Aurora Borealis LLC pursues an “active investor” strategy where they “identify opportunities for a
corporation restructure, invest significantly in the stock of the target firm and then undertake a process of persuading management and directors to restructure.” Susan Chandler working for Aurora Borealis LLC was asked by Blanka Dobrynin to research The Wrigley Company as a potential investment. Under recapitalisation, Chandler must determine whether The Wrigley Company should issue an equivalent dividend or repurchase an equivalent amount of shares in order to maximise shareholder value. Accordingly, Chandler listed the following findings which are critical to making the decision. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.
Market value of common equity- $13.1bn Borrowing capability- $3bn Credit rating of The Wrigley Company- Between B and BB Yield- 13% Revenue growth rate- 10% Earnings growth rate- 9% Total assets (2001)- $1.76bn Marginal tax rate- 40% Pre-tax cost of debt- 13% Market risk premium- 7% Shares outstanding- 232.441mn Wrigley family ownership- 21% of common stock and 58% of Class B stock
We will try to find out the effect on WACC to identify the effect of leverage on the company finances Cost of Equity (Before Recapitalization) Market Risk Premium 20 Yr Risk free rate Beta
7% 5.65% 0.75
Ke
10.900%
Share Price
56.37
O/S Shares (in millions)
232.441 Value of Firm (in $ billions)
Value of unlevered Firm Debt capacity Value of tax shield Value of levered Firm
13.10 3.00 1.2 14.30
MV of Equity in levered firm
11.30
Financial Ratio
Value
Credit Rating
EBIT Interest Coverage Funds from Operations/Debt Free Op CF/Debt RoC Op Income/Sales LTD/Capital
1.41 18.82% 15.99% 21.12% 21.32% 70.15%
B B BBB A A BB
Tot Debt/Capital
70.15%
BB
From the above table we can see that company has high chances of getting a BB or a BBB rating. Below we try to compare the effective cost of borrowing for different ratings: Assumed cost of Debt Tax Rate Pre Tax cost of Debt (Rating B) After Tax cost of Debt Pre Tax cost of Debt (Rating BB) After Tax cost of Debt Pre Tax cost of Debt (Rating BBB) After Tax cost of Debt
40% 14.66% 8.80% 12.75% 7.65% 10.89% 6.54%
WACC (After Recapitalization) New D/E Levered Beta Ke (L) D/V E/V WACC (as per BBB) WACC (as per BB)
0.265 0.87 11.74% 0.210 0.790 10.65% 10.88%
WACC (as per B)
11.12%
The above calculations show that:
If the firm gets Credit Rating B, then it’s WACC is more than the cost of equity If the firm gets Credit Rating BB, then it’s WACC is almost equivalent to cost of equity If the firm gets Credit Rating BBB, then it’s WACC is less than the cost of equity
If the firm gets a B or BB rating then, it is not a good idea to take a loan as taking Debt is not serving the intended purpose of reducing the WACC for the firm, while adding unnecessary risk to the capital structure.
