The Wm. Wrigley Jr. Company: Capital Structure, Valuation, and Cost of Capital Wm. Wrigley Jr. Company is a well-known leader that manufactures confections such as gums, mints, hard and chewy candies, lollipops, and chocolates. The company was founded in 1891 and its headquarters is based in Chicago, Illinois. It has operations in over 40 countries and distributes many of its world famous brand such as Double mint, Extra, Skittles, Orbit to more than 180 countries.
Investment strategy of Blanka Dobrynin, managing partner of Aurora Borealis LLC focused on distressed companies, merger arbitrage, change of control transactions, and recapitalizations. They are trying to buy a large stake in the company and thereby force the management to reorganize the capital structure by raising the debt and using it to pay the dividends or buy back the shares. As a part of evaluating they wanted to find if they are inefficiently financed or not.
Under the proposed recapitalization, Wrigley would borrow $3 billion and use it either to pay equivalent dividends or to repurchase equivalent shares. Chandler, an associate in Aurora Borealis, was calculating the impact of this debt on the company. This would affect firm’s share value, cost of capital, debt coverage, earnings per share, and voting control. The debt can increase the value of firm by providing appropriate tax shields. This will give Wrigley a rating of BB/B, and as a result the interest rate charged will be 13%. Chandler knows that maximum value will be achieved when WACC is minimized and she is estimating the impact of recapitalization on cost of equity and WACC.
Management is being forced to reorganize the capital structure by raising the debt and using it to pay the dividends or buy back the shares because Blanka Dobrynin is trying to buy a large stake in the company. The buyback of shares would increase the EPS for the firm as a natural consequence of reduction in number of shares outstanding. The increase in EPS will signal towards a positive market sentiment, which would result in increase in share price. Also, raising debt at lower cost of debt i.e. at good credit ratings lowers the WACC due effect of the tax shield and hence the value of the
firm. Rather than banking on the long term investment in growth and stability of the firm, Aurora Borealis, banks on instantaneous rise and fall in stock prices.
The value of the company has increased because the introduction of debt in the capital structure of an un-levered firm increases the worth of the company by the amount equal to the present values of the tax shield the stock price of the company rises. This certainly will help in decreasing the value of the company as the overall wacc should also decrease. As the company will have the obligation of paying assured interests to the banks, one also will have to become cautious of the financial distress costs & the bankruptcy costs associated with it. We find that the voting control of the family has increased from 47% pre capitalization to 51% post capitalization, assuming that the Wrigley family did not sell any shares during repurchase and all the shares sold were of common stock and not of class B stock. According to the case, William Wrigley Jr. Company had 232.441 million shares outstanding and the marginal tax rate was 40%, reflecting the sum of federal, state, and local taxes, but there is no debt in its capitalization. Reviewing the extra dividend and stock buyback through new debt of the leveraged recapitalization. Now assuming Wrigley make 3 billion as new debt to pay an equivalent dividend, then the extra dividend per share will be 3 billion / 232.441 million= 12.91. And a serious of data will change following the debt, the former equity value is 56.37. So cause of the tax effect, the former equity value will be: 56.37 + (3 billion * 40%) / 232.441 = 61.53.
So, because of the new price, the new number of shares that will be repurchased: 3 billion / 61.53 = 48.75 million
And the new outstanding shares remain:
232.441 – 48.75 = 183.69 million.
So the new market value of equity= 183.69 * 67.53= 11.3 billion, the new market value = 11.3+3= 14.3 billion. Reviewing the WACC, EPS versus EBIT analysis of Wrigley and voting control. Analysis of WACC
WACC = ke x We (1 – T) * Wd
In this case, Wrigley’s market value of common equity was about 13.1 billion and its debt is 0. So We = 1 and Wd = 0. Assume that a risk-free rate Rf = 5.65% for 20-year U.S. Treasuries, the practice at Aurora Borealis was to use an equity-market risk premium Rp = 7%, and ? = 0.75. So, Ke = Rf + ? * Rp = 5.65% + 0.75 * 7% = 10.9%
WACC = 10.9% * 1 + Kd (1 – T) * 0 = 10.9%
In this case, the shareholders’ equity in 2001 is 1.276287 billion. After recapitalization, Wriglry will have 3 billion in debt. Short-term debt = 3 / (3 + 1.276287) = 70.15%
According to the rate of company, it is between B and BB, so same as Dobrynin’s choice that Wrigley’s pretax cost of debt Kd would be 13%. Beta of Wrigley from EXHIBIT 5, ?u= 0.75
?l = ?u [1 + (1-T) D/E] = 0.75*[1 + (1 – 40%) * 3 /11.3] = 0.87 Finally, ke= Rf + ? * Rp = 5.65% + 0.87 * 7% = 11.74%
We = 11.3 / (3 + 11.3) = 79%
Wd = 3 / (3+11.3) = 21%.
After computing these data, the post-recapitalization WACC can be computed: WACCn = ke x We + Kd(1-T) x Wd
= 11.74% * 797% + 21% * (1 – 40%) * 13%
Analysis the voting control
Before the recapitalization, the Wrigley family controlled 21% of the common shares outstanding and 58% of class B common stock, so the percentage of Wrigley‘s family’s votes in the company:(189.8 * 21% + 42.641 * 58% * 10) / (189.8 + 42.641 * 10) = 46.60% After the recapitalization, assume that the new shares outstanding remain the same percentage. But the percentage of votes has been changed: (189.8 * 21% + 42.641 * 58% * 10) / (183.69 * 189.8/232.441 + 183.69 * 10 * 42.641/232.441) = 58.97% > 46.60% The current WACC of Wrigley is 10.9%. The raised debt, because of the debt tax shield under good credit ratings, it would reduce the WACC and hence increase the value of the firm. But in this case, the WACC almost remains the same. Although re-levering shows no effect on value of the firm, the EPS rises and the stock price rises due to the repurchase.
A possible explanation for this would be the decreasing financial stability of the firm and its ability to make profits in the future. The dividend payout, in our view is an ongoing commitment, as once the dividend is paid, shareholders expects at least the same dividends in the future. The reduction in dividends in future may disappoint the shareholders and the stock price may drop significantly after an announcement. A share repurchase is a temporary phenomenon and the company remains more flexible in terms of its financial decisions in the future. In conclusion, leveraged recapitalizations have the greatest impact on value when the target firm is trading at depressed values. Also, the very large asset value underlying the debt, the costs of financial distress appear to be negligible. But from the long-term growth perspective of the firm, the best policy would be to reinvest in the firm to grow in form of sales or pursue more profitable acquisitions. The dividend and stock buyback would although raise the price of the firm, but if control of the firm is not an issue of urgency and the management do not plan an appropriate utilization of the retained earnings and the new debt, then the company should refrain from adding on additional debt.