Wrigley's Recapitalization

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THE WM. WRIGLEY JR. COMPANY
Team 14
Constantine Brocoum
Courtney Delia
Stephanie Doherty
David Dubois
Radu Oprea
November 19th, 2009
William Wrigley Junior
Page i
Contents
Objectives ..................................................................................................................................................... 1
Management Summary ................................................................................................................................ 2
Active Investor Strategy ................................................................................................................................ 2
Effects of $3 Billion in New Debt for Dividend or Stock Repurchase ............................................................ 2
a.
Outstanding Shares ..................................................................................................................... 2
b.
Book Value of Equity ................................................................................................................... 2
c.
Price per Share............................................................................................................................. 3
d.
Earnings per Share ....................................................................................................................... 3
e.
Debt Interest Coverage Rations and Financial Flexibility ............................................................ 3
f.
Outstanding Shares .......................................................................................................................... 3
Wrigley’s Current Weighted Average Cost of Capital (WACC)...................................................................... 3
Debt Proceeds to Pay a Dividend or Repurchase Shares .............................................................................. 4
Wrigley’s Recapitalization ............................................................................................................................ 4
Should Wrigley’s directors undertake the recapitalization? ........................................................................ 5
Appendices.................................................................................................................................................... 6
William Wrigley Junior
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Objectives
This report seeks to answer the following five questions about William Wrigley Jr.:
1. In the abstract, what is Blanka Dobrynin hoping to accomplish through her active-investor
strategy?
2. What will be the effects of issuing $3 billion of new debt and using the proceeds either to pay a
dividend or to repurchase shares on:
a. Wrigley’s outstanding shares?
b. Wrigley’s book value of equity?
c. The price per share of Wrigley stock?
d. Earnings per share?
e. Debt interest coverage ratios and financial flexibility?
f.
Voting control by the Wrigley family?
3. What is Wrigley’s current (pre-re-capitalization) weighted-average cost of capital (WACC)?
4. What would you expect to happen to Wrigley’s WACC if it issued $3 billion in debt and used the
proceeds to pay a dividend or to repurchase shares?
5. Should Blanka Dobrynin try to convince Wrigley’s directors to undertake the recapitalization?
William Wrigley Junior
Page 1
Management Summary
The analysis identifies both risks and benefits associated with undertaking the
recapitalization for Wrigley. Given the reduction WACC, Wrigley should undertake the
recapitalization. The conclusions reached in the following will illustrate the effects that
the recapitalization will have on both equity in terms of outstanding shares, voting
powers, and earnings per share. It will also illustrate the effect of WACC in a B/BB
environment.
Active Investor Strategy
Blanka Dobrynin is a managing partner of the Aurora Borealis Company. The company utilizes a
strategy called “Active Investor” in which the firm identifies companies that could benefit from
restructuring and then invests heavily in the company’s stock. Aurora Borealis must convince
management and directors that restructuring will benefit the company and its stock holders.
Wrigley has virtually no debt. If Wrigley were to change the capital structure of the company by
increasing its debt/equity ratio, significant financial value would be created from the debt tax
shelter. This strategy created $156 million to be invested for shareholder gain. The value of this
extra cash flow is shown as the present value of a perpetuity at $1.2 billion. This is a significant
amount of value that is created due to the leveraging of the firm.
The market value of a levered firm versus an unlevered firm is as follows:
EBIT
Interest
EBT
[email protected]%
Levered
$ 527.00
$ 390.00
$ 137.00
$
54.80
Difference
Borrow Rate
PVP
Unlevered In Millions
$ 527.00
$
$ 527.00
$ 210.80
$
156.00
13%
$ 1,200.00
Effects of $3 Billion in New Debt for Dividend or Stock Repurchase
a.
Outstanding Shares
Issuing 3 billion dollars of new debt to buy back shares will reduce the number of outstanding
shares, placing those shares in the company treasury as treasury stock. Paying a dividend with
this borrowed money will not affect the number of shares outstanding.
b.
Book Value of Equity
The net asset value or book value of a company is calculated by total assets minus intangible
assets (patents, goodwill) and liabilities. So as the company issues more debt the book value is
William Wrigley Junior
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not changed since both sides of the balance sheet are increased by $3 Billion. The book value of
the company should not be affected by a dividend payout.
c.
Price per Share
The price of a share will decrease by the amount of the dividend paid per share. Repurchasing
shares of the company stock will not have an effect on the share price directly. Some investors
see share repurchase as a “bullish sign” for the company so the shares may appreciate on that
basis.
d.
Earnings per Share
Earnings per share (EPS) = Earnings After Taxes(EAT)/Outstanding Shares.
If the number of outstanding shares is reduced by a buyback of shares then the EPS will increase
if the EAT remains unchanged. However the EAT is reduced since there is interest expense. If
the dividend payout remains the same then the dividend paid per share will increase as well.
The debt interest would be 13% of $3 billion which is $390 million. EBIT in 2001 was
$527,366,000. So the EBIT is $137,366,000. Then this is taxed at 40% so the EAT is $82,420,000.
So by taking on more debt the EAT diminishes so the earnings per share will drop dramatically.
Dividends affect next years earnings as they are taken out of the EAT.
e.
Debt Interest Coverage Rations and Financial Flexibility
The debt interest coverage ratio is EBIT/Debt Interest. The interest on the debt is $390 million as
calculated above. The EBIT in 2001 is $527,366,000. So debt coverage ratio is
527,366/390,000=1.35 If Wrigley’s gets a non-investment grade rating then their financial
flexibility is severely limited.
f.
Outstanding Shares
Issuing 3 billion dollars of new debt to pay dividends should not have any effect on the voting
control of the Wrigley family. Using that money to buy back shares will have an effect on the
voting right of the family. When shares are repurchased they are put in the company treasury
and are no longer outstanding. Then the Wrigley family’s percent of outstanding shares would
rise giving them more voting control. They also have 58% if the outstanding shares of the Class B
shares which have a 10 to 1 voting advantage over the common share class. These shares are
not affected by the buyback.
Wrigley’s Current Weighted Average Cost of Capital (WACC)
The practice at Aurora Borealis is to use an equity market risk premium of 7.0 percent, therefore
this number was used in the WACC calculation.
Wrigley’s Market value of Equity is 13.103 (from exhibit 5).
William Wrigley Junior
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WACC
rD * (1-Tc) * D/V + rE * E/V
Unlevered
Equity Beta
Risk free rate
Equity Market Risk Premium
Corporate tax rate (tc)
re
rd (net cost of debt)
debt/equity
Wdebt
Wequity
0.750
4.86%
7.00%
40.0%
10.11%
0.000%
0
0.000
1.000
WACC
10.110%
Debt Proceeds to Pay a Dividend or Repurchase Shares
The $3 billion in debt would be used to either pay a dividend or repurchase shares, both having
as effect a reduction in market equity for Wrigley. When paying a dividend of 3B, the share price
would decrease correspondingly with 3B /outstanding shares, thus reducing the equity with 3B.
When repurchasing shares for 3B, the purchased stock would be either retired or kept in the
treasury with no voting rights or dividend rights. The number of shares outstanding is reduced
with 3B/share price, thus reducing the equity with 3B.
The effect of paying a dividend or repurchasing shares lowers the cost of equity, thus lowering
the investment risk in Wrigley. The WACC is consistently under the opportunity cost of capital,
after and before paying the dividend or repurchasing shares. We can conclude that borrowing
3B would benefit Wrigley, by lowering the cost of capital and keeping shareholders happy (by
paying a dividend or increasing the EPS), while maintaining the same level of investment risk.
Wrigley’s Recapitalization
Dobrynin estimates the Cost of Debt to be around 13%, placing it in line with the B/BB bonds.
The leveled WACC was mostly calculated considering the unleveled WACC as the opportunity
cost of capital (r) and estimating the cost of equity re, Modigliani and Miller prop2, as
re = r + (r – rd) D/E
On one instance the WACC was calculated by leveraging Beta and afterwards using CAPM.
βl = βu + βu(1- Tc) D/E
Wrigley’s market equity after taking debt and before paying dividends was calculated using
Modigliani and Miller prop 1, as
Equity = Equityunlevered + Tc * D
William Wrigley Junior
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WACC Calculation
Unlevered
CAPM
Equity Beta
Risk free rate (tr)
Expected return on market
Corporate tax rate (t c )
Cost of equity (re)
Cost of debt (rd)
Debt/Equity
Wdebt
Wequi ty
Wrigley's Equity (market)
Wrigley's Debt
Cost of debt
Net cost of debt
0.75
4.86%
11.86%
40.0%
10.11%
5.850%
0
0.000
1.000
13.103
0.000
WACC
10.110%
Levered (BB)
MM2
4.86%
11.86%
40.0%
10.762%
7.652%
0.265
0.210
0.790
11.303
3.000
12.753%
7.652%
Levered (Dobr) Levered(Dobr) Levered (B)
MM2
CAPM+lv beta MM2
0.869
4.86%
4.86%
4.86%
11.86%
11.86%
11.86%
40.0%
40.0%
40.0%
10.723%
10.95%
10.458%
7.800%
7.800%
8.798%
0.265
0.265
0.265
0.210
0.210
0.210
0.790
0.790
0.790
11.303
11.303
11.303
3.000
3.000
3.000
13.000%
13.000%
14.663%
7.800%
7.800%
8.798%
9.468%
9.456%
11%
10%
9%
8%
7%
9.632%
9.372%
WACC/Cost of Debt
12.753%
13.000%
13.000%
14.663%
Should Wrigley’s directors undertake the recapitalization?
After carefully considering the risks and benefits of the recapitalization for Wringley, we
recommend that the Board of Directors should undertake the recapitalization.
As Wrigley currently does not hold any debt, financial value would be added as a debt tax
shelter would be created by which the Company would be increasing its debt to equity ratio. As
previously stated $156 million would be invested for shareholder gain and the extra cash flow
would have a present value of $1.2billion.
Looking at the question about if a dividend or a stock repurchase occurred the positives of this
scenario was that there would be no affect on outstanding shares as this transaction would take
them from outstanding and put them back into treasury. Besides them being a treasury stock
the only other effect would be dividends paid. In addition, if this occurs, since they would now
be treasury stock Wrigley would have more voting control as the portion of Wrigley stock would
be greater. The book value of equity would remain unchanged as the balance sheet equity of
assets is equal to liabilities and equity would be balances because the $3 billion transaction
would affect both sides of the equation. The price per share would also remain unchanged
William Wrigley Junior
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because this number only changes when a dividend is paid. The only negative of this transaction
would be that next year’s earnings after taxes would drop due to the dividends.
Finally, the cost of equity was 13% which is B/BB, our WACC is declining of unlevered 10.110,
levered BB of 9.409%, levered (DoBr) of 9.396, and levered (B) of 9.304% support our conclusion
that the board should undertake the recapitalization.
Appendices
Levered Beta Calculation
Beta Calculations - Using Exhibit 6 Equity Beta estimate
Equity Beta = AssetBeta * (1 + MV D/E)
Unlevered
Levered
0.75
Equity Beta = 0.75 + 0.75 * (1 - 0.4) * 0.265 0.869
Equity Beta = 0.75 * (1 + 0) =
CAPM
Unlevered
Levered
William Wrigley Junior
CAPM = .0486 +.750 (.07) =
CAPM = .0486 + 0.869 (.07) =
10.110%
10.943%
Page 6
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