Final Exam Case: “The WM. Wrigley Jr. Company: Capital Structure, Valuation and Cost of Capital” Submitted by: Rashid Mammadov, FTMBA 2014 Instructor: Prof. Sergei Chernenko, BUSFIN 7210 Date: April 28, 2013
I.
Business and credit risks at The Wm. Wrigley Jr. Company.
With round 13.1 billion worth of equity by June 2002, the Wm. Wrigley Jr. Company (herein after the Wrigley’s) is operating in branded consumer foods and candy industry, an industry with high level of concentration and intense rivalry. Although the industry itself is highly competitive, the Wrigley’s occupies a specific niche in the market as the leading producer and distributor of chewing gums putting itself into more advantageous position compared to the other industry players. As of 2002 the Wrigley’s was the biggest manufacturer of chewing gums with very high brand equity and strong presence globally. Being geographically diversified in multiple markets, maintaining market leadership in anti-cyclical industry and having strong growth in foreign markets the Wrigley’s is safe from the business risks prospective. Its low riskiness is also reflected in its equity beta of 0.75 as of 2002. Adding that through its history Wrigley has always maintained extremely conservative financial policy with zero debt, we can consider the Wrigley’s as AAA/AA graded company. In terms of financial risks, since the Wrigley’s does not have any debt obligations at the moment, it is financially risk free. With different levels of debt in its capital structure, the Wrigley’s credit ratings will change. II.
Effect of recapitalization on The Wrigley’s financial ratios and credit rating.
For analysis of the effect of proposed USD 3 billion recapitalization on the Wrigley’s, pro forma financial statements were forecasted under 10 per cent sales growth rate and percentage of sales method. The pro forma financials are given in Exhibits 1-4. Exhibit 1 shows key financial ratios under different credit rating assumptions reflecting changing interest burden and taxes. Further, the calculated ratios are compared to industry averages by credit ratings, shown in exhibit 2. From the comparison of exhibits 1 and 2, the Wrigley’s can’t maintain its high grade credit rating if it borrows 3 billion, as its main financial ratios will correspond to speculative grade levels. Therefore, restructured capital shall be most probably funded with debt rated between BB and B, which is supported by EBIT coverage, FFO-to-debt and FCFO-to-debt ratios. The other indicators, EBIT coverage and return on capital support higher credit rating. As the company book value of equity does not reflect the company real value, market leverage of the company was shown in Exhibit 1, which is 20.7% - rather consistent with high grade companies. Since the business risks are low for the Wrigley’s a BB rating - a higher side of the credit rating range that major financial ratios imply - is more likely. Rating agencies also account on management as an indicator of credibility therefore credible management character of the company also supports BB rating. 1
If company follows a share repurchase or dividend payout its book value will be reduced by 3 billion and will become negative, -1.6 billion. Possible prudential or accounting restrictions associated with negative book equity of public corporations were omitted in current analysis. III.
The Wrigley’s WACC without leverage.
Since the Wrigley’s is 100% owned by equity holders its WACC will be equal to its rate of equity (due to miscellaneous impact, a potential small negative leverage created by the excess cash is omitted). Given the unlevered beta of equity of 0.75, risk premium of 7% and risk-free rate of 4.86%, the Wrigley’s, according to CAPM, has cost of equity and WACC of 10.11% for fully equity owned company. IV.
The Wrigley’s WACC after recapitalization.
Method 1 – Assuming debt beta of 0.17 for BB rated borrowing, according to CAPM, cost of debt equals 6.05%, which is risk free rate of 4.86% added product of beta of 0.17 and risk premium or 7%. Then, based on Miller Modigliani Proposition II, with unlevered beta of equity of 0.75 and beta of debt of 0.17, equity beta re-levered by D/E of 26.2% will equal to 0.9. With equity beta of 0.9 and risk free rate and risk premium of 4.86% and 7% estimated cost of equity is 11.2%. In that case, given recapitalized D/V of 20.7% WACC equals 9.61%. Method 2 – Assuming yield on corporate debt of the Wrigley’s equals to average YTM of 10 year BB rated bond of 9.70% given from the case, cost of debt is equal to 7.63%. This reflects the adjustment for the expected probability and level of losses associated with debt. Calculation assumes rate of loss of 0.6 and default rate of 3.45% - average for consumer industry in 2002, which is also consistent with the range of default rates of 1.4% to 4.0% for BB+ to BB- rated bonds in 2002 in the US1. Given cost of debt of 7.63%, beta of debt shall equal to 0.40 according to CAPM. Miller Modigliani Proposition II formula implies that unlevered beta of equity of 0.75 with debt beta of 0.40 and D/E of 26.2 will result in levered equity beta of 0.84. Again from CAPM, given equity beta of 0.84 cost of equity will equal to 10.76%. With leverage of D/V of 20.7% that is implied from recapitalization, our WACC will equal 9.48%. The calculations assume risk free rate equal to YTM of 10 year US Treasury Bond, BB-rated debt YTM of 9.7%, market premium of 7% and tax rate of 40% which are given from the case. The results from two methods have a very small difference of 13 basis point and for further necessary calculations I would suggest Dobrynin uses WACC of 9.61%.
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https://www.standardandpoors.com/ratings/articles/en/us/?articleType=HTML&assetID=1245331026864#ID1942 5
2
Cost of debt Beta of debt Equity Beta (relev) Cost of equity WACC V.
Given benchmark YTM 7.63% 0.40 0.84 10.76% 9.48%
Given Debt Beta 6.05% 0.17 0.90 11.2% 9.61%
Effect of interest tax shield on stock price of the Wrigley’s.
On June 7, 2002 the Wrigley’s stock price was USD 57.07 per share. Given 232.441 million shares it means market capitalization of almost 13.26 billion US dollars. At tax rate of 40%, 3,000 million debt will result in interest tax shield of 1,200 million. The effect of interest tax shield will immediately be reflected into the new share price under perfect capital market assumptions. It means shareholders of the Wrigley’s will be 5.16 dollars better-of and the share price will go up to USD 62.23 per share. Under stock repurchase scenario, share prices will not change from 62.23 but the total market value of equity will be reduced through reduction in number of shares outstanding. Under 3 billion special dividend scenario, after pay back of 12.90 dollar per share, share price will go down to 49.33. Thus in both payout scenarios total value of equity will be the same 11,465.41 million after the transactions. VI.
Using share repurchase at the Wrigley versus paying special dividends.
Although under capital market assumptions both share repurchase and special dividends yield same results and shareholders are indifferent between those two, tax legislations and behavioral perceptions favor price repurchase to special dividends. Firsts, capital gain was often taxed less than dividend income. But in 2002 under J.W. Bush legislation both tax rates were same. However, shareholders might postpone their revenue recognition for tax purposes under share repurchase thus preferring share repurchase. Second reason for favoring share repurchase is that due to behavioral imperfections it is considered by investors as indicator of underpriced share which can drive company share prices up. Thus, share repurchase may cause extra capital gain for investors in addition to realization of interest tax shield. Third, the Wrigley’s stuff who receive options will be better of if 3,000 million will be distributed through capital gain rather than dividends, since capital gain of shares will also increase their stock option value. VII.
Possible financial distress costs at the Wrigley’s.
Under perfect capital market, bankruptcy will cause the shift of ownership from equity holders to debt holders while the total value of the firm will not be damaged. This assumption omits the fact companies under bankruptcy follow either liquidation or reorganization both processes involving direct and indirect costs. Debt holders foreseeing the costs of distress, which is usually 15-20% of the total value, set their lending rates at levels that already incorporate the bankruptcy costs therefore shifting those costs to equity
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holders. Therefore, price of fairly traded company stock will already incorporate the present value of likely bankruptcy costs imposed to them by debt holders. Direct costs associated with bankruptcy are costs for hiring experts in the area such as lawyers, accountants, auditors and other experts. In addition, management engagement in bankruptcy rather than to their business as usual duties is an opportunity costs associated with bankruptcy. Since Wrigley is a huge organization with operations in various countries possible direct costs of distress can be medium to high. Indirect costs for the Wrigley’s shall be very high. First of all, Wrigley is a producer and distributor of chewing gums, it means that partial liquidation of the Wrigley’s will damage distribution channels, important value added for the Wrigley’s. Second, company suppliers, various contractors, transportation providers that operate in different countries may not rely on the Wrigley’s anymore and request cash for the services. As we see from the Wrigley’s balance sheet in year 2001 company had accounts and accrued payables of round 220 million, in worst case scenario when partners may not be willing to maintain credit terms with the Wrigley’s, The Wrigley Jr. Company would require additional 220 million in cash for its daily operations. Third, the most important, the balance sheet shows that company does not have huge tangible assets that it can realize at reasonable price. The biggest assets of the Wrigley’s are its intangible patents and brand names. In case of fire sell with limited bargaining power, company may sell those assets at very low price which significantly increase the costs of bankruptcy for the Wrigley’s. VIII.
The effect of recapitalization on EPS of the Wrigley’s.
The below table illustrates the Wrigley’s share price, EPS and total value of the firm under three scenarios. Under first scenario – Status Quo, The Wrigley’s has highest EPS since it does not have any interest expenses. But it is also worth to notice that the total value of the Wrigley’s is the lowest. Adding the leverage of USD 3,000 million under BB rating assumption will significantly reduce the net income of the company therefore reduce the EPS. Therefore, if only effect on EPS is considered, misguiding conclusion to not to issue debt can be inferred. This effect will partially be offset in case of share repurchases, since decrease of the number of shares outstanding associated with share repurchase will push EPS up. In case of special dividend payout the downward effect of recapitalization and interest burden on EPS will not be adjusted since the number of shares outstanding will remain same. I believe that although EPS is an important index, it is not reliable indicator of value maximization of the shareholders, the ultimate goal in an organization that the decision should serve to. As we further see from the below table the total value will be maximized under recapitalization assumption through realization of interest tax shield which EPS measure does not support. Therefore, EPS shall not play a primary role in recapitalization decision. 4
Status Quo Repurchase Sp. Dividends IX.
# of shares 232.441 184.2 232.441
Share Price $57.07 $62.23 $49.33
EPS $1.45 $0.88 $0.70
Total Value $13,265.41 $14,465.41 $14,465.41
Opinion on Dobrynin to pursue or not with recapitalization proposal.
The decision on recapitalization shall consider several important factors: the amount of interest tax shield generated by leveraging, the probability of bankruptcy, costs of bankruptcy, effects on financial ratios, risk culture of company management and ownership. The recapitalization of the Wrigley’s will increase the total value of the company by 1.200 billion, which shareholders will immediately realize through capital appreciation. It is a very strong support toward leveraging. Another support for the recapitalization is that the revenues of the Wrigley’s are not volatile and business risks are low which makes the probability of the bankruptcy for the company low. Meanwhile, the impact of the bankruptcy through high costs of the financial distress associated with the nature of the business model of the Wrigley’s will increase the bankruptcy costs thus not favoring high leveraging. The implications on financial ratios show that the company will move to higher range of speculative grade from high grade level of credibility. This move may not be consistent to the risk culture of the management and the owners of the Wrigley’s therefore recapitalization could be rejected in spite of huge financial benefits. Given the pros and cons of re-leveraging, in my opinion, recapitalization through 3 billion of debt and same share repurchase is in the best interests of The WM. Wrigley Jr. Company shareholders, since it will in total increase their wealth by 1.2 billion which is a fair premium for the risks associated with leveraging the company.
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Exhibit 1. Pro Forma Financial Ratios under various credit rating assumptions The Wm. Wrigley Jr. Company - Key Financial Ratios under different credit rating assumptions AAA AA A BBB BB B EBIT interest coverage (x) 3.50 3.56 3.17 2.58 1.93 1.73 Funds from operations/total debt (%) 9.4% 9.5% 9.1% 8.3% 6.8% 6.2% Free operating cash flow/total debt (%) 6.6% 6.6% 6.2% 5.4% 3.9% 3.3% Return on capital (%) - market value 33.4% 33.4% 33.5% 33.6% 33.8% 33.9% Operating income/sales (%) 21.0% 21.0% 21.0% 21.0% 21.0% 21.0% Long-term debt/capital (%) - b.v. 195.2% 195.2% 195.2% 195.2% 195.2% 195.2% Total debt/capital (%) 195.2% 195.2% 195.2% 195.2% 195.2% 195.2% Long-term debt/capital (%) - market v. 20.7% 20.7% 20.7% 20.7% 20.7% 20.7% Inputs for calculations: Interest burden Funds from operations Free operating cash flow
$160.5 $283.1 $196.5
$157.8 $284.7 $198.2
$177.0 $273.2 $186.6
$217.8 $248.7 $162.2
$291.0 $204.8 $118.2
$324.6 $184.6 $98.1
BBB 3.9 30.6 12.8 13.1 15.5 40.3 47.0
BB 2.2 19.7 7.3 11.5 15.4 53.6 57.7
B 1.0 10.4 1.5 8.0 14.7 72.6 75.1
Exhibit 2. Key Industrial Financial Ratios (Three-year medians 2000-2002)
EBIT interest coverage (x) Funds from operations/total debt (%) Free operating cash flow/total debt (%) Return on capital (%) Operating income/sales (%) Long-term debt/capital (%) Total debt/capital (%)
AAA 23.4 214.2 156.6 35.0 23.4 (1.1) 5.0
AA 13.3 65.7 33.6 26.6 24.0 21.1 35.9
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A 6.3 42.2 22.3 18.1 18.1 33.8 42.6
Exhibit 3. Pro Forma Statement of Earnings (assuming BB debt rating for recapitalization scenario) The Wm. Wrigley Jr. Company Pro Forma Statement of Earnings (in millions) Earnings Net sales Cost of sales Gross profit Selling, general and administrative Operating income Investment income Other expense Earnings before income taxes Interest Expense Income taxes Net earnings Divideds Retained Earnings
year ended December 31 1999 2000 2001
Status Quo 2002*
Recapitalized 2002**
$2,061.6 $904.2 $1,157.4 $721.8 $435.6 $17.6 ($8.8) $444.4 $0.0 $136.2 $308.2 $152.9 $155.3
$2,672.6 $1,095.8 $1,576.8 $1,015.6 $561.2 $0.0 $0.0 $561.2 $0.0 $224.5 $336.7 $154.9 $181.8
$2,672.6 $1,095.8 $1,576.8 $1,015.6 $561.2 $0.0 $0.0 $561.2 ($291.0) $108.1 $162.1 $74.6 $87.6
$2,145.7 $904.3 $1,241.4 $778.2 $463.2 $19.2 ($3.1) $479.3 $0.0 $150.4 $328.9 $158.8 $170.1
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$2,429.6 $997.1 $1,432.6 $919.2 $513.4 $18.6 ($4.5) $527.4 $0.0 $164.4 $363.0 $168.0 $195.0
Exhibit 4. Pro Forma Balance Sheet Statement (assuming BB debt raging for recapitalization scenario) The Wim. Wrigley Jr. Company Consolidated Pro Forma Balance Sheet (in millions of dollars) ASSETS Current assets: Cash and equivalents Short-term investments, amortized cost Accounts receivable Inventories Other current assets Deferred income taxes - current Total current assets Marketable equity securities, fair value Deferred charges and other assets Deferred income taxes - noncurrent Property, plant, and equipment (at cost) Less accumulated depreciation Net property, plant and equipment TOTAL ASSETS LIABILITIES AND EQUITY Current liabilities: Accounts payable Accrued expenses Dividends payable Income and other taxes payable Deferred income taxes - current Total current liabilities Deferred income taxes - noncurrent Long term debt liabilities Other non-current liabilities Common stock Class B convertible stock Additional paid-in capital Retained earnings Treasury stock Accumulated other comprehensive income Total stockholders' equity TOTAL LIABILITIES AND EQUITY
2000
2001
Status quo 2002*
$ $ $ $ $ $ $ $ $ $ $ $ $ $
300.60 29.30 191.57 253.29 39.73 14.23 828.72 28.54 83.71 26.74 1,139.63 532.60 607.03 1,574.74
$ $ $ $ $ $ $ $ $ $ $ $ $ $
307.79 25.45 239.89 278.98 46.90 14.85 913.84 25.30 115.75 26.38 1,256.09 571.72 684.37 1,765.64
$ $ $ $ $ $ $ $ $ $ $ $ $ $
378.26 28.00 263.87 306.88 51.59 16.33 1,044.92 27.83 127.32 29.02 1,381.69 614.36 767.34 1,996.43
$ $ $ $ $ $ $ $ $ $ $ $ $ $
283.97 28.00 263.87 306.88 51.59 16.33 950.64 27.83 127.32 29.02 1,381.69 614.36 767.34 1,902.14
$ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $
73.13 113.78 39.47 60.98 0.86 288.21 40.14 113.49 12.56 2.94 0.35 1,492.55 (256.48) (119.01) 1,132.90 1,574.74
$ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $
91.23 128.41 42.71 68.44 1.46 332.23 43.21 113.92 12.65 2.85 1.15 1,684.34 (289.80) (134.90) 1,276.29 1,765.65
$ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $
100.35 141.25 46.98 75.28 1.60 365.46 47.53 125.31 12.65 2.85 1.15 1,866.18 (289.80) (134.90) 1,458.13 1,996.43
$ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $
100.35 141.25 46.98 75.28 1.60 365.46 47.53 3,000.00 125.31 12.65 2.85 1.15 1,771.90 (3,289.80) (134.90) (1,636.15) 1,902.14
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Restructure 2002**
