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The Situation

Aurora Borealis was an activeinvestor 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 i


total assets of $1.76B.

n 2001,

S tock 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
D+E

($
in
Millions)
D
E

D/

E/

D/E

(D+E)
Unlevered

Recapitaliz
ed
Dividend
Recapitaliz
a:on
Recapitaliz
ed
Buyback

13,10
3

- 13,10
3

13,10 3,000
3

10,10
3

0.2290

13,10
3
3,000

10,10
3

0.2290

10,10
3
3,000

7,103 0.2969

(D+E)
1

0.7710

0.2969

0.7710

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

Buyback
Share

PV

PV

Tax

Price

Shield

(Tc
x
Debt)/Shares
Adjusted
Share
Price

56.37
56.37

56.37

5.16

5.16

61.53

61.53

232.441

232.441

61.533

Shares

(Millions)

Repurchase

Shares

Price

56.37

232.441
-

Repurchased

= (Debt /
Repurchase
Price)
Adjusted
Shares
(Millions)

48.755

Shs

232.441

232.441

183.686

Market
Equity
Recapitalized

Value

of
Unlevered
Recapitalized

Lev eraging 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 = T
V alue 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
Yield
year)
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


EBIT interest coverage (x)
Funds from operations/total debt (%)
Free operating cash flow/total debt (%)

Investment Grade
AAA
AA
A
23.4
13.3
6.3

BBB
3.9

Non-Investment
BB
2.2

B
1.0

214.2
156.6

65.7
33.6

42.2
22.3

30.6
12.8

19.7
7.3

10.4
1.5

Return on capital (%)


Operating income/sales (%)

35.0
23.4

26.6
24.0

18.1
18.1

13.1
15.5

11.5
15.4

8.0
14.7

Long-term debt/capital (%)

(1.1)

21.1

33.8

40.3

53.6

72.6

5.0

35.9

42.6

47.0

57.7

75.1

Total debt/capital, incl. short-term debt


(%)

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
Unlevered

Beta

Bu

Be
= Bu
/
]
Be[1+(1-t)

=
/1+(1 Tc
/) Bu
x
No
(D/E)
Tc
Be
Be
Debt 0.75

No
-

-
0.40
0.75

Beta

Recapitalized
0.8694
0.2654

(D/E)
Bu
Debt 0.40 0.7
5
0.7500
0.40
0.7
5
0.40
0.7
5
Dividend
0.40

Recapitaliza:on
0.8694
0.2654

0.7
5

Recapitalized
Buyback
0.8804
0.2897
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
Bi
(Rm- Ri
rf
Rf)
0.75 Unlevered
0.07 0.109
0.0565
0
Recapitalized
0.0565 0.87 Dividend
0.07 0.117
Recapitaliza:on
4
Recapitalized
0.0565 0.87 Buyback
0.07 0.117
4
0.118
0.0565 0.88 0.07
1

Current weighted average cost of


WACC
capital is 10.9%.
With an assumed
(1-
WACC
Wd
Kd
Tm)
We
Ke
40% tax rate and 0 beta of debt, the
0.000 0.930
0.1090 0.1090
debt
will7 not0.60
correlate
significantly
1
with
the broader 0.7710447
market.0.1174
Leverage
0.229
0.1083
0.13 0.60 99
will0.229
drive down our
cost 0.1174
of Capital
0.7710447
0.1083
0.13
0.60
99
minimally.
0.297

0.13 0.60

0.7030584 0.1181 0.1062


97

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
/
With
WorstNo Repurchase
Most
Best
Case
Case
-10%
Likely
+10%
Interest
Rate
Debt
13.0%

Dividend
AssumpAons

on

Worst
Case
-10%

Most
Likely

462,020

Debt
Debt

Pre-
-

($
in

Best
Case
+10%

513,356

564,692

-
-
462,020

184,808

Recap

513,356

564,692 Tax

Rate

($
in
000)
Tax Rate
40.0%
72,020
40.0%
123,356 174,692

205,342

in
225,877 000,

000,
Except

Except
EPS)
28,808
EPS)
49,342
69,877

OperaAng
Interest
Taxable
Taxes

Interest
Rate on
564,692
462,020
0.0% 513,356
($
in
000)
390,000
3,000,000
390,000 390,000
Debt

Income
277,212

232.44

Net
$1.19

308,014

338,815 Expense
Income
Taxable

232.44

232.44

$1.33

$1.46

Income

OperaAng

Income

(EBIT)
43,212
74,014 104,815
-
Interest
Expense
Income
232.44
Taxes

$0.19

232.44

232.44

$0.32

$0.45

($
(EBIT)

Shares
(Millions)
Earnings

Net

Income

Outstanding
Shares
Outstanding
Per Share
(Millions)

Earnings

Impact on EPS
EPS

v.

EBIT
Before

Analysis
Recapitaliza:on

Per

Share

AssumpAons
Interest

Most
Best
Best
Case
Case
+10%
Likely AVer
+10%
Recapitaliza:on
Interest
With Share
Rate
on
Debt
462,020
462,020
Repurchase
513,356Debt
564,692
513,356 564,692
13.0%
($
in
000)
3,000,000
-Tax Rate
40.0%
390,000
390,000
390,000
-

0.0%

on

Rate
Debt

($

Pre-
Debt
in

Recap

Worst
Worst
Most
Case
Case
-10%
Likely
-10%
AssumpAons
-

40.0%

000)
Tax

72,020

Rate
($

OperaAng
Income
(EBIT)
Interest

in
EPS)
in
EPS)

28,808

(EBIT)
Expense
Interest

Taxable
Income
Taxable
Income
Taxes Taxes
Net
Income
Net Income
Shares
Outstanding
Shares
(Millions)
(Millions)
Earnings
Per Share
Earnings

43,212

183.69
$0.24

462,020
123,356
184,808
49,342
277,212

513,356
174,692

205,342
69,877

74,014

308,014
104,815

183.69
232.44

183.69
232.44

$1.19
$0.40

564,692
000,
000,
225,877
OperaAng
338,815
Expense
232.44
Outstanding

$1.33
$1.46
$0.57 Per Share

Except
($
Except
Income
-

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

Repurchase
AVer

Share

Class
Stock

Common

Ownership
%
Wrigley All
Family

Share

Others

Shares Family
(Millions)

Shares
58%
42%
Held
(Million
21%
79%
s)
Wrigle All
y
Class Family
Others Total
Common
Common

Stock

24.7

Total

42%
79%

100%
100%

Shares
Held
(Millions)
Wrigley All
Family

Others

Common
Stock
Total

Wrigley All
Family

17.9

Others

Total

149.9

Total

-
10.2

189.8

64.6

Held
Others

58%
21%

42.6
39.9

Ownership

%
Wrigle All
y

167.9

38.5

48.8

38.5

48.8

10.2
232.4

24.7 B 17.9
Stock
29.6 -111.4

141.0

54.4

183.7

129.3

42.6

Votes
Votes
Class
B
Common
Stock
Common
Stock
Total

Per

Share

Votes

(Millions)

Wrigley

Votes

Wrigley All

Family

Per
Share

Family

10

Others

Total

10
247.3

247.3

179.1

426.4

29.6

111.4

141.0

276.9

290.5

567.5

1
1

VoAng
Interest
%
VoAng

287.2
Interest

Class
29.1%
Common

Wrigley
Wrigley
Family
Family
B

%
All
All

Others
Others
Common Stock
69.2%
43.6%

Stock
30.8%5.2%19.6%
Total
100.0% 48.8%

Total
Total
40.1%
31.6% 75.1%
6.5%
24.9%

51.2%

24.3%

46.6% 53.4%
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 retur ning 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

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

Thanks for listening!

Questions?

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