BWFF 3193 SEMINAR IN FINANCE (GROUP A) A122 CASE STUDY 5
SUBMITTED TO:
MS. SHAHRIZA BINTI OSMAN
PREPARED BY: OOI MEI LING
206729
CHIA KAH YEN
206807
LEONG CHIAO LENG
206866
YONG CHEW WEI
207079
Table of Contents
Case Summary .................................................................................... 3 1.0 Introduction .................................................................................. 4 2.0 Data Analysis................................................................................ 5 2.1 Active-investors strategy ........................................................... 5 2.2 The effect of issuing $3 billion of new debt and using the proceeds either pays dividend or shares repurchase on: ................. 5 2.3 Wrigley’s per-recapitalization and post-recapitalization of weighted average cost of capital (WACC) ...................................... 7 2.4 Determine the EPS/EBIT analysis to estimate the potential change in value using adjusted present value (APV) analysis in pay dividend and share repurchase. ..................................................... 10 2.5 Undertake the Recapitalization ............................................... 14 3.0 Conclusion .................................................................................. 15
A122 BWFF3193 SEMINAR IN FINANCE (GROUP A)
Case Summary Blanka Dobrynin is managing partner of Aurora Borealis LLC. He asked Susan Chandler to initiate the research for a potential investment in Wrigley. Aurora Borealis was a hedge fund with about $3 million under management and an investment strategy that focused on distresses companies, merger arbitrage, changeof-control transactions, and recapitalizations. In June 2002, he was considering the possible gains from increasing the debt capitalization of the Wm. Wrigley Jr. Company. Wrigley had been conservatively financed and at the date of the case, carried no debt. Chandler has to estimate the potential change in value from relevering Wrigley using adjusted present value analysis. Besides, she also has to assess the impact on the weighted-average cost of capital, earnings per share, the credit rating of the firm, and voting control of the Wrigley family. Not to forget, she has to consider the merits of dividend or share repurchase as a means of returning cash to shareholders.
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A122 BWFF3193 SEMINAR IN FINANCE (GROUP A)
1.0 Introduction The Wm. Wrigley Jr. Company was founded in Delaware in 1891 by William Wrigley, Jr. It became a corporation in 1903 where it moved its corporate headquarters to Chicago Illinois. Wrigley Jr. Company competes in the confection industry with an emphasis on chewing gum. Wrigley began with two gum brands, spearmint and juicy fruit and has since become the words number one manufacture of chewing and bubble gum. The company distributes to over 180 countries and has 15,800 employees worldwide. The Wm. Wrigley Jr. Company is a publically traded company on the New York Stock Exchange under the symbol, WWY. Wrigley’s competitors include Hershey Co. (HSY), Cadbury Schweppes (CSG) and Tootsie Roll Industries Inc. (TR). The case’s objective is to explore the financial effects of the capital structure change. Significant here is the trade-off between the tax benefits of debt and the associated costs in the form of financial distress and loss of flexibility. Next, related issues include signaling to investors, clientele effects (control considerations for the Wrigley family), and incentives created for directors and managers. Finally, to make a comparison of dividends and share repurchases.
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A122 BWFF3193 SEMINAR IN FINANCE (GROUP A)
2.0 Data Analysis 2.1 Active-investors strategy In active investor strategy, the firm looks for companies that could benefit from restructuring. Therefore, Blanka Dobrynin seeks to exploit inefficient in investment valuation and corporate finance. Hence, Dobrynin was trying exploring the financial effects of the capital structure change in Wrigley family which have no debt at all. Besides that, Dobrynin also need consider the merits of dividend or share repurchase as a means of returning cash to shareholders. In a result, Dobrynin was assumption that Wrigley can borrow 3 billion at a credit rating between BB and B, which yield 13%. This combination of actions could affect the firm’s share value, cost of capital, debt coverage, earnings per share and voting control.
2.2 The effect of issuing $3 billion of new debt and using the proceeds either pays dividend or shares repurchase on: i.
Wrigley’s outstanding shares Issuing 3 billion new debts to pay dividend to shareholder, number of outstanding shares will remain same or no effect. While, if Wrigley’s firm buy back shares will reduce the number of outstanding shares.
ii.
Wrigley’s book value of equity The total book value of equity is 1,276,000,000 outstanding shares. Hence, book value per share is 5.49. The book value will remain same and no affect by that two dividend payout method. This is because issuing more debt will not change company’s asset and company’s liability in balance sheet. 5
A122 BWFF3193 SEMINAR IN FINANCE (GROUP A)
iii.
The price per share of Wrigley stock The price of share will decrease if firm pay dividend. However, with repurchasing shares of the company stock will not effect on the share price directly. Some investors will see share repurchase as a “bullish sign” of the company so the shares may appreciate on that basis.
iv.
Earnings per share If the number of outstanding shares is reduced by repurchase shares, then the EPS will increase if EAT remains unchanged. In fact, The EAT is reduced because interest expenses. So by issuing more debt the EAT diminishes, then EPS will drop dramatically. Dividend affect next year’s earnings as they are taken out of the EAT. However, the EPS of share repurchase is higher than pay dividends.
v.
Debt interest coverage ratios and financial flexibility The debt interest coverage ratio is EBIT/Debt interest. The interest on the debt is 390 million and EBIT in 2001 is 527,366,000. The result is 1.35 (527,366/390,000). The dividend payout, in investors view is an ongoing commitment, as once the dividend is paid, stockholders expects at least the same dividends in the future. The reduction in dividends in future may disappointed many shareholders and the stock price may drop significantly after an announcement. Mean while, share repurchase is a temporary phenomenon and the company remain more flexible in terms of its financial decisions in the future.
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A122 BWFF3193 SEMINAR IN FINANCE (GROUP A)
vi.
Voting control by the Wrigley family Borrowed 3 billion of new debt to pay dividend should not any effect on the voting right of the Wrigley family. If firm buys back shares will have an effect on the voting right of the family. The percentage of the shareholdings of the Wrigley family is increase because when put shares repurchase in the company treasury are not longer outstanding.
2.3 Wrigley’s per-recapitalization and post-recapitalization of weighted average cost of capital (WACC) i.
Pre-recapitalization
Wrigley company did not leverage fund with debt instruments before, thus the WACC=CAPM that mean cost of capital unlevered firm = cost of capital levered firm. The WACC before recapitalization is 10.11%. First, we use 10 years U.S. Treasury bond as risk free rate which 4.86% and risk premium is 7% that estimate by Dobrynin and beta of unlevered is 0.75. Unlevered mean the company issues fund
with all equity, without debt.
CPAM 4.86% (7.0%)(0.75) 10.11% CAPM WACC 10.11%
ii.
Post-recapitalization
To create a successful recapitalization plan, we evaluated the appropriate level of debt to issue for the William Wrigley Jr. Company. We chosen capital structure is based on the effort to minimize the WACC and at the same time reducing increases in the cost of equity. The bellow figure 1 shown analysis performed at four proposed levels of debt:
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A122 BWFF3193 SEMINAR IN FINANCE (GROUP A)
RETURN ON CAPITAL OPERATING INCOME/SA LES LONG TERM DEBT/CAPIT AL
PRERECA P RATI O 41.32 %
AAA
$1 BILLI ON RATI O 23.17 %
21.13 %
AA-A
0
AAA
Estimated Rating
RATI NG
AA-A
$2 BILLI ON RATI O 16.10 %
21.13 %
AA-A
21.13 %
AA-A
21.13 %
AA-A
43.93 %
BBBBB
61.04 %
BB-B
70.15 %
BB-B
RATIN G
RATI NG BBBBB
RATING
A/B BB
AAA
A-BBB
$3 BILLI ON RATI O 12.33 %
BBB/ BB
BB/ B
Figure 1: Financial Ratios and Debt Ratings
From the figure, we estimated different level of debt will have different bond rating by calculate each financial ratio. With different debt issuing, cost of debt also different. For the 3 billion debt, cost of debt is 13% ((14.663%+12.753%)/2).
Cost
of
debt
of
2
billion
is
11.8%
((12.753%+10.894%)/2) and 1 billion is 10.5% ((10.894%+10.083%)/2). (Refer to EXHIBIT 7).
After find cost of debt, we calculate cost of equity use CAPM. Under CAPM, beta need recalculate because unlevered beta ≠ levered beta. The formula of levered beta show as below:
(1 t c ) Debt BUL BL 1 Equity whichBUL unleveredbeta
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A122 BWFF3193 SEMINAR IN FINANCE (GROUP A)
Tax rate in this case is 40% and unlevered beta is 0.75. After gather all information, we can start calculate WACC and we will create the table to see the differential with different mix weighted of capital structure of debt and equity.
Unlevered
1 billion
2 billion
3 billion
0.75
0.78
0.82
0.85
Risk free rate
4.86%
4.86%
4.86%
4.86%
Risk premium
7.0%
7.0%
7.0%
7.0%
Corporate tax rate (tc)
40%
40%
40%
40%
Cost of debt
0.0%
10.5%
11.8%
13.0%
Equity beta
Cost of debt after tax
0.00%
6.30%
7.08%
7.80%
Cost of equity=CAPM
10.11%
10.32%
10.60%
10.81%
Weight of debt
0.000
0.071
0.132
0.186
Weight of equity
1.000
0.929
0.868
0.814
10.11%
10.03%
10.13%
10.25%
2 billion
3 billion
WACC
Figure 2: WACC
Cost of debt WACC Estimated Rating
Unlevered
1 billion
NA 10.11% AAA
10.5% 11.8% 13.0% 10.03% 10.13% 10.25% A/BBB BBB/BB BB/B
Figure 3: Compare Debt rating and WACC
In the bass scenario estimated by Dobrynin, the corporation increases its debt level to 3 billion dollars. In this situation, the WACC is 10.25% which higher than before leverage (10.25%≥10.11%). This situation is no good sign, because we need find the minimum WACC. Besides that, The Corporation’s debt rating falls to BB to B range are classifies as a junk bond according rating agencies.
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A122 BWFF3193 SEMINAR IN FINANCE (GROUP A)
In the second scenario, we examined the cost of capital at 2 billion in debt. WACC is 10.13% and debt rating is range between BBB and BB, falling short of investment grade.
In the third scenario, total 1 billion will be issuing and WACC is 10.03% in overall. The calculated ratios based on 1 billion of debt leads to an estimated investment grade debt rating of A.
In conclusion, we choose the 1 billion debts to issues in capital structure. This is due to the minimum WACC and at the same time the rating grade is categories in A. With rating A will give more attractive and confident to the investor or shareholder supply more fund to the corporation.
2.4 Determine the EPS/EBIT analysis to estimate the potential change in value using adjusted present value (APV) analysis in pay dividend and share repurchase. First, we calculate the market value of the shares use APV. With the addition of the 1 billion new debt, Wrigley’s share price should quickly and fully reflect the changes in investors’ perceptions stemming from the repurchase once the company publicly discloses its intentions.
Post-
= Pre-recap.
Present value
Present value of
Signalling,
recapitalization
equity value
+ Debt tax
distress-related
incentive &
shields
costs
clientele
equity value
effects
= $56.37
+ Tc × Debt
Challenging to
Unobservable
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A122 BWFF3193 SEMINAR IN FINANCE (GROUP A)
$58.09
0.4 × ($1,000)
observe
+
?
= $56.37
?
$400,000,000 or + $1.72/per Shares
The effect of the present value of debt tax shields: It shows that adding $1 billion in debt to Wrigley’s capitalization and returning a like amount to shareholders will add $0.4 billion in equity value due to tax effects. The tax benefits are estimated assuming that Wrigley commits to maintain the $1 billion in debt in perpetuity. The net revised value per Wrigley share is $58.09. Debt grows from zero to $1 billion. Assets grow by $0.4 billion, equal to the present value of the debt tax shields. Second,
calculate
EPS/EBIT
with
pre-recapitalization
and
post-
recapitalization with repurchase shares and pay dividend. Both methods will experiment as below: Assumptions Interest rate on debt Pre-recap debt Tax rate
Before recapitalization 0 0 0.4
Before recapitalization Operating income (EBIT) Interest expense Taxable income Taxes Net income Shares outstanding
Worst case 474,629,000 474,629,000 189,851,600 284,777,400 232,441,000
Most likely 527,366,000 527,366,000 210,946,400 316,419,600 232,441,000
Best case 574,820,009 574,820,009 229,928,004 344,892,005 232,441,000
Earnings per share
1.23
1.36
1.48
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A122 BWFF3193 SEMINAR IN FINANCE (GROUP A)
If Wrigley want pay dividend in the future, the outstanding shares will remain unchanged which total 232.441 million. Due to firm use the debt, hence interest will be charged in this scenario. All figure can shown in below table:
Assumptions Interest rate on debt Pre-recap debt Tax rate
PAY DIVIDEND After recapitalization 0.10083 1,000,000,000 0.4
After recapitalization Operating income (EBIT) Interest expense Taxable income Taxes Net income Shares outstanding
Worst case 474,629,000 100,830,000 373,799,000 149,519,600 224,279,400 232,441,000
Most likely 527,366,000 100,830,000 426,536,000 170,614,400 255,921,600 232,441,000
Best case 574,820,009 100,830,000 473,990,009 189,596,004 284,394,005 232,441,000
Earnings per share
0.96
1.10
1.22
However, if the firm use the debt to repurchase the shares, then the outstanding shares will be reduced. Hence, we need shown the solution how many shares can we buy back and how much will be reduced.
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A122 BWFF3193 SEMINAR IN FINANCE (GROUP A)
Solution: Original share outstanding = 232.441 million Buyback amount/borrowed debt = 1 billion Current price of one shares = current stock price + tax shield = 56.37 + 1.72 = 58.09 Number of shares repurchased = (Invested amount / price of one share) = 1 billion / 58.09 = 17.215 million Remaining number of shares = 232.441 million – 17.215 million = 215.226 million
Assumptions Interest rate on debt Pre-recap debt Tax rate
SHARES REPURCHASED After recapitalization 0.10083 1,000,000,000 0.4
After recapitalization Operating income (EBIT) Interest expense Taxable income Taxes Net income Shares outstanding
Earnings per share
Worst case 474,629,000 100,830,000 373,799,000 149,519,600 224,279,400 215,226,590
Most likely 527,366,000 100,830,000 426,536,000 170,614,400 255,921,600 215,226,590
Best case 574,820,009 100,830,000 73,990,009 189,596,004 284,394,005 215,226,590
1.04
1.19
1.32
After estimate EPS/EBIT, we can conclude that EPS will reduce after issuing debt. This is because interest expenses. However, we still can see different result between pay dividend and share repurchase. ESS of shares repurchase still higher than pay dividend.
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2.5 Undertake the Recapitalization Blanka Dobrynin should try to convince Wrigley’s directors to undertake the recapitalization. With recapitalization, the corporation can enjoyed many benefits such as repurchase the undervalued shares, tax shield benefits from debt and others. In more detail, we will write down in conclusion and recommendation part.
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A122 BWFF3193 SEMINAR IN FINANCE (GROUP A)
3.0 Conclusion Considering all scenarios, we suggested Wrigley to issue 1 billion in debt. This option will minimize the overall cost of funding (see figure 3), as well as potential increase future profitability with higher leverage. At 1 billion dollars in debt, the firm maintain strong financial solvency and reduces change of default. In this case, the expected bankruptcy costs are small enough to be immaterial. With the additional fund, we advised the Wrigley use the debt to repurchase shares as opposed to delivering value through dividends. This approach allows the company to concern the voting rights of shareholders and provides positive market signals relating to management’s perception of an undervalued share price. Moreover, a repurchase has a tax advantages over dividends. It also provides services which shareholder can delay the dividend if no need. We would not suggest company pay cash dividend, this is due to three reasons: (1) it will not affect the number of outstanding shares decrease (2) shares price will not show any positive result, EPS not increase (3) people may think the company increasing debt to pay its dividend show that company not doing well. Therefore, with other solution, I recommended Wrigley buy back the shares. This is because the decreasing number of shares will lead EPS increase if EAT remain unchanged. However, EPS of shares repurchase will higher than EPS of pay dividend. A repurchase returns value to shareholders avoiding the negative signals associated with having reduced dividend after an unsustainably large payout. Overall, share price should not change as a direct result of the repurchase. This situation happened because in some investors perspective will see share repurchase as a “bullish sign” of the company so the shares may appreciate on that basis.
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