Jr.
FINA2222 Corporate Financial Policy
2022 Semester 2
Case Study (20%)
Proposal for Wrigley Wrigley Jr.’s recapitalization
Due date (Sep 17 noon)
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Your name is Blake Chandler, a fresh graduate from New York
University, now working for a prestigious hedge fund , Clark Asset
Management. You were called in to see your boss this morning,
Michael Clark, the managing partner.
“Interest rates are at their lowest point in 50 years. Yet the use of debt financing by
corporations is declining – this happens anyway in 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 extreme case you have mature firms who use no debt at all! Take WWJ
Company for instance. It has a leading market share in a stable low-technology business
– it makes chewing gum – and yet has no debt. I bet that if we could persuade WWJ
sport to do a leveraged recapitalisation through a dividend or major share purchase, we
could create significant new value. Blake, please run some numbers on the potential
change in value. And get me the names and phone numbers of all of WW Jays directors.”
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With these words, Michael asked you to initiate the research for a potential investment in
company named WWJ. The operation model for Clark Asset Management is to identify
opportunities for a corporation to restructure, invest significantly in the stock of the target firm,
and then undertake a process of persuading management and directors to restructure.
You noted that WWJ’s market value of common equity was about $13.1 billion. You also
discussed with Michael the current capital-market conditions and decided to focus on the
assumption that WWJ could borrow $3 billion at a credit rating of AAA with a yield of 9.31% in
the current market.
WWJ company overview
WWJ was the worlds largest manufacturer and a distributor of chewing gum. The firm’s
industry, branded consumer foods and candy was intensely competitive and was dominated by
a few large players. Its revenues had grown at an annual compound rate of 13% and earnings
at 10% reflecting the introduction of new products and foreign expansion (Exhibit 1: Income
Statement in Excel). Historically, the firm had been conservatively financed. At the end of 2021,
it had total assets of $1.66 billion and no long-term debt (Exhibit 2: Balance Sheet in Excel).
WWJ’s stock price (Exhibit 4: Other Information in Excel) had significantly outperformed the
S&P 500 composite index and was running slightly ahead of its industry index.
Estimating the effect of leveraged recapitalization
Under the proposed leveraged recapitalisation, WWJ would borrow $3 billion and use it either
to pay an equivalent dividend or to re-purchase an equivalent value of shares. You knew that
this combination of actions could affect the firm’s share value, cost of capital, debt coverage,
and earnings per share. Accordingly, you thought to evaluate the effect of the capitalisation on
these areas.
•
The impact on valuation and share price
You recalled that debt increased the value of a firm by means of shielding cash flows from taxes.
Thus, the present value of debt tax shields could be added to the value of the underlying
unlevered firm to yield the value of the levered enterprise. The marginal tax rate proposed to
use was 25%, reflecting the sum of federal state and local taxes.
•
The impact on the cost of capital
You also knew that the maximum value of the firm was achieved when the weighted average
cost of capital (WACC) was minimised. Thus, you intended to estimate what the cost of equity
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and the WACC might be, if WWJ pursued this capital structure change. The projected cost of
debt (rD) would depend on the assessment of the firm’s debt rating, AAA given the current
capital market rates (Exhibit 3: Credit Rating in Excel).
The cost of equity (rE) could be estimated by using a capital asset pricing model (CAPM). Exhibit
4 gives yields on U.S. Treasury instruments which afforded possible estimates of the risk-free
return (rf) and the equity market risk premium (rm – rf) of 7%. WWJ’s beta would also need to
be re-levered to reflect the projected recapitalisation.
•
The impact on reported earnings per share
You intended to estimate the expected effect on earnings per share (EPS) that would occur at
different levels of operating income (EBIT) with a change in leverage. You planned to draw a
graph to illustrate this.
•
Other effects
Lastly, you wondered whether your analysis covered everything. Where, for instance, should
you consider potential costs of bankruptcy and distress or the effects of leverage as the signal
about future operations? More leverage would also create certain constraints and incentives
for management. Where should those be reflected in the analysis?
Questions you answer to help drafting the proposal
As you draft a detailed proposal the recapitalization, you are guided by the above thoughts to
lay out the following questions for consideration.
Question 1 (Q1) The basic theory of capital structure
In perfect capital markets, what is the relationship between capital structure and cost of capital
(WACC)? Use the famous Miller-Modigliani proposition I and II, and WWJ as an example to
explain this thoroughly.
Tips:
1. Complete the table in Excel spreadsheet Q1 Perfect Mkt.
2. Draw a chart using debt level (D) against rE and WACC to support the discussion of MM
proposition I and II. (Paste the chart in appendix.)
3. Show your calculations for each variable in row (6) to (15) using debt = $3 billion.
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Question 2 (Q2) Impact of leverage on valuation and share price
To test the valuation effect of leverage, you assume that WWJ could borrow a maximum of $3
billion at a pre-tax cost of debt based on the firm’s AAA credit rating, and that the aggregate
amount of debt will remain constant in perpetuity. Also, you assume that the proceeds of the
loan would be used to repurchase shares or be paid as a special dividend to shareholders.
What is the amount of tax benefit, i.e., the present value of interest tax shields? How does
WWJ’s value and price per share change in the four-stage process, namely pre-recapitalization
(or initial), at the announcement of debt, when debt is issued, and after the fund is spent on (1)
repurchasing shares, or (2) paying a lumpsum of special dividend?
Tips:
1. Complete tables a and b under Q2 in Excel spreadsheet Q2 Valuation & Q3 WACC.
2. Show workings.
Question 3 (Q3) Impact of leverage on the cost of capital (WACC)
How does additional debt affect the cost of capital (WACC), in each scenario of debt being used
to repurchase shares and to pay a special dividend?
Tips:
1. Complete the table under Q3 in Excel spreadsheet Q2 Valuation & Q3 WACC.
2. Show workings.
Question 4 (Q4) Impact of leverage on EPS
You use sensitivity analysis to examine the effect on earnings per share (EPS) of issuing $3
billion of new debt and using the proceeds to repurchase existing shares or pay a special
dividend. The worst case is where EBIT drops by $400 million, and the best case is where EBIT
increases by $400 million, from the current level. What do you conclude from this analysis?
Should WWJ go with share repurchase or dividend?
Tips:
1. Complete the tables in Excel spreadsheet Q4 EBIT vs EPS.
2. Draw a chart using EBIT against EPS of share repurchase and EPS of dividend. (Paste the
chart in appendix.)
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3. Show workings.
Question 5 (Q5) other effects of leverage
What are other effects of the company issuing debt on its investors? Discuss it from the
perspectives of signalling effect, bankruptcy risk, managerial incentive, and anything you think
relevant. And finally, given the current position of WWJ in the market, should it go ahead with
debt issuance or not? (No calculation is needed for this one.)
Important tips from your colleagues that will help make this task easier:
While figures given in financial statements are in thousands, for simplicity, all numbers
calculated in the questions (spreadsheet Q1 to Q4) should be in millions with zero decimal place,
except for percentages and share prices, where 2 decimal places are needed.
Use MS Excel formula for calculations in the tables as Excel gives accurate numbers. When
showing workings in MS Word, for simplicity, you can round the numbers (in million dollars) to
integer, i.e., zero decimal place.
The total number of shares outstanding = common stock + Class B common stock (Balance
Sheet).
The cost of debt rD is fixed. Find it from supplementary documents in Appendix I.
APPENDIX I SUPLEMENTARY DOCUMENTS
EXCEL TABLE TEMPLATES
WWJ’SFINANCIAL STATEMENTS
OTHER COMPANY, INDUSTRY AND MARKET INFORMATION
AVAILABLE ON THE UNIT’S LMS - ASSESMENT 2: Wrigly_student.xlsx
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APPENDIX II IMPORTANT INSTRUCTIONS FOR COMPLETING THE ASSIGNMENT
• SUBMIT PDF DOCUMENT ONLY. Excel files are not acceptable.
• PAGE LIMIT: 5 PAGES (excluding appendices or references).
• The attached MS Excel spreadsheet tables must be completed and pasted into your
assignment together with graphs as appendices.
• On the front page of your assignment, include your group number, each contributing
members’ names, and their student ID.
• Fill out the Meeting Minutes Sheet after each meeting. The template is available for
download on LMS.
• Complete the assignment in MS Word using size 11 pt. Times New Roman font and 1.5
line spacing. Then convert it into PDF for submission
• For each question, use formular to complete Excel tables, and CLEARLY SHOW THE BASIS
OF YOUR CALCULATIONS in the Word document, so that partial credit can be awarded
where possible.
• Use Firefox or Chrome and avoid using Internet Explorer when you upload your
assignment. Upload it onto LMS from your hard drive, not Google Drive.
APPENDIX III REQUIREMENT ON SPARKPLUS - PEER ASSESSMENT
We use SPARKPLUS as a peer assessment mechanism to help track individual contribution
within a team. It is compulsory for this unit.
In SPARK, each student is required to provide anonymous rating and feedback to the other
team members in their group.
To register for SPARKPLUS – go to https://uwa.sparkplus.com.au, or use the SPARKPLUS link
provided on LMS (left-hand-side menu).
SPARKPLUS will be open twice, complete the task each time by its due date. Look out for the
reminders on LMS for the opening and closing times in Week 6, and 8-9, respectively.
Failing to complete the second SPARK assessment will result in the group score being
multiplied by 0.8 to obtain your individual mark (unless your SPARK assessment is lower).
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APPENDIX IV MARKING GUIDE
Q
1
2
3
4
5
Assessment Criteria
Completion of the spread sheet table and graph with clear workings
and a succinct discussion.
Completion of the spread sheet table with clear workings and a
succinct discussion.
Completion of the spread sheet table with clear workings and a
succinct discussion.
Completion of the spread sheet table and graph with clear workings
and succinct discussion.
Mark
Allocation
18
20
15
15
Succinct discussion (no calculation needed)
12
Total
80
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