The William Wrigley Jr. Company Essay

1.0 IntroductionIdentifying opportunities for corporate fiscal restructuring was typical for Blanka Dobrynin, a managing partner of the hedgerow fund Aurora Borealis LLC. In 2002, with the then debt free William Wrigley Jr. Comp either (Wrigley) in her sights, she asked her associate Susan Chandler to conduct research on the impact of a $3 one thousand million debt re groovyisation on the ph championr. This case report aims to obtain an informed recommendation on whether Wrigley should pursue the $3 billion debt proposal.2.0 Optimal gravid Structure fit to Miller and Modiglianis (1958) first pro shoes, the value of a firm is independent of its capital structure, assuming no corporate assesses. It was later demonstrated that the existence of debt in the capital structure creates a debt shield that increases the value of the firm by the depict value of the tax shield (Miller & Modigliani, 1963). This line of reasoning implies that debt financing adds operative value to the firm and an optimal capital structure occurs with 100% debt. However, this is an unlikely outcome in reality with restrictions imposed by lending institutions, bankruptcy cost and the need for preserving fiscal flexibility implying that management will maintain a substantial reserve of borrowing power (Miller & Modigliani, 1963). These imperfections be possessed of since been discussed as additional factors when find an optimal capitalstructure.The trade off theory suggests that an optimal capital structure may be achieved by determining the trade-off between tax shields and the be of financial affliction (Kraus & Litzenberger, 1973). The presence of tax shields means that the optimal capital structure decision is unique for each firm (DeAngelo & Masulis, 1980). High levels of debt butt lead to indirect bankruptcy costs and financial distress costs which relate generally the costs associated with going bankrupt or avoiding bankruptcy. At risque debt levels, the expediency of debt may be offset by financial distress costs. It appears that the optimal cash structure exists somewhere in the middle.Jensen and Meckling (1976) celebrated the existence of procedure costs of debt. These costs arise when equity holders act in their own interest rather than the firms interest. As Wrigley is a family owned company it is unlikely that agency costs will be an issue.3.0 Weighted Average Cost of capital letter (WACC)The question that underlies the decision to pursue the debt proposal is whether Wrigley is efficiently financed without debt. In this report, the WACC will be the main factor when determining whether Wrigley is efficiently financed. The WACC is the minimum return that a company needs to satisfy all of its investors, which is also the it is the inevitable rate of return on the overall firm. The value of Wrigley will be maximized when its WACC is minimized. This report will examine the optimal capital structure as the one that produces the lowest possible W ACC.WACC is one of the most important methods in assessing a companys financial health, both for internal enforce, such(prenominal) as capital budgeting, and external use, such as valuing investments or companies. It is able to provide an insight into the cost of financing and nates be used as a bank vault rate for investment decisions. It can also be used to find the best capital structure for the company. The WACC can be used as a rough guide to the interest rate per monetary unit of capital (Pratt & Grabowski, 2008).The WACC method can be considered a better indicator than former(a) methods such as earnings per destiny (EPS) or earnings before interest and tax (EBIT) because it takes into consideration the relative weight of each component of a companys capital structure (Armitage, 2005). The calculation uses the market values of the components rather than the book values as these values may differ importantly. The components WACC takes into consideration include internal and external factors such as equity, debt, warrants, woofs, pension liabilities, executive stock options and government subsidies (Hazel, 1999) whereas the EPS and EBIT calculations only take into consideration the internal factors, such as be earnings. of the company and However, the earnings reported by a company may non be a reliable value, as they head for the hills to report more favourable values as opposed to the true amounts.However, as the WACC is calculated according to M&M theory, some of the input parameters can be problematic to ascertain. This is due to the uncertainty that exists in the market that would influence the outcome. Another issue limitation with the WACC, is that it relies on the assumption made in the M&M propositions, which do not necessarily apply in the real world. Some assumptions that do not apply include the fact that transaction costs exist and individuals and corporations do not borrow at the same rate.Referring to Appendix 1, the calculations sh ow a slight increase in the WACC after the $3 billion debt is acquired. This change is more profound when using the 10 year US treasury rate as the risk free return an increase from 10.11% to 10.28% for the WACC. therefrom it appears that the optimal capital structure for Wrigley would be one containinginclude no debt as this provides the lowest WACC.4.0 Estimating the effect of the recapitalisation on4.1 Share valueIn an efficient market, it is anticipate that the share price will changequickly to reflect investors changing perceptions about the new debt issue. The effect of the recapitalisation on the share price can be summarised by Miller and Modiglianis adjusted NPV formulaPost-recapitalisation equity value = Pre-recapitalisation equity value + Present value of debt tax shields + Present value of distress related costs + SignalingSignalling, incentive & clientele effectsAssuming the debt will continue into perpetuity, the present value of the $3 billion debt would be $1.2 bi llion. use the post recapitalisation value of equity incorporating the tax shield of $1.2 billion, the stock price is increased from $56.37 to $61.51. The remaining factors of this equation are very difficult to ascertain. The present value of the distress related costs could be assumed to be the value of a put option on the debt. Nevertheless, it could be assumed that financial distress costs would be negligible in Wrigleys situation, as it is a market leader with a strong financial position. It is very difficult to estimate the cost of signalingsignalling and clientele effects and it is necessary to bear this in mind when looking at the increase on share price as it does not fully reflect all relevant considerations. 4.2 Level of Flexibility pecuniary flexibility refers to the ability of a firm to respond in a timely and value-maximizing manner to unexpected changes in the firms cash flows or investment opportunity set (Dennis, 2011). Chief Financial Officers surveyed by whole m eal flour and Harvey (2001) state that financial flexibility is the most important determinant of corporate capital structure (Graham and Harvey, 2001).A flexible capital structure can be achieved by preserving access to low-cost sources of capital. DeAngelo and DeAngelo (2011) argue that firms should optimally maintain low levels of leverage in most periods in order to be better weaponed to cope with the adverse consequences of exogenous shocks. They also argue that firms should maintain low leverage and high dividend payouts in normal periods in order to preserve the option to borrow or issue equity in future tense abnormal periods characterised by earnings shortfalls and/or mercenary investment opportunities.The financial flexibility of Wrigley will be reduced as borrowing $3 billion now will lower their ability to borrow in the future if there are any lucrative investment opportunities or cope with any unexpected exogenous shocks to the market and themselves.4.3 Mix of Debt a nd EquityConsiderations have to be made when evaluating the recapitalisation of Wrigleys capital structure by adding debt. A concern of Wrigley is deciding the debt ratio which optimizes the overall value of the firm. Companies are often inclined to subscribe to debt over equity as the cost of debt is cheaper due to the tax shield created.With the addition of $3 billion of debt in Wrigleys capital structure, the tax shields benefit will increase the equity value by $1.2 billion. The estimation of the tax benefits are assumed under the condition that Wrigley will maintain debt value of $3 billion in perpetuity. As a result of $3 billion payout, the value of equity will decline by $1.8 billion which will be offset by the present value of the debt tax shield ($1.2 billion).Wrigleys debt/equity level after recapitalisation will be 78% and 22% debt. The conventional view is that taking on higher levels of debt could potentially generate more earnings on positive NPV projects which coul d increase the companys value. Although it should be noted that considerations have to be made at what which point, debt becomes more costly to Wrigley in terms of increased risk to shareholders.Assessing Wrigleys optimal debt level, it suggests that the optimal point would be not taking on any debt. By taking on debt, Wrigleys credit rating will fall from AAA to BB/B, as it would be increasing its risk levels of financial distress and risk of bankruptcy cost. Assessing From this, it can be recommended that Wrigleys optimal debt level, it suggests that the optimal point would be not taking on any debt.having minimal debt.4.4 Reported earnings per shareBefore the proposed recapitalisation, Wrigley will have no minimal debt. If Wrigley does not have any income, they still need to pay the interest on the debt, so EPS will be negative. Referring to Appendix 2, the two lines intersect where EBIT is $1.70 billion and EPS is $12.21. This is the break-even point if EBIT is preceding(preno minal) this point leverage is beneficial. If Wrigleys income was higher than $1.70 billion, they could should take the $3 billion debt. In fact, the current income is only $0.51 billion therefore according to a breakeven EBIT analysis, Wrigley should not pursue the debt.5.0 Other matters for the boards consideration5.1 Effect on Voting ControlAssuming the $3billion is used either for a dividend payout or share repurchase, only the second option would alter the amount of shares outstanding.The Wrigley family already controlled 21% of the common stock and 58% of the Class B common stock, which had superior voter turnout rights attached. A $3 billion share repurchase would substantially increase the voting control of the Wrigley family, however the family was already in a majority position so voting control would not be substantially different. A strong controlling majority is highly advantageous in deterring potential mergers and acquisitions.5.2 disdain and Signaling effectsIn gene ral, companies that take on debt signal to investors that the company is in a good financial position as it is able to make future interest repayments.If the debt were used for a dividend payout, this would signal to investors that the company is doing well and increase the stock price.However, using the debt for a share repurchase might have a clientele effecton potential investors that prefer dividend payouts. These investors could potentially sell their remaining stock in reaction to the share buyback resulting in the stock price falling.6.0 ConclusionThe WACC indicated that taking on $3b of debt would reduce the value of Wrigley company. This value could change, provided the Wrigley company had an investment opportunity or plan to use the pertly obtained debt of $3b. The WACC value may be disregarded or adjusted if Wrigley had a high NPV project to invest in or provided a specific use for the funds. However, in the current situation, there is no indication of the reasons for Wr igley to take on the debt and thus they are unnecessarily restricting their financial flexibility. This could prove costly in the future if there are any unexpected negative shocks to the market or Wrigley may miss out on a highly lucrative investment opportunity due to their inability to borrow more. Therefore it is our recommendation that the Wrigley company does not take on the $3b of new debt as it would reduce the total value of the company at this point in time.7.0 ReferencesArmitage, S. (2005). The Cost of Capital Intermediate Theory. Cambridge, UK Cambridge University Press. DeAngelo H., & DeAngelo, L., (2006) Capital Structure, Payout Policy, and Financial Flexibility, University of Southern California working paper. DeAngelo, H., & R.W. Masulis. 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