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The Wm. Wrigley Jr. Company: Capital Structure, Valuation, and Cost of Capital

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Case 34: The Wm. Wrigley Jr. Company: Capital Structure, Valuation, and Cost of Capital

FEG Corporate Finance II

2015-02-23

William Bratt 920501-3478

Linnéa Larsson 920623-4305

Sarah Nyman 920820-4546

Emma Lund 930320-5802

Johan Sandwall 910130-2413

Table of Contents

1. Introduction        

1.1 Problem statement        

1.2 Background company - The William Wrigley Jr. Company        

1.3 Methodology        

2. Theory        

The effect of a leveraged recapitalization        

2.1 Impact on Share Value, book value and market value        

The effect from the recapitalization        

2.2 Impact on Debt Rating        

2.3 Impact on Cost of Capital (WACC)        

WACC Before recapitalization        

WACC after recapitalization        

2.4 Impact on Reported Earnings Per Share        

EPS versus EBIT analysis        

2.5 Impact on Voting Control        

3. Analysis        

3.1 Conclusion        

4. References        


1. Introduction

Even though the interest rates are at their lowest point in 50 years, the debt financing by corporations is declining. Some firms choose to deleverage as a strategic choice, in for example the technological innovation industry. But firms deleveraging are many times unjustified, and it’s common that CEOs might miss valuable opportunities to create value for their shareholders. The William Wrigley Jr. Company uses no debt at all, even though it has a leading market share in a stable low-technology business.

Therefore has Blanka Dobrynin, managing partner of Aurora Borealis LLC, asked Susan Chandler, an associate to Wrigley, to initiate a research for a potential investment in Wrigley. Aurora Borealis is a hedge fund with about $3 billion under management and they have an investment”active-investor” strategy.  At first must opportunities for corporations to restructure be found, then they invest significantly in that firms’ stock. Then is the focus on increase firm value through recapitalizations, thus create arbitrage opportunities.

The investment would imply a leveraged recapitalization, either through a dividend or a major share repurchase. The purpose of the investment would be to create significant new firm value for Wrigley. According to the current market capital-market conditions, the assumption that Wrigley could borrow $3 billion at a credit rating between BB and B have been made. This would yield 13 %.

  1. Problem statement

  • A potential investment from Aurora Borealis to accomplish a leveraged recapitalization will affect the firms’ financial ratios.  How will share value, cost of capital, debt coverage, earnings per share and voting control be affected? 
  • The effects of the financial ratios will be different wether if the firm choose to pay out a dividend or repurchase shares. Which alternative is the most favorable? 
  • An investment will affect the firm on several different ways. Should Wrigley go for Aurora Borealis’ active-investor strategy or not?
  1. Background Company - The William Wrigley Jr. Company

The William Wrigley Jr. Company produces chewing gum and is the world’s largest manufacturer and distributor of this particular product. The industry that Wrigley operates in is distinguished by intense competition and is dominated by a few big companies. Wrigley have four main competitors: Cadbury Schweppes plc, Hershey Foods Corp., Kraft Foods Inc., and Tootsie Roll industries, Inc. Due to the introduction of new products and foreign expansion, Wrigley's’ revenues had grown at an annual compound rate of 10 %. The value of total assets were $1.76 billion end of 2001, and the firm used no debt in their financing. The stock price of Wrigley have had an excellent development last years. It was running ahead both the S&P 500 Composite Index and slightly ahead of the industry index. [1]

1.3 Methodology

An overview of The William Wrigley Jr. Company will be given in the beginning of the report. This will be followed up with a research of the different outcomes from the leveraged capitalization, on the basis of the financial ratios that concern share value, cost of capital, debt coverage, earnings per share and voting control. The research will be supported by calculations and a discussion whether which alternative, pay out a dividend or repurchase shares, is the most favorable in creating new firm value for Wrigley. Finally a conclusion will be given, whether the firm should go for Aurora Borealis’ active-investor strategy or not.

2. Theory

The effect of a leveraged recapitalization

The proposed leverage recapitalization of increased debt capital of $ 3 billion will be used for either dividend or repurchase shares. The change in mixture of equity and debt capital will affect share value, cost of capital, debt coverage, earnings per share and voting control.

2.1 Impact on Share Value, book value and market value

Market Value of Wrigley = 13.1 Billion

Amount of shares (189.8 + 42.642) = 232.441 million shares

Current Market Price for Shares: $ 13.1 / 232.441 million shares = $ 56,3584 per share

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With leverage Wrigley would reduce its annual tax payments, by using a permanent $3 billion debt. Tax rate is 40 %.

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The value of the firm has increased, the value of equity dropped after the recap. Thus once the investors know the recap will occur, the share price will rise immediately to a level that reflects the $ 1.2 billion value of the interest tax shield. [2]

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Wrigley currently has 232.441 million shares outstanding. They will therefore be able to buy back.

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Post recap. equity value

Pre recap.

Equity value

Present Value + Debt tax shield

$ 56.3584

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$ 61.5289

$ 56.3584

+ (0.4 * $ 3,000) = + $1,200 or + € 5.1626 per share

...

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