Advanced Corporate Finance.

Wrigley Case

MSc Finance

Advanced Corporate Finance

25 September 2018

Table of Contents:

Potential Change in Value        2

Impact on WACC, EPS, Credit Rating and Voting Control        2

The Merits of Returning Cash to the Shareholders        4

Advice for the Wrigley Family        4

Appendix        5

Bibliography        8

Potential Change in Value

The formula for the APV methodology  is: Vlevered= Vunlevered + PV(ITS).

Before the recapitalization, the long term debt for Wrigley was zero. By relevering Wrigley the long term debt increased to $3bn. Despite this increase, Wrigley benefits from the present value of the tax shield.  Wrigley’s assets grew by $1.2Bn (0.4*$3Bn). Since the debt increased by $3Bn the value of equity decrease by $1.8Bn ($3Bn-$1.2Bn).

The total value of the firm before recapitalization (V-unlevered) was $56,37 USD * 232.441 million shares ($13.102.699.000). The present value of the interest tax shield is $1.2Bn. Therefore, the total value of Wrigley following the APV method is $14.302.699.000. So, $1.8Bn is the potential change in value from relevering Wrigley, which equals an increase of 9.2%. For further details see appendix I. 

Since Wrigley has a leading market share in a stable low technology business, we assumed the costs for financial distress after recapitalization are zero. Furthermore, we assumed other signaling effects also at zero. The signaling effects are not observable in this case, therefore we assumed them to be zero as well.

Furthermore, a dividend recapitalization has no effect on the number of outstanding shares. Contradictory, the repurchase leads to different number of outstanding shares.  As shown in appendix I, the share price increased by $5,16 (new share price $61,53 by new value of shares/number of outstanding shares). The number of outstanding shares changed by 3Bn/$61,53 which resulted in a repurchase of 48.755million shares, which resulted in 183.686 million shares outstanding after the repurchase recapitalization. However, since the new share price is $61,53 the enterprise value of Wrigley is not different for a dividend or repurchase recapitalization.

Impact on WACC, EPS, Credit Rating and Voting Control

WACC

Pre-recapitalization WACC

The cost of debt  corresponds with the 10-year Corporate Debt Obligations for AAA rated firms, since Wrigley had no debt before the recapitalization we assumed a triple A credit rating for Wrigley with a corresponding cost of debt of 9.31%. The cost of equity  is estimated with the CAPM. In this estimation, the risk-free rate (5.65%) is derived from the 20-year U.S. Treasury Obligations. A simple CAPM calculation shows the cost of equity is 10.90%. When a firm is unlevered, the cost of equity equals the WACC, this means the pre-recapitalization WACC of Wrigley is 10.90%. For further details see appendix II.[pic 1][pic 2]

Post-recapitalization WACC

Wrigley’s WACC is affected in three ways after the recapitalization. First of all, the cost of debt changes because the credit rating changes to a credit rating between BB and B, with a corresponding  of 13% before taxes, multiplying this with (1-40%) results in a  after tax of 7.80%. Secondly, the post-recapitalization WACC changes by the changing weights of the total capital. In the post-recapitalization situation, the amount of Debt increased to almost 21%. At last, the WACC is affected by the change in beta, because there exists a difference between the levered and unlevered beta. We have adjusted the unlevered beta with the Hamada equation^[1]. Using this equation resulted in a levered beta for Wrigley of 0.87. The change in credit rating, changing capital weights and the different beta results in a post-recapitalization WACC of 10.91%. When we compare the pre and post WACC we can conclude that relevering the firm has almost no impact on Wrigley’s WACC.[pic 3][pic 4]

EPS

The effect of the recapitalization on the Earning Per Share (EPS) are clearly visible in appendix III. Before the recapitalization, the EPS was $1325,13 in the most likely state. After the recapitalization through repurchasing shares, the EPS dropped significantly to $402,93 in the most likely state. Post-recapitalization with dividend pay-out, the EPS will be $318,42. The decrease in EPS can be explained by the interest expenses, which significantly affects the net income, and therefore the EPS. We assumed a 50% decrease/increase in EBIT for estimating the worst/best state.

Credit Rating

Wrigley’s’ credit rating before recapitalization, is for all of the different criteria AAA credit rated except the operating income/sales, which is between AA and A. Post-recapitalization we calculated for each specific criteria its corresponding credit rating. These can be found

in appendix V. After the recapitalization, Wrigley consists of four times a B credit rating, one time a BB rating, two times an A rating. Therefore, the assumption of Dobrynin and Chandler yield percentage of 13% is reliable since the credit rating of Wrigley after recapitalization is between BB and B.

Voting Control

A repurchase of shares would be favorable for the Wrigley family, as shown in the Excel file, the repurchase would mean an increase from 48,06% to 52,19% of the votes. This would provide the Wrigley family with the majority of the votes and therefore centralizes the decision-making. These calculations can be seen in appendix IV.

The Merits of Returning Cash to the Shareholders

There are several merits of returning cash by either dividend or share repurchase. When Wrigley would consider a share repurchase, their shares outstanding would decrease. Wrigley would have more control since they will possess more shares and therefore have a greater influence on the decision making: more concentrated ownership. This incentivize the large shareholders to increase the value of the company and think about the long term. Additionally, it has been shown that high concentrated ownership increases long-term stock returns (Edmans, 2016).