Allison Behuniak, Taylor Jordan,

Bettina Lopes, and Thomas Testa

William Wrigley Jr.

Company: Capital
Structure, Valuation, and
Cost of Capital


The Situation

Aurora Borealis was an active-investor hedge fund

with an investment strategy focused on distressed
companies, merger arbitrage, change of control
transactions and recapitalizations.

Blanka Dobrynin is a managing partner of Aurora

Borealis LLC. She identifies opportunities for a corporation
to restructure, invest in the stock of the target firm and
then persuades management to restructure.
The Situation

Worlds largest manufacturer and distributer of chewing gum.

The industry, branded consumer foods and candy was

intensively competitive and dominated by a few large players.

Over the last two years, revenues grew at annual compound

rate of 10% and earnings at 9% reflecting the introduction of
new products and foreign expansion.

William Wrigley Jr. Company has a leading market share and
no debt.

Firm had been financed conservatively and in 2001, total
assets of $1.76B.

Stock price significantly outperformed the S&P 500 Composite

Index and was running slightly ahead of the industry index.

Question 1: What other issues are involved
with a company being underleveraged?
Answer: The company will have insufficient debt in its
capital structure. Because bond interest is deductible for
tax purposes and is generally a fixed amount for a long
period of time, some use of debt can often result in
greater share price for stockholders. Companies are
missing opportunities to create value for the
shareholders.

Issue Dividends or Repurchase Stocks?

Due to the low interest rates, Auro Borealis LLC. is
suggesting Wrigley take on $3B in debt and use it to pay
equivalent dividend or to repurchase an equivalent value
of shares.

We are going to examine the effect of both on the firms

share value, cost of capital, debt coverage, EPS, voting
rights and financial distress of the company.
Issuing Debt

If Wrigley decides to issue debt, they

will have to pay fixed future interest
payments. This will indicate to investors
that management believes the company
will have strong future cash flows.

Management will choose to issue debt

when they believe equity is undervalued.
Trade-off Hypothesis

As the debt to equity ratio increases there is a tradeoff
between the interest tax shield and bankruptcy causing
the target capital structure.
Capital Structure

($ in Millions)
D+E D E D/(D+E) E/(D+E) D/E
Unlevered 13,103 - 13,103 0 1 -
Recapitalized 13,103 3,000 10,103 0.2290 0.7710 0.2969
Dividend
Recapitaliza:on
13,103 3,000 10,103 0.2290 0.7710 0.2969
Recapitalized
Buyback 10,103 3,000 7,103 0.2969 0.7031 0.4224

Repurchasing stocks will decrease the amount of equity

while equity remains the same when issuing dividends .
Repurchasing stocks will increase the debt to equity ratio
because they are retiring outstanding shares of equity.
Impact on Share Value
Market Value of Equity Unlevered Recapitalized Recapitalized
Buyback
Share Price 56.37 56.37 56.37
PV Tax Shield - 5.16 5.16
PV = (Tc x Debt)/Shares
Adjusted Share Price 56.37 61.53 61.53

Shares (Millions) 232.441 232.441 232.441
Repurchase Price - - 61.533
Shares Repurchased 48.755

Shs = (Debt / Repurchase Price)

Adjusted Shares (Millions) 232.441 232.441 183.686

Market Value of Equity
(Millions) 13,103 11,303 10,354
Debt (Millions) - 3,000 3,000

Leveraging the company will result in an increase in share value.

Interest expense will reduce the amount of corporate tax firms
must pay.
Share value will increase by the PV of the interest tax shield.
Valuing the Interest Tax Shield

We want to estimate the additional amount of taxes that a
firm would have to pay if it did not integrate leverage in its
capital structure.

The value of a levered firm will exceed the value of an

unlevered firm by an amount equal to the interest tax
shield.

APV Method of Valuation: VL = VU + PV of Interest Tax

Shield

Assumptions in tax shield valuation:
Debt levels are fixed (Wrigley will hold $3 billion debt
in perpetuity).
Interest rates and tax rates remain constant
PV of Interest Tax Shield = TC x D
Value will increase on a per share basis by:
Adjusted Share Price = Current MV SP + (TC x D)/Shares
 Impact of Debt Rating

Assume that Wrigley could borrow $3B at rating between BB
and B, to yield 13%.

Was this rating of BB/B likely? We do not know the exact

formula credit ratings use but when looking at size and
interest coverage ratio Wrigley falls in the BB/B range.




Corporate debt obligations
(10 year) Yield
AAA 9.307%
AA 9.786%
A 10.083%
BBB 10.894%
BB 12.753%
B 14.663%
Impact of Debt Rating

If Wrigley took on 3B in Debt, credit rating would drop to

BB. The cost of debt would increase and this would have a
negative impact on share price.

If you drop below a BBB, insurance companies will not

invest in those bonds. When insurance companies do not
invest, it will lower the demand and the yield to maturity
will increase. The increase in the YTM, will increase
Wrigleys cost of debt.

The debt securities would be considered junk bonds

and the market will perceive the companys equity
securities as a riskier investment.
Impact of Debt Rating

Investment Grade Non-Investment

AAA AA A BBB BB B
EBIT interest coverage (x) 23.4 13.3 6.3 3.9 2.2 1.0
Funds from operations/total debt (%) 214.2 65.7 42.2 30.6 19.7 10.4
Free operating cash flow/total debt (%) 156.6 33.6 22.3 12.8 7.3 1.5
Return on capital (%) 35.0 26.6 18.1 13.1 11.5 8.0
Operating income/sales (%) 23.4 24.0 18.1 15.5 15.4 14.7
Long-term debt/capital (%) (1.1) 21.1 33.8 40.3 53.6 72.6
Total debt/capital, incl. short-term debt
(%) 5.0 35.9 42.6 47.0 57.7 75.1

Wrigleys Interest Coverage= EBIT/Interest Expense= 1.32

IC is one of the most straight forward indicators of a
companys ability to comply with ST obligations.
Measures how many times a company could pay its
interest obligations out of its ongoing operating CFs if its
investments were only equal to depreciation.
 Beta Calculations
Re-Levering Beta
Unlevered Beta
Bu = /1+(1 /) x Be = Bu [1+(1-t) / ]
Be Be (D/E) Tc Bu
Bu (D/E) Tc Be No Debt 0.7500 - 0.40 0.75
No Recapitalized 0.8694 0.2654 0.40 0.75
Debt 0.75 - 0.40 0.75 Dividend
Recapitaliza:on 0.8694 0.2654 0.40 0.75
Recapitalized
Buyback 0.8804 0.2897 0.40 0.75

We need to unlever and relever Wrigleys beta to account for the

change in capital structure. The beta increases when we take on
debt and then again when we repurchase stocks because the debt to
equity ratio is increasing. The beta is a measure of the riskiness of the
firm which increases because of the increase in debt.
 Impact on Cost of Capital

CAPM Current weighted average cost of

rf Bi (Rm-Rf) Ri capital is 10.9%. With an assumed 40%
0.0565 0.75 0.07 0.1090 tax rate and 0 beta of debt, the debt
0.0565 0.87 0.07 0.1174 will not correlate significantly with the
0.0565 0.87 0.07 0.1174 broader market. Leverage will drive
0.0565 0.88 0.07 0.1181 down our cost of Capital minimally.
WACC
Wd Kd (1-Tm) We Ke WACC
Unlevered 0.000 0.9307 0.60 1 0.1090 0.1090
Recapitalized 0.229 0.13 0.60 0.771044799 0.1174 0.1083
Dividend Recapitaliza:on 0.229 0.13 0.60 0.771044799 0.1174 0.1083
Recapitalized Buyback 0.297 0.13 0.60 0.703058497 0.1181 0.1062

The new cost of equity WACC moves from .1090 to .1083 with a
dividend recapitalization and .1062 with a recapitalized buyback.
Weighted average cost of capital surprisingly remains similar
despite the $3 billion increase in leverage.
Question 3: Why does WACC not substantially
decrease?

Answer: The tax benefit of using more debt is
offset by the higher cost of equity. The estimate
of the levered beta post recap fails to reflect
costs of financial distress. The lower cost of debt
in the weighted cost of capital is largely offset of
the cost of equity (risk adjusted for leverage).
 Impact on EPS
EPS v. EBIT Analysis
AVer Recapitaliza:on
Before Recapitaliza:on AssumpAons No Repurchase / With Dividend
AssumpAons Interest Rate on Debt 13.0%
Interest Rate on Debt 0.0% Debt ($ in 000) 3,000,000
Pre-Recap Debt ($ in 000) - Tax Rate 40.0%
Tax Rate 40.0%
Worst Case Most Best Case
Worst Case Most Best Case
($ in 000, Except EPS) -10% Likely +10%
($ in 000, Except EPS) -10% Likely +10%
OperaAng Income
OperaAng Income (EBIT) 462,020 513,356 564,692
(EBIT) 462,020 513,356 564,692
Interest Expense - - -
Interest Expense 390,000 390,000 390,000
Taxable Income 462,020 513,356 564,692
Taxable Income 72,020 123,356 174,692
Taxes 184,808 205,342 225,877
Net Income 277,212 308,014 338,815 Taxes 28,808 49,342 69,877
Shares Outstanding Net Income 43,212 74,014 104,815
(Millions) 232.44 232.44 232.44 Shares Outstanding
Earnings Per Share $1.19 $1.33 $1.46 (Millions) 232.44 232.44 232.44
Earnings Per Share $0.19 $0.32 $0.45
 Impact on EPS

EPS v. EBIT Analysis

Before Recapitaliza:on
AssumpAons AVer Recapitaliza:on
Interest Rate on Debt 0.0% AssumpAons With Share Repurchase
Pre-Recap Debt ($ in Interest Rate on Debt 13.0%
000) - Debt ($ in 000) 3,000,000
Tax Rate 40.0% Tax Rate 40.0%

Worst Case Most Best Case Worst Case Most Best Case
($ in 000, Except EPS) -10% Likely +10% ($ in 000, Except EPS) -10% Likely +10%
OperaAng Income (EBIT) 462,020 513,356 564,692 OperaAng Income (EBIT) 462,020 513,356 564,692
Interest Expense - - - Interest Expense 390,000 390,000 390,000
Taxable Income 462,020 513,356 564,692 Taxable Income 72,020 123,356 174,692
Taxes 184,808 205,342 225,877 Taxes 28,808 49,342 69,877
Net Income 277,212 308,014 338,815 Net Income 43,212 74,014 104,815
Shares Outstanding Shares Outstanding
(Millions) 232.44 232.44 232.44 (Millions) 183.69 183.69 183.69
Earnings Per Share $1.19 $1.33 $1.46 Earnings Per Share $0.24 $0.40 $0.57

Shareholders will experience a decrease in EPS under all three

growth scenarios with the issuance of $3 billion in debt. The share
repurchase scenarios result in higher EPS than the dividend based
recapitalization case, due to the decrease in shares outstanding.
Question 4: Does a decrease in EPS matter?
Answer: It has been suggested that shareholders focus
less on reported EPS and more on cash flow when
evaluating investment opportunities.
 Voting Interest Analysis
Before Repurchase Repurchase AVer Repurchase

Share Ownership % Share Ownership %

Wrigley All Wrigley All
Family Others Total Family Others Total
Class B Common Stock 58% 42% 100% 58% 42% 100%
Common Stock 21% 79% 100% 21% 79% 100%

Shares Held (Millions) Shares Held (Millions) Shares Held (Millions)

Wrigley All Wrigley All Wrigley All
Family Others Total Family Others Total Family Others Total
Class B Common Stock 24.7 17.9 42.6 - - - 24.7 17.9 42.6
Common Stock 39.9 149.9 189.8 10.2 38.5 48.8 29.6 111.4 141.0
Total 64.6 167.9 232.4 10.2 38.5 48.8 54.4 129.3 183.7

Votes (Millions) Votes (Millions)

Votes Wrigley All Votes Wrigley All
Per Share Family Others Total Per Share Family Others Total
Class B Common Stock 10 247.3 179.1 426.4 10 247.3 179.1 426.4
Common Stock 1 39.9 149.9 189.8 1 29.6 111.4 141.0
Total 287.2 329.0 616.2 276.9 290.5 567.5

VoAng Interest % VoAng Interest %

Wrigley All Wrigley All
Family Others Total Family Others Total
Class B Common Stock 40.1% 29.1% 69.2% 43.6% 31.6% 75.1%
Common Stock 6.5% 24.3% 30.8% 5.2% 19.6% 24.9%
Total 46.6% 53.4% 100.0% 48.8% 51.2% 100.0%
Voting Control Position

The Wrigley family did not sell any shares. After the
repurchase the Wrigley Family's voting control position
improves from 46.6% to 48.8%, due to the family's large
holding of Class B stock (which carries 10 votes per share
compared to 1 vote per share for common stock).

The actual voting control composition changes very little

as controlling levels of ownership remain consist with
levels prior to the recapitalization.

Because the Wrigley family still holds under 50%, there

will not be a significant change in the familys voting
control position in the company.
Financial Distress

Leads to decrease in customers, decrease in
skilled employees and a reduction in R&D.

The threat of financial distress will cause
managers to purse certain strategies.

Agency costs are much higher when the firm is

close to bankruptcy.

There is an incentive to take large risks (asset

substitution), under invest and cash out.
Signaling

Capital Structure decisions are complicated
due to signaling.

Wrigleys managers have more information

about the firms business and finances and can try
to manipulate signals.

Decisions are watched carefully because they

carrying significant signaling value . However,
these signals have little value in the long run.

Increasing leverage and returning cash to

investors will signal a positive market reaction.
Dividend Signaling

Asymmetric information

Stocks price will generally increase when

the firm announces an increase in
dividends.

Thus, increased dividends cause the

stockholders to increase their expectations
of future earnings and cash flows.
Wrigley should repurchase its stocks
because it will create more value for
shareholders.

By leveraging, Wrigley will

have a more efficient capital
structure and will benefit
from the tax shield.
Question 5: How will Wrigley benefit by
opting to repurchase over a dividend?

More flexibility
Offset to dilution
Repurchase as investment
Tax advantage
Executive compensation
 WRIGLEY STOCK PRICE 2000-2008

$120.00

$100.00

$80.00

$60.00

$40.00

$20.00

$0.00
2000 2001 2002 2003 2004 2005 2006 2007 2008
 Debt to Equity Ratio
2002 2003 2004 2005 2006
Wrigley 0.3847 0.3842 0.4535 1.014 0.952
Hershey's 1.5374 2.4862 1.7992 3.194 5.0834
Tootsie Roll 0.2266 0.2399 0.4237 0.3179 0.2552
Wrigley Total Adjusted Annual Dividend Paid per Share
$1.20

$1.00

$0.80

$0.60

$0.40

$0.20

$0.00
Thanks for listening!






Questions?