INTRINSIC VALUE: In theory, the company’s management should try to maximize intrinsic value, and
the company’s stock price in the market – in the long run – should reflect this intrinsic value.
(From Brigham and Daves’ text “Intermediate Financial Management” 11th ed., page 236)
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How should company management choose between making investments in capital projects,
paying down debt, or distributing cash to shareholders via buybacks or dividends?
The company’s options for how to use cash:
1)
Invest in positive net present value (NPV) projects to grow future cash flows (FCFs).
2)
Pay down the debt.
3)
Repurchase common stock in the market or through a tender offer.
4)
Pay cash dividends to shareholders.
Finance textbook recommendations are typically:
Maximize the
value of the firm
#1: “Investment Decision”:
Invest in Positive NPV Projects
#2: “Financing Decision”:
Choose Optimal Mix of
Debt & Equity
#3: “Dividend Decision”:
After #1 and #2 decided,
return remaining cash to
shareholders
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How should management choose between making investments in capital projects versus
distributing cash to shareholders via buybacks or dividends?
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How should management choose between making investments in capital projects versus
distributing cash to shareholders via buybacks or dividends?
http://media.gm.com/media/us/en/gm/news.detail.html/content/Pages/news/us/en/2014/Oct/1001-gm-plan.html
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How should management choose between making investments in capital projects versus
distributing cash to shareholders via buybacks or dividends?
“ [Morgan Stanley lead auto analyst Adam Jonas wrote] ‘At its investor day, GM understandably focused its
attention on reestablishing cultural and strategic momentum. They didn't warn, so we're doing it for them.’
… [Jonas] argues that this kind of thing consumes tons of money. What he calls, with typically artful
language, a ‘crucial industrial metamorphosis’ is a process that will pit GM-the-carmaker against GM-thecompany-with-shareholders.
‘What concerns us...is whether shorter-term constituents in the stock market will appreciate the need for
GM to expend many billions of up-front capital to execute such important goals that may ostensibly
compete for capital return from share buybacks and dividends,’ he writes.”
Read more: http://www.businessinsider.com/morgan-stanley-downgrades-general-motors-2014-10#ixzz3FfTwkYYo
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Are Stock Repurchases (Buybacks) Good or Bad?
• We’ll talk about some of the pros and cons as we analyze the Wrigley case.
• For a more complete discussion, I encourage you to read the blog by Professor Aswath
Damodaran of New York University at:
http://aswathdamodaran.blogspot.com/2014/09/stock-buybacks-they-are-big-they-are.html
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Often when we think about companies who buy back shares or pay dividends, we think in
terms of companies who are flush with cash and trying to decide what to do with it.
Another option – BORROW money to buy back stock and/or pay dividends!
Leveraged recapitalization
From Wikipedia, the free encyclopedia
“In corporate finance, a leveraged recapitalization is a change of the capital structure of a
company, a substitution of equity for debt —e.g. by issuing bonds to raise money, and using that
money to buy the company's stock or to pay dividends.
• Such a maneuver is called a leveraged buyout when initiated by an outside party, or
• A leveraged recapitalization when initiated by the company itself for internal reasons.
These types of recapitalization can be minor adjustments to the capital structure of the company,
or can be large changes involving a change in the power structure as well.”
http://en.wikipedia.org/wiki/Leveraged_recapitalization
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Another consideration for company management when considering a leveraged
recapitalization so it can distribute cash to shareholders via buybacks and dividends:
Fitch Downgrades KLA-Tencor to 'BBB-' on Leveraged Recapitalization; Outlook Stable
Published: Oct 24, 2014 9:56 a.m. ET
• Fitch Ratings has downgraded the ratings for KLA-Tencor Corporation (KLA-Tencor) to 'BBB-' from
'BBB'. The action follows the company's announcement that it will issue $3.25 billion of
incremental debt in connection with a leveraged recapitalization transaction (the transaction).
The Rating Outlook is Stable. The rating actions affect approximately $4 billion of total debt, pro
forma for the completion of the transaction. A full list of rating actions follows at the end of this
release.
• The rating actions reflect KLA-Tencor's weakened credit protection measures, pro forma for the
transaction. Fitch estimates total leverage (total debt to operating EBITDA) will increase to
approximately 4x for the latest 12 months (LTM) ended Sept. 30, 2014, pro forma for the
transaction, versus 1x prior to the transaction. Fitch believes the higher leverage weakly positions
KLA-Tencor's credit profile within the 'BBB-' rating. However, Fitch anticipates increased
complexity for semiconductor makers will drive solid operating performance over the
intermediate term and result in total leverage below 3x in fiscal 2017.
• KLA-Tencor plans to issue $3.25 billion of incremental debt, consisting of senior unsecured notes
and a pre-payable term loan facility. The company will use net proceeds, along with cash on hand,
to fund a $2.75 billion special dividend payable by the end of calendar 2014 and $250 million of
incremental share repurchases within 12 to 18 months.
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Our roadmap for the Wrigley case
• We’ll build an Excel model to let us analyze whether Wrigley should do a leveraged recapitalization
(“recap”). Specifically, should Wrigley borrow cash using long-term debt (e.g., issue bonds) and use
the cash to either buy back shares of stock or pay dividends?
• The case focuses on a $3 billion recap. That will be our base case. Then we’ll look at other recap
sizes (e.g., $2 billion and $4 billion).
• We’ll need our model to generate the following items so we can consider them in our analysis:
1) Book value of equity before recap and for the various recap cases
2) Market value of equity before recap and for the various recap cases
3) Key financial ratios that will probably affect Wrigley’s debt rating and costs of borrowing
4) Expected impact on EBIT and earnings per share for the various recap cases
• When we’ve built the model, we’ll use it to:
 Consider qualitative factors that need to be considered
 Draw our conclusions and make our recommendation to Wrigley’s management
• Discuss what Dobrynin’s firm would do to make money (Apple and Icahn analogy).
• Discuss what Wrigley did over the following years.
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QUESTION: How does the recap impact the firm’s intrinsic value?
We’ll use the recap “shortcut” (next slide).
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The recap “shortcut”
Key assumptions:
1) Wrigley will borrow the money “into perpetuity” (forever) and pay interest each year but not pay down
principal. For example, if it issues 30-year bonds today, it will borrow the same amount in 30-years to
pay back the principal. Repeat every 30 years.
2) Wrigley will use all the money it borrows today to buy back shares or issue a “special” dividend.
3) Immediately upon the announcement of the recap, the stock’s price will reflect the recap value.
4) The value of the recap is the present value (PV) of the “debt tax shield” (text: page 620).
What’s the present value of a perpetuity that makes one payment each year?
Present value (PV) of a perpetuity = annual payment / required annual rate of return
Wrigley’s annual tax savings = [(interest rate per year)(Debt principal)]x(tax rate). (i.e., an “annual payment”)
Wrigley’s PV of its tax savings (“debt tax shield”) = [(interest rate per year)(Debt principal)]x(tax rate)
interest rate per year
For example: if Wrigley borrows $3 billion at 13% interest per year and has a 40% tax rate,
the PV of its tax savings (“debt tax shield”) = (.13)($3 billion)(.40)/(.13) = $1.2 billion.
[IN THEORY, INTEREST RATE DOESN’T MATTER AND THE PV IS ADDED TO WRIGLEY’S INTRINSIC VALUE IMMEDIATELY UPON ANNOUNCEMENT.]
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There are some additional considerations we’ll have to consider
Post-recapitalization equity market value =
From the last slide
Current “pre-recap” equity market value
+ PV of the debt tax shield
+ PV of distress-related costs (i.e., bankruptcy risks)
+ signaling effects, incentive effects, & clientele effects
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But there are some additional considerations we’ll have to consider
Post-recapitalization equity market value =
Current “pre-recap” equity market value
+ PV of the debt tax shield
+ PV of distress-related costs (i.e., bankruptcy risks)
+ signaling effects, incentive effects, & clientele effects
Let’s start building our Excel model to analyze these.
Then we’ll come back to these and also discuss the expected impact to WACC.
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Our Excel model starting point: How do we reconcile a company’s balance sheets (book value)
with its market value?
Market Value of Equity
From INVESTOPEDIA
DEFINITION of 'Market Value Of Equity'
The total dollar market value of all of a company's outstanding shares. Market value of equity is calculated by
multiplying the company's current stock price by its number of outstanding shares. A company's market
value of equity is therefore always changing as these two input variables change. A company's market value
of equity differs from its book value of equity because the former does not take into account the company's
growth potential.
INVESTOPEDIA EXPLAINS 'Market Value Of Equity'
Market value of equity is basically a synonym for market capitalization. It is used to measure a company's size
and helps investors to diversity their investments across companies of different sizes and different levels of
risk.
http://www.investopedia.com/terms/m/market-value-of-equity.asp
Let’s build our model. Please click on: Book value versus market value template.xlsx
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