Wm Wrigleys Jr Company Case Study

This Report investigates the financial effects on Wrigley’s with the issuance of $3bn debt. It explores two alternate means of allocation for the funds; pay out a one-time dividend or carry out a share repurchase. Both methods are analyzed in regards to an optimal capital structure and maximizing share holder value (value of the firm). A compilation of historical data and future predictions were used for the basis of this report, and recommendations.

Literature Review
The following paper will draw on Modigliani and Miller’s (1958) theorem of capital structure to determine whether an ‘optimal’ level for Wrigley’s can in fact be reached. A further discussion of agency costs and incentives by Jensen, Meckling (1976), and Lenland (1998) will evaluate the relative impact of these risks on re-structuring. Finally, Chambers, Harris and Pringle (1982) distinguish the approaches in valuation used for Wrigley’s.

Optimal Capital Structure
The Modigliani and Miller (1958) theorem has been widely touted as the basis for capital structure theory (M&M Propositions). While previously rationalizing that a firm should be indifferent between various levels of financial leveraging – a further study ‘optimal’ level of capital structure which enhances the use of a tax shield to best offset the cost of debt. It is important to note however, that there are several implicit considerations & limitations that are imposed with the increase of leverage (Modigliani and Miller, 1963).

Financial Distress & Flexibility
Financial distress and corporate performance is a widely debated topic. Although literature has portrayed financial distress as costly and important in concluding on a firm’s optimal capital structure, Opler and Titman (1994) discovered that it is substantially difficult to quantify. While Wrigley’s has been given a B/BB rating, due in part to their interest coverage ratio of 1.47; due to the fact that WACC has only increased 0.01%, it can be assumed that financial distress would be relatively trivial.

Incentive & Agency Costs
Another factor has been found by Jensen and Meckling (1976) to fall under consideration is that of agency costs. They found the costs associated with a ‘value transfer’ to bondholders – although essentially unobservable – are offset to a much larger degree by the tax advantage gained by equity holders (Leland, 1998).

Adjusted Present Value
With the proposed restructuring at a set amount of $3bn, APV is used to measure the tax benefit associated with debt separately to that of the firm’s operations (Chambers, Harris and Pringle, 1982). Under this method, the value of Wrigley’s post-restructuring increases by an amount equal to that of the tax benefit: VL = VU + PV of Tax benefits. Once distributed between shareholders, reflects the following: Post-recapitalizationequity value| = Prerecap.equity value| Present value+ Debt tax shields| Present value ofdistress-relatedcosts| Signaling, incentive, & clientele effects| $61.53| = $56.37| + $5.16/sh| Insignificant | Unobservable|

In terms of WACC – currently at 10.90% – the effect of leveraging should (in theory) result in an overall reduction in the cost of capital thus optimizing both the value and structure of the firm (Modigliani and Miller, 1963). However, WACC is seen to increase marginally by 0.01%. This can be attributed to a possible insufficiency of the debt tax shield to offset the costs of interest payments, along with the levered beta of 0.87 bearing higher systematic risk than that of the un-levered beta at 0.75.

Payoff
With a dividend payout of $3bn, the book value of total assets/capital will remain unchanged. However, common equity decreases by the debt amount, causing the book value per share to drop the exact dividend payout of $12.91. Similarly, the market value of common equity sees a decline of $3bn. Total capital on the other hand, sees an increase of $1.2bn due to the tax shield; lowering the market value of equity and subsequently the value to public shareholders. In turn, the share price loses ground by $7.74, sinking to levels of that of the S&P Food Beverage & Tobacco Index.

In terms of share-repurchasing alternative, the market value and book-value of equity sees a proportionate drop. Due to the number of shares outstanding dropping from 232.441m to 183.684m*, the book-value per share dramatically declines; whereas the share price increases by $5.16 showing a spike in the WWY Index**.

Pre-capitalization EPS was at 1.61. However, due to the interest payments net income was lowered causing EPS to drop considerably to 0.48 from a running growing average. Using the funds to repurchase shares also saw a drop in EPS down to 0.60 – higher than that of the dividend – due to the decrease in shares. From an EBIT-EPS breakeven analysis however, the repurchase method shows exponential growth as opposed to dividend.

Voting Control
From the two alternatives, only the option of share-repurchasing results in a change in Wrigley’s voting control. As such, following a re-purchase of 48.8m shares, various approaches have shown a boost in Wrigley’s voting power from 46.6% to a majority vote of above 51%.

Summary
The issuance of $3bn debt to the Wm. Wrigley Jr. Company can be seen to cause a structurally significant impact on both the short and long term operations. As such, there are many implications that have been taken into consideration as to the viability and subsequent sustainability of the debt issue.

The analysis has shown that by re-structuring, Wrigley’s as a company will be affected in several distinct ways. In regards to cost of capital, WACC was seen to increase by 0.01% which indicates the possible insufficiency of the debt shield to offset the cost of interest payments. This, along with an increased likelihood of financial distress, and the introduction of agency costs (brought about by a higher beta) has placed Wrigley’s with a non-investment grade rating of B/BB.

While these may seem detrimental in the short term, long term estimates point to an increased benefit. As debt is serviced into perpetuity, the continuous growth in earnings (with Wrigley’s being an established company within the market, operating in a low technology industry, and consistently sustainable growth) will greatly reduce the probability of financial distress and bankruptcy; moreover, incentive and agency costs would be largely offset by the interest tax shield. This will result in an improved credit rating and reduction in overall cost of capital until an ‘optimal’ level is reached.

From the two alternatives given, an explicit preference is clear to see. With the dividend alternative, the loss of share price value and dramatic decline in EPS value will be likely to result in a negative market sentiment. Also, the provision of a large dividend payment is unsustainable to maintain. In respect to the alternative of a re-purchase scheme, while the EPS does show a considerable decline at first, long-term growth in earnings are seen to increase exponentially as the benefits of the tax shield reflects in a higher EPS. Value to shareholders increases through a rise in share price – upheld by $1.2bn tax benefit into perpetuity; and value to Wrigley’s is achieved through acquiring the majority voting power.

Recommendations:
In relation to the 3bn debt restructuring, the recommendations are assuming that Wrigley’s has two options; Dividend or Repurchase.

The Dividend option in comparison to the repurchase is not feasible as it places Wrigley’s in a less favorable position than that of the latter. In this case, value maximization out of the two options is better achieved through the repurchase method.

With financial policy objectives, a focal point is placed on maximizing shareholder value. In respect to the $3bn debt raising, it is evident that prerequisites are not adequately satisfied. Although the debt level can be achieved and maintained, the financial and operational strain shows that it’s not at an optimal debt to equity level. The flexibility is hindered with the level of debt also the time frame in which EBIT is at an optimal level of safety and sustainability is too lengthy giving rise to an alternative solution; lowering the debt issuance to $1.2bn brings Wrigley’s into an optimal capital structure.

Recommended: Repurchase over Dividend

Alternative:$1.2bn Debt raising

Bibliography
Opler, T. C., & Titman, S. (1994). Financial Distress and Corporate Performance. The Journal of Finance, 49(3), 1015-1040. Myers, S. C. (2001). Capital Structure. The Journal of Economic Perspectives, 15(2), 81-102. Accessed: 15/08/2011 05:26 Modigliani, F., & Merton, H. M. (1963). Corporate Income Taxes and the Cost of Capital: A Correction. The American Economic Review, 53(3), 433-443. Modigliani, F., & Merton, H. M. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review, 48(3), 261-297. Leland, H. E. (1998). Agency Costs, Risk Management, and Capital Structure. The Journal of Finance, 53(4), 1213-1243. Jensen, Michael C., and Meckling, William H. “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.” J. Financial Ecoti. 3 (October 1976): 305-60. Chambers, D. R., Harris, R. S., & Pringle, J. J. (1982). Treatment of financing mix in analyzing investment opportunities. Financial Management, 11(2), 24-24. Retrieved from http://search.proquest.com/docview/208182435?accountid=13380 SABAL, J. (2007), « WACC or APV ? », Journal of Business Valuation and Economic Loss Analysis, Vol. 2, No. 2, pp.1-15