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The Wm. Wrigley Jr. Company Capital Structure, Valuation and Cost of Capital Case Solution
Blanka Dobrynin is the managing partner of Aurora Borealis, a hedge fund that has a strategy of investing in distressed companies. Founded in 2000, Aurora Borealis has been outperforming S&P stock index and industry index by following the “Active-Investor” strategy, i.e. focusing on distressed companies, merger arbitrage, change-of-control transactions, and recapitalizations.
Dobrynin is now interested to make an investment in Wm. Wrigley Jr. Company and change its financial position by leveraging up. Dobrynin seeks to take a debt of $ 3 billion and use the entire amount to either pay out dividends or repurchase shares. A detailed analysis shows that Aurora Borealis can materialize a return of 9.2% (capital gains) by investing in Wm. Wrigley Jr. Company and undergoing recapitalization.
Following questions are answered in this case study solution
What do you hope to accomplish Dobrynin through active investor strategy?
What is the nature of business of Wrigley? Is it a healthy and growing company? What would be an important signal for investors Wrigley recapitalization?
What will be the effect of the issuance of $ 3 billion in new debt and use the proceeds to pay a dividend or repurchase shares on the market value per share of Wrigley, no. of outstanding shares of Wrigley book value and the market value.
What are the relative merits of dividends or share buybacks?
Will they change the book value and market value as a result of the recapitalization?
What is the WACC Wrigley before the repurchase?
What will be the effect on earnings per share (EPS) for the issuance of $ 3 billion in new debt and use the proceeds to buy back shares or pay a dividend?
Case Analysis for The Wm. Wrigley Jr. Company Capital Structure, Valuation and Cost of Capital
2. What is the nature of business of Wrigley? Is it a healthy and growing company? What would be an important signal for investors Wrigley recapitalization?
Wm. Wrigley Jr. Company is the world’s largest manufacturer and distributer of chewing gums. Wrigley is competing in an industry, branded consumer foods and candy, with high competition and dominated by few confectionary and beverages giants such as Hershey Foods Corp. the financials of the company show that Wrigley consistently had a high dividend payout, compound growth of earnings and Price/Earnings ratio in the industry that shows high investor’s confidence, and it is one of the reasons why Wrigley has outperformed both S&P Food, Beverage & Tobacco Index and S&P 500 Index consecutively during the period 2000-2002.
Also, the high equity orientation of the company highlights the conservative financial policy of the company. However, the beta of Wrigley is higher as compared to other firms showing the higher volatility of returns. Moreover, a credit rating of BB/B for Wrigley’s would be likely if the total debt to capital ratio remains below 75% and above 57.7% after borrowing $3 million, as proposed by Dobrynin. Furthermore, a rising U.S Treasury yield curve over next 30 years shows high-interest rate risk and maturity risk if Wrigley opts for long term orientation.
The recapitalization of Wrigley would send a positive signal to its existing investors as it would showcase the management’s confidence on the future performance of the company. On the one hand, dividends would show expected stability and growth in the company’s cash flows; while, on the other hand, share repurchase would show that the company is undervalued. Both will result in higher share price.
3. What will be the effect of the issuance of $ 3 billion in new debt and use the proceeds to pay a dividend or repurchase shares on the market value per share of Wrigley, no. of outstanding shares of Wrigley book value and the market value.
Since, there is no debt in Wrigley’s current capital structure; therefore, an increase in debt will increase the value of the company as per M&M’s theory. A debt of $3 billion will increase the debt ratio (D/TA) of the company and result in an increase in the firm’s value through tax shield. The tax shield will be $1.2 billion ($3 billion *40%). The value of the firm will increase from $13.103 million to $14.303 million. Moreover, the share price will increase to $61.53 in the case of dividends while $ 63.07 in the case of share repurchase. The increase in share price has been calculated by dividing the tax shield by the remaining outstanding no. of shares.
4. What are the relative merits of dividends or share buybacks?
Dividends and share buyback, both are cash-methods of paying capital back to shareholders/investors. Dividend is a regular form of paying back to the shareholders while share buyback is more of a onetime decision. The impact of both the methods on the financial ratios differs as well as the message carried by each. Since cash dividends are expected to remain steady or increase overtime, an increase in dividends brings forth positive connotation about the management’s assertions regarding company’s future performance. Consequently, reducing or cutting dividends gives a bad impression about the company’s future performance.
On the other hand, share repurchase or share buyback comes with a strong signal that the stock is undervalued. Another important benefit of share-buyback is that it doesn’t build an expectation of high dividends in the coming years while distributing the cash to shareholders. Moreover, the number of shares outstanding decreases that would increase the EPS. Finally, the capital gains resulting from the share repurchase program have a lower tax rate as compared to cash dividends.
5. Will they change the book value and market value as a result of the recapitalization?
The recapitalization of Wrigley will affect both the book value and market value of equity. First, the book value of the company will decrease due to a cash payout of $ 3 billion, making the book value of equity negative. The current book value of equity for Wrigley is $ 1.28 billion. A $ 3 billion payout will bring the book value of equity to negative $ 1.72 billion.
Moreover, the recapitalization will also decrease the market value of equity, though the change will be smaller than that in the book value.
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