Case 5.docx

BWFF 3193

SEMINAR IN FINANCE (GROUP A) A122

CASE STUDY 5

SUBMITTED TO:

MS. SHAHRIZA BINTI OSMAN

PREPARED BY:OOI MEI LING 206729

CHIA KAH YEN 206807

LEONG CHIAO LENG 206866

YONG CHEW WEI 207079

Table of Contents

Case Summary....................................................................................3

1.0 Introduction..................................................................................4

2.0 Data Analysis................................................................................5

2.1 Active-investors strategy...........................................................5

2.2 The effect of issuing $3 billion of new debt and using the

proceeds either pays dividend or shares repurchase on:..................5

2.3 Wrigley’s per-recapitalization and post-recapitalization of

weighted average cost of capital (WACC)......................................7

2.4 Determine the EPS/EBIT analysis to estimate the potential

change in value using adjusted present value (APV) analysis in pay

dividend and share repurchase.......................................................10

2.5 Undertake the Recapitalization................................................14

3.0 Conclusion..................................................................................15

A122 BWFF3193 SEMINAR IN FINANCE (GROUP A)

Case Summary

Blanka Dobrynin is managing partner of Aurora Borealis LLC. He asked

Susan Chandler to initiate the research for a potential investment in Wrigley. Aurora

Borealis was a hedge fund with about $3 million under management and an

investment strategy that focused on distresses companies, merger arbitrage, change-

of-control transactions, and recapitalizations. In June 2002, he was considering the

possible gains from increasing the debt capitalization of the Wm. Wrigley Jr.

Company. Wrigley had been conservatively financed and at the date of the case,

carried no debt.

Chandler has to estimate the potential change in value from relevering

Wrigley using adjusted present value analysis. Besides, she also has to assess the

impact on the weighted-average cost of capital, earnings per share, the credit rating of

the firm, and voting control of the Wrigley family. Not to forget, she has to consider

the merits of dividend or share repurchase as a means of returning cash to

shareholders.

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1.0 Introduction

The Wm. Wrigley Jr. Company was founded in Delaware in 1891 by William

Wrigley, Jr. It became a corporation in 1903 where it moved its corporate

headquarters to Chicago Illinois. Wrigley Jr. Company competes in the confection

industry with an emphasis on chewing gum. Wrigley began with two gum brands,

spearmint and juicy fruit and has since become the words number one manufacture of

chewing and bubble gum. The company distributes to over 180 countries and has

15,800 employees worldwide. The Wm. Wrigley Jr. Company is a publically traded

company on the New York Stock Exchange under the symbol, WWY. Wrigley’s

competitors include Hershey Co. (HSY), Cadbury Schweppes (CSG) and Tootsie Roll

Industries Inc. (TR).

The case’s objective is to explore the financial effects of the capital structure

change. Significant here is the trade-off between the tax benefits of debt and the

associated costs in the form of financial distress and loss of flexibility. Next, related

issues include signaling to investors, clientele effects (control considerations for the

Wrigley family), and incentives created for directors and managers. Finally, to make a

comparison of dividends and share repurchases.

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2.0 Data Analysis

2.1 Active-investors strategy

In active investor strategy, the firm looks for companies that could benefit

from restructuring. Therefore, Blanka Dobrynin seeks to exploit inefficient in

investment valuation and corporate finance. Hence, Dobrynin was trying exploring

the financial effects of the capital structure change in Wrigley family which have no

debt at all. Besides that, Dobrynin also need consider the merits of dividend or share

repurchase as a means of returning cash to shareholders. In a result, Dobrynin was

assumption that Wrigley can borrow 3 billion at a credit rating between BB and B,

which yield 13%. This combination of actions could affect the firm’s share value, cost

of capital, debt coverage, earnings per share and voting control.

2.2 The effect of issuing $3 billion of new debt and using the proceeds either pays dividend or shares repurchase on:

i. Wrigley’s outstanding shares

Issuing 3 billion new debts to pay dividend to shareholder, number of

outstanding shares will remain same or no effect. While, if Wrigley’s

firm buy back shares will reduce the number of outstanding shares.

ii. Wrigley’s book value of equity

The total book value of equity is 1,276,000,000 outstanding shares.

Hence, book value per share is 5.49. The book value will remain same

and no affect by that two dividend payout method. This is because

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issuing more debt will not change company’s asset and company’s

liability in balance sheet.

iii. The price per share of Wrigley stock

The price of share will decrease if firm pay dividend. However, with

repurchasing shares of the company stock will not effect on the share

price directly. Some investors will see share repurchase as a “bullish

sign” of the company so the shares may appreciate on that basis.

iv. Earnings per share

If the number of outstanding shares is reduced by repurchase shares,

then the EPS will increase if EAT remains unchanged. In fact, The

EAT is reduced because interest expenses. So by issuing more debt the

EAT diminishes, then EPS will drop dramatically. Dividend affect next

year’s earnings as they are taken out of the EAT. However, the EPS of

share repurchase is higher than pay dividends.

v. Debt interest coverage ratios and financial flexibility

The debt interest coverage ratio is EBIT/Debt interest. The interest on

the debt is 390 million and EBIT in 2001 is 527,366,000. The result is

1.35 (527,366/390,000). The dividend payout, in investors view is an

ongoing commitment, as once the dividend is paid, stockholders

expects at least the same dividends in the future. The reduction in

dividends in future may disappointed many shareholders and the stock

price may drop significantly after an announcement. Mean while, share

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repurchase is a temporary phenomenon and the company remain more

flexible in terms of its financial decisions in the future.

vi. Voting control by the Wrigley family

Borrowed 3 billion of new debt to pay dividend should not any effect

on the voting right of the Wrigley family. If firm buys back shares will

have an effect on the voting right of the family. The percentage of the

shareholdings of the Wrigley family is increase because when put

shares repurchase in the company treasury are not longer outstanding.

2.3 Wrigley’s per-recapitalization and post-recapitalization of weighted average cost of capital (WACC)

i. Pre-recapitalization

Wrigley company did not leverage fund with debt instruments before, thus the

WACC=CAPM that mean cost of capital unlevered firm = cost of capital

levered firm. The WACC before recapitalization is 10.11%. First, we use 10

years U.S. Treasury bond as risk free rate which 4.86% and risk premium is

7% that estimate by Dobrynin and beta of unlevered is 0.75. Unlevered mean

the company issues fund with all equity, without debt.

CPAM=4 .86%+(7 .0 % )(0 .75 )=10 . 11%CAPM=WACC=10 .11 %

ii. Post-recapitalization

To create a successful recapitalization plan, we evaluated the appropriate level

of debt to issue for the William Wrigley Jr. Company. We chosen capital

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structure is based on the effort to minimize the WACC and at the same time

reducing increases in the cost of equity. The bellow figure 1 shown analysis

performed at four proposed levels of debt:

PRE-RECA

P

$ 1 BILLION

$ 2 BILLION

$ 3 BILLION

RATIO

RATING

RATIO

RATING

RATIO RATING

RATIO

RATING

RETURN ON CAPITAL

41.32% AAA

23.17% AA-A

16.10% A-BBB

12.33%

BBB-BB

OPERATING INCOME/SALES

21.13% AA-A

21.13% AA-A

21.13% AA-A

21.13% AA-A

LONG TERM DEBT/CAPITAL 0 AAA

43.93%

BBB-BB

61.04% BB-B

70.15% BB-B

Estimated Rating AAA

A/BBB

BBB/BB

BB/B

Figure 1: Financial Ratios and Debt Ratings

From the figure, we estimated different level of debt will have different

bond rating by calculate each financial ratio. With different debt issuing, cost

of debt also different. For the 3 billion debt, cost of debt is 13% ((14.663%

+12.753%)/2). Cost of debt of 2 billion is 11.8% ((12.753%+10.894%)/2) and

1 billion is 10.5% ((10.894%+10.083%)/2). (Refer to EXHIBIT 7).

After find cost of debt, we calculate cost of equity use CAPM. Under

CAPM, beta need recalculate because unlevered beta ≠ levered beta. The

formula of levered beta show as below:

BL=(1+(1−t c )Debt

Equity )BUL

whichBUL=unleveredbeta

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Tax rate in this case is 40% and unlevered beta is 0.75. After gather all

information, we can start calculate WACC and we will create the table to see

the differential with different mix weighted of capital structure of debt and

equity.

Unlevered 1 billion 2 billionEquity beta 0.75 0.78 0.82Risk free rate 4.86% 4.86% 4.86%Risk premium 7.0% 7.0% 7.0%Corporate tax rate (tc) 40% 40%Cost of debt 0.0% 10.5% 11.8%Cost of debt after tax 0.00% 6.30% 7.08%Cost of equity=CAPM 10.11% 10.32% 10.60%Weight of debt 0.000 0.071 0.132Weight of equity 1.000 0.929 0.868

WACC 10.11% 10.03% 10.13%Figure 2: WACC

Unlevered 1 billion 2 billion

Cost of debt NA 10.5% 11.8%WACC 10.11% 10.03% 10.13%Estimated Rating AAA A/BBB BBB/BB

Figure 3: Compare Debt rating and WACC

In the bass scenario estimated by Dobrynin, the corporation increases its debt

level to 3 billion dollars. In this situation, the WACC is 10.25% which higher than

before leverage (10.25%≥10.11%). This situation is no good sign, because we need

find the minimum WACC. Besides that, The Corporation’s debt rating falls to BB to

B range are classifies as a junk bond according rating agencies.

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In the second scenario, we examined the cost of capital at 2 billion in debt.

WACC is 10.13% and debt rating is range between BBB and BB, falling short of

investment grade.

In the third scenario, total 1 billion will be issuing and WACC is 10.03% in

overall. The calculated ratios based on 1 billion of debt leads to an estimated

investment grade debt rating of A.

In conclusion, we choose the 1 billion debts to issues in capital structure. This

is due to the minimum WACC and at the same time the rating grade is categories in

A. With rating A will give more attractive and confident to the investor or shareholder

supply more fund to the corporation.

2.4 Determine the EPS/EBIT analysis to estimate the potential change in value using adjusted present value (APV) analysis in pay dividend and share repurchase.

First, we calculate the market value of the shares use APV. With the addition

of the 1 billion new debt, Wrigley’s share price should quickly and fully reflect the

changes in investors’ perceptions stemming from the repurchase once the company

publicly discloses its intentions.

Post-

recapitalization

equity value

= Pre-recap.

equity value

Present value

+ Debt tax

shields

Present value of

distress-related

costs

Signalling,

incentive &

clientele

effects

= $56.37 + Tc × Debt Challenging to Unobservable

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$58.09

= $56.37

0.4 × ($1,000)

+

$400,000,000

or

+ $1.72/per

Shares

observe

? ?

The effect of the present value of debt tax shields: It shows that adding $1

billion in debt to Wrigley’s capitalization and returning a like amount to shareholders

will add $0.4 billion in equity value due to tax effects. The tax benefits are estimated

assuming that Wrigley commits to maintain the $1 billion in debt in perpetuity. The

net revised value per Wrigley share is $58.09.

Debt grows from zero to $1 billion. Assets grow by $0.4 billion, equal to the

present value of the debt tax shields.

Second, calculate EPS/EBIT with pre-recapitalization and post-

recapitalization with repurchase shares and pay dividend. Both methods will

experiment as below:

Assumptions Before recapitalization Interest rate on debt 0Pre-recap debt 0Tax rate 0.4

Before recapitalization Worst case Most likely Best caseOperating income (EBIT) 474,629,000 527,366,000 574,820,009Interest expense - - -Taxable income 474,629,000 527,366,000 574,820,009Taxes 189,851,600 210,946,400 229,928,004Net income 284,777,400 316,419,600 344,892,005Shares outstanding 232,441,000 232,441,000 232,441,000

Earnings per share 1.23 1.36 1.48

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If Wrigley want pay dividend in the future, the outstanding shares will remain

unchanged which total 232.441 million. Due to firm use the debt, hence interest will

be charged in this scenario. All figure can shown in below table:

PAY DIVIDENDAssumptions After recapitalization Interest rate on debt 0.10083Pre-recap debt 1,000,000,000Tax rate 0.4

After recapitalization Worst case Most likely Best caseOperating income (EBIT) 474,629,000 527,366,000 574,820,009Interest expense 100,830,000 100,830,000 100,830,000Taxable income 373,799,000 426,536,000 473,990,009Taxes 149,519,600 170,614,400 189,596,004Net income 224,279,400 255,921,600 284,394,005Shares outstanding 232,441,000 232,441,000 232,441,000Earnings per share 0.96 1.10 1.22

However, if the firm use the debt to repurchase the shares, then the

outstanding shares will be reduced. Hence, we need shown the solution how

many shares can we buy back and how much will be reduced.

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Solution:

Original share outstanding = 232.441 million

Buyback amount/borrowed debt = 1 billion

Current price of one shares = current stock price + tax shield

= 56.37 + 1.72 = 58.09

Number of shares repurchased = (Invested amount / price of one share)

= 1 billion / 58.09 = 17.215 million

Remaining number of shares = 232.441 million – 17.215 million = 215.226

million

SHARES REPURCHASEDAssumptions After recapitalization Interest rate on debt 0.10083Pre-recap debt 1,000,000,000Tax rate 0.4

After recapitalization Worst case Most likely Best caseOperating income (EBIT) 474,629,000 527,366,000 574,820,009Interest expense 100,830,000 100,830,000 100,830,000Taxable income 373,799,000 426,536,000 73,990,009Taxes 149,519,600 170,614,400 189,596,004Net income 224,279,400 255,921,600 284,394,005Shares outstanding 215,226,590 215,226,590 215,226,590Earnings per share 1.04 1.19 1.32

After estimate EPS/EBIT, we can conclude that EPS will reduce after issuing

debt. This is because interest expenses. However, we still can see different result

between pay dividend and share repurchase. ESS of shares repurchase still higher than

pay dividend.

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2.5 Undertake the Recapitalization

Blanka Dobrynin should try to convince Wrigley’s directors to undertake the

recapitalization. With recapitalization, the corporation can enjoyed many benefits

such as repurchase the undervalued shares, tax shield benefits from debt and others. In

more detail, we will write down in conclusion and recommendation part.

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3.0 Conclusion

Considering all scenarios, we suggested Wrigley to issue 1 billion in debt.

This option will minimize the overall cost of funding (see figure 3), as well as

potential increase future profitability with higher leverage. At 1 billion dollars in debt,

the firm maintain strong financial solvency and reduces change of default. In this

case, the expected bankruptcy costs are small enough to be immaterial.

With the additional fund, we advised the Wrigley use the debt to repurchase

shares as opposed to delivering value through dividends. This approach allows the

company to concern the voting rights of shareholders and provides positive market

signals relating to management’s perception of an undervalued share price. Moreover,

a repurchase has a tax advantages over dividends. It also provides services which

shareholder can delay the dividend if no need.

We would not suggest company pay cash dividend, this is due to three

reasons: (1) it will not affect the number of outstanding shares decrease (2) shares

price will not show any positive result, EPS not increase (3) people may think the

company increasing debt to pay its dividend show that company not doing well.

Therefore, with other solution, I recommended Wrigley buy back the shares.

This is because the decreasing number of shares will lead EPS increase if EAT remain

unchanged. However, EPS of shares repurchase will higher than EPS of pay dividend.

A repurchase returns value to shareholders avoiding the negative signals associated

with having reduced dividend after an unsustainably large payout. Overall, share price

should not change as a direct result of the repurchase. This situation happened

because in some investors perspective will see share repurchase as a “bullish sign” of

the company so the shares may appreciate on that basis.

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