BB B
Free operating cash 156.6 33.6 22.3 12.8 7.3 1.5 7.2%
flow/total debt (%)
As most of the ratios we calculated to determine where the company stand put them at a
BB/B rating. With a few higher values we believe they are closer to a BB rating putting the 13%
estimate as quite accurate.
Rm- Rf, which is also called risk premium, measures how much the return of the specific
company exceeds the geometric returns of the market. Aurora Borealis determined the risk
premium is 7%. For risk free rate, we used the 10-year U.S. Treasury rate, 4.86% this was to
match the kd analysis. The unlevered Beta is 0.75, according to Susan’s estimate. It is well
accepted that Beta should be levered due to the effect of debt on the volatility of the company in
comparison to the market as a whole. Tax shield increases the volatility of the company’s return
to the overall market. Although the levered Beta is meaningless under the equilibrium theory in
the capital market, it is accurate enough reveal the return of company’s stock against the return
of the overall market.
The levered Beta formula is:
βL = βu (1+ ((1-t)D/E))
The Beta of a financial-leveraged company is influenced by the tax rate and D/E ratio of the
company. WM is recommended to borrow $3 billion and its current market value is $13.1 billion,
and then the D/E ratio is 3/13.1=0.2290.
What is interesting to note here is that the company actually had a lower WACC before the
issuance of debt as it would only contain the Ke.
We assumed another alternative is all cash payout ratio, and thus the stock price and
outstanding shares remain the same, with $56.37/share and 232.441 million, respectively.
EPS
From the table, it is concluded that debt could decrease EPS because of the less Net Income
resulted from interest expenses. Additionally, repurchasing can reduce the impact of debt on the
change in EPS due to reduced shares outstanding.
Before recapitalization
% ownership 46.6%
After recapitalization
in millions except ownership and common stock class B stock total
votes
% ownership 60.4%
The dividend payout alternative would not change the ownership of WM family because we
assumed pay out the dividend by cash, which does not change the stock price and outstanding
shares. Therefore, the ownership of WM family in dividend payout is the same as that before
recapitalization.
From the table, Wrigley family’s vote control will increase to 60.4% from 46.6% due to a drop of
total votes outstanding. Wrigley family will increase its voting control by the repurchasing. This
would actually give the owners complete control over the direction of the firm.
Before
Com
mon LT LT LT
Shares Total Debt/ (LT Debt/ Debt /
Outstan Market Book LT Debt + (LT Debt LT Mkt
ding Value of Value of Debt Book + Mkt Debt/Boo Value
Company Recent (million Equity Equity (million Value of Value of k Value of
Name Price s) (millions) (millions) s) Equity) Equity) of Equity Equity
Cadbury
Schweppes $ $
plc $ 26.66 502.50 13,397 $ 5,264 2,264 30.07% 14.46% 43.01% 16.90%
Hershey $ $
Foods Corp. $ 65.45 136.63 8,942 $ 2,785 869 23.77% 8.85% 31.18% 9.71%
1,735.0 $ $
Kraft Foods $ 38.82 0 67,353 $ 39,920 8,548 17.64% 11.26% 21.41% 12.69%
Tootise Roll
Industries $ $
Inc. $ 31.17 51.66 1,610 $ 509 8 1.45% 0.46% 1.47% 0.47%
Wm.
Wrigley Jr. $
Co. $ 56.37 232.44 13,103 $ 1,276 $ - 0.00% 0.00% 0.00% 0.00%
S&P 500
Composite $1,148.08 18.23% 8.76% 24.27% 9.94%
After
Com
mon LT LT LT
Shares Total Debt/ (LT Debt/ Debt /
Outstan Market Book LT Debt + (LT Debt LT Mkt
ding Value of Value of Debt Book + Mkt Debt/Boo Value
Company Recent (million Equity Equity (million Value of Value of k Value of
Name Price s) (millions) (millions) s) Equity) Equity) of Equity Equity
Cadbury $ $
Schweppes $ 26.66 502.50 13,397 $ 5,264 2,264 30.07% 14.46% 43.01% 16.90%
plc
Hershey $ $
Foods Corp. $ 65.45 136.63 8,942 $ 2,785 869 23.77% 8.85% 31.18% 9.71%
1,735.0 $ $
Kraft Foods $ 38.82 0 67,353 $ 39,920 8,548 17.64% 11.26% 21.41% 12.69%
Tootise Roll
Industries $
Inc. $ 31.17 51.66 1,610 $ 509 $ 8 1.45% 0.46% 1.47% 0.47%
Wm.
Wrigley Jr. $ $
Co. $ 63.07 179.20 11,303 $ 1,276 3,000 70.16% 20.97% 235.07% 26.54%
S&P 500
Composite $1,148.08 18.23% 8.76% 24.27% 9.94%
4. Conclusion
It is common that companies repurchase outstanding shares since they believe their shares are
undervalued. However, currently, the firm is actually outperforming the S&P, which means they
are likely overvalued. It is an inappropriate time for WM to repurchase shares.
Share-repurchasing also leads to the loss in control. Although the owners may accumulated
voting right, end up being over 50% stake in the company after share-repurchasing, share-
repurchasing may be beneficial to an activist investor. They purchase a stake in the firm then try
to get the changes implemented, which means they would be totally reliant on the current
owners. If they butted heads on restructuring, it could greatly increase the chance of a loss in
the investment for an activist investor. This sends a signal that the deal may not be beneficial.
Additionally, while it would artificially increase the value of the overall firm ever other effect is
negative. We see an increased WACC, they would be a chance of bankruptcy costs with only a
BB rating which we did not even calculate as the deficiencies in this strategy were apparent
without additional calculation, a strong dilution in EPS sending a negative signal to the market,
and the consolidation of control. These signal that for the activist investor this would be a bad
investment and should not be attempted.
Further the best and worst case analysis proposed is not the best use of time i believe an
analysis showing the different EPS and EBIT would have been better showing the diffference in
proposed amount of debt. This would have allowed a better comparison of what would have
been the actual optimal debt structure for them firm not just a wild guess.
5. Recommendation
It is recommended for WM to issue less debt. I would analyze the effects of only 500,000 million
or 1 billion dollar debt on the ratios which are used to rate securities. By borrowing those
amount of debt, WM can capture an AA or an A rating respectively. As shown in chart 2, this
would push them lower on the wacc line and result in a lower cost of capital. The less reduction
in earnings should push up the EPS to be more in line, which is still not ahead of the
comparable firms. WM is not suggested to use this debt for share-repurchase which
concentrates ownership and sends a negative signal in the market. we recommend WM to issue
a one time dividend to stockholders, which will actually send a positive signal to the market
negating some of the negative signal in the falling EPS.
Tables below shows the higher credit ratings available from this strategy of less debt. Therefore,
we recommend WM to issue less debt to reduce the cost of debt and thus fully benefit from
financial leverage. The proposed plan would not be as profitable as hopped, but WM could still
generate substantial returns by having this firm restructure with less debts.
1 billion in debt
3 mos. 1.670%
6 mos. 1.710%
1 yr. 2.310%
2 yr. 3.160%
3 yr. 3.660%
5 yr. 4.090%
7 yr. 4.520%
10 yr. 4.860%
20 yr. 5.650%
AAA 9.307%
AA 9.786%
A 10.083%
BBB 10.894%
BB 12.753%
B 14.663%
Interest expense $ - $ - $ -
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