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A122 BWFF3193 SEMINAR IN FINANCE (GROUP A)
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Tax rate in this case is 40% and unlevered beta is 0.75. After gather all
information, we can start calculate WACC and we will create the table to see
the differential with different mix weighted of capital structure of debt and
equity.
Unlevered 1 billion 2 billion 3 billion
Equity beta 0.75 0.78 0.82 0.85
Risk free rate 4.86% 4.86% 4.86% 4.86%
Risk premium 7.0% 7.0% 7.0% 7.0%
Corporate tax rate (tc) 40% 40% 40% 40%
Cost of debt 0.0% 10.5% 11.8% 13.0%
Cost of debt after tax 0.00% 6.30% 7.08% 7.80%
Cost of equity=CAPM 10.11% 10.32% 10.60% 10.81%
Weight of debt 0.000 0.071 0.132 0.186
Weight of equity 1.000 0.929 0.868 0.814
WACC 10.11% 10.03% 10.13% 10.25%
Figure 2: WACC
Unlevered 1 billion 2 billion 3 billion
Cost of debt NA 10.5% 11.8% 13.0%
WACC 10.11% 10.03% 10.13% 10.25%
Estimated Rating AAA A/BBB BBB/BB BB/B
Figure 3: Compare Debt rating and WACC
In the bass scenario estimated by Dobrynin, the corporation increases its debt
level to 3 billion dollars. In this situation, the WACC is 10.25% which higher than
before leverage (10.25%10.11%). This situation is no good sign, because we need
find the minimum WACC. Besides that, The Corporations debt rating falls to BB to
B range are classifies as a junk bond according rating agencies.
A122 BWFF3193 SEMINAR IN FINANCE (GROUP A)
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In the second scenario, we examined the cost of capital at 2 billion in debt.
WACC is 10.13% and debt rating is range between BBB and BB, falling short of
investment grade.
In the third scenario, total 1 billion will be issuing and WACC is 10.03% in
overall. The calculated ratios based on 1 billion of debt leads to an estimated
investment grade debt rating of A.
In conclusion, we choose the 1 billion debts to issues in capital structure. This
is due to the minimum WACC and at the same time the rating grade is categories in
A. With rating A will give more attractive and confident to the investor or shareholder
supply more fund to the corporation.
2.4 Determine the EPS/EBIT analysis to estimate the potential change
in value using adjusted present value (APV) analysis in pay dividend
and share repurchase.
First, we calculate the market value of the shares use APV. With the addition
of the 1 billion new debt, Wrigleys share price should quickly and fully reflect the
changes in investors perceptions stemming from the repurchase once the company
publicly discloses its intentions.
Post-
recapitalization
equity value
= Pre-recap.
equity value
Present value
+ Debt tax
shields
Present value of
distress-related
costs
Signalling,
incentive &
clientele
effects
= $56.37
+ Tc Debt
Challenging to
Unobservable
A122 BWFF3193 SEMINAR IN FINANCE (GROUP A)
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$58.09
= $56.37
0.4 ($1,000)
+
$400,000,000
or
+ $1.72/per
Shares
observe
?
?
The effect of the present value of debt tax shields: It shows that adding $1
billion in debt to Wrigleys capitalization and returning a like amount to shareholders
will add $0.4 billion in equity value due to tax effects. The tax benefits are estimated
assuming that Wrigley commits to maintain the $1 billion in debt in perpetuity. The
net revised value per Wrigley share is $58.09.
Debt grows from zero to $1 billion. Assets grow by $0.4 billion, equal to the
present value of the debt tax shields.
Second, calculate EPS/EBIT with pre-recapitalization and post-
recapitalization with repurchase shares and pay dividend. Both methods will
experiment as below:
Assumptions Before recapitalization
Interest rate on debt 0
Pre-recap debt 0
Tax rate 0.4
Before recapitalization Worst case Most likely Best case
Operating income (EBIT) 474,629,000 527,366,000 574,820,009
Interest expense - - -
Taxable income 474,629,000 527,366,000 574,820,009
Taxes 189,851,600 210,946,400 229,928,004
Net income 284,777,400 316,419,600 344,892,005
Shares outstanding 232,441,000 232,441,000 232,441,000
Earnings per share 1.23 1.36 1.48
A122 BWFF3193 SEMINAR IN FINANCE (GROUP A)
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If Wrigley want pay dividend in the future, the outstanding shares will remain
unchanged which total 232.441 million. Due to firm use the debt, hence interest will
be charged in this scenario. All figure can shown in below table:
PAY DIVIDEND
Assumptions After recapitalization
Interest rate on debt 0.10083
Pre-recap debt 1,000,000,000
Tax rate 0.4
After recapitalization Worst case Most likely Best case
Operating income (EBIT) 474,629,000 527,366,000 574,820,009
Interest expense 100,830,000 100,830,000 100,830,000
Taxable income 373,799,000 426,536,000 473,990,009
Taxes 149,519,600 170,614,400 189,596,004
Net income 224,279,400 255,921,600 284,394,005
Shares outstanding 232,441,000 232,441,000 232,441,000
Earnings per share 0.96 1.10 1.22
However, if the firm use the debt to repurchase the shares, then the
outstanding shares will be reduced. Hence, we need shown the solution how
many shares can we buy back and how much will be reduced.
A122 BWFF3193 SEMINAR IN FINANCE (GROUP A)
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Solution:
Original share outstanding = 232.441 million
Buyback amount/borrowed debt = 1 billion
Current price of one shares = current stock price + tax shield
= 56.37 + 1.72 = 58.09
Number of shares repurchased = (Invested amount / price of one share)
= 1 billion / 58.09 = 17.215 million
Remaining number of shares = 232.441 million 17.215 million = 215.226
million
SHARES REPURCHASED
Assumptions After recapitalization
Interest rate on debt 0.10083
Pre-recap debt 1,000,000,000
Tax rate 0.4
After recapitalization Worst case Most likely Best case
Operating income (EBIT) 474,629,000 527,366,000 574,820,009
Interest expense 100,830,000 100,830,000 100,830,000
Taxable income 373,799,000 426,536,000 73,990,009
Taxes 149,519,600 170,614,400 189,596,004
Net income 224,279,400 255,921,600 284,394,005
Shares outstanding 215,226,590 215,226,590 215,226,590
Earnings per share 1.04 1.19 1.32
After estimate EPS/EBIT, we can conclude that EPS will reduce after issuing
debt. This is because interest expenses. However, we still can see different result
between pay dividend and share repurchase. ESS of shares repurchase still higher than
pay dividend.
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2.5 Undertake the Recapitalization
Blanka Dobrynin should try to convince Wrigleys directors to undertake the
recapitalization. With recapitalization, the corporation can enjoyed many benefits
such as repurchase the undervalued shares, tax shield benefits from debt and others. In
more detail, we will write down in conclusion and recommendation part.
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3.0 Conclusion
Considering all scenarios, we suggested Wrigley to issue 1 billion in debt.
This option will minimize the overall cost of funding (see figure 3), as well as
potential increase future profitability with higher leverage. At 1 billion dollars in debt,
the firm maintain strong financial solvency and reduces change of default. In this
case, the expected bankruptcy costs are small enough to be immaterial.
With the additional fund, we advised the Wrigley use the debt to repurchase
shares as opposed to delivering value through dividends. This approach allows the
company to concern the voting rights of shareholders and provides positive market
signals relating to managements perception of an undervalued share price. Moreover,
a repurchase has a tax advantages over dividends. It also provides services which
shareholder can delay the dividend if no need.
We would not suggest company pay cash dividend, this is due to three
reasons: (1) it will not affect the number of outstanding shares decrease (2) shares
price will not show any positive result, EPS not increase (3) people may think the
company increasing debt to pay its dividend show that company not doing well.
Therefore, with other solution, I recommended Wrigley buy back the shares.
This is because the decreasing number of shares will lead EPS increase if EAT remain
unchanged. However, EPS of shares repurchase will higher than EPS of pay dividend.
A repurchase returns value to shareholders avoiding the negative signals associated
with having reduced dividend after an unsustainably large payout. Overall, share price
should not change as a direct result of the repurchase. This situation happened
because in some investors perspective will see share repurchase as a bullish sign of
the company so the shares may appreciate on that basis.