The WM. WRIGLEY JR.

COMPANY

CAPITAL STRUCTURE, VALUATION AND COST

OF CAPITAL

David Drouin 100869152

Katherine Dao 101053911
Lucas Liu 101031547
Contents
Executive summary .................................................................................................................... 3
1. Summary of the situation/context ........................................................................................ 4
2. Identification of the problems/issues ................................................................................... 4
3. Proposed solution/recommendations .................................................................................. 5
3.1 Impact on market value of the firm .................................................................................... 5
3.2 Impact on debt rating: ....................................................................................................... 6
3.3 Impact on cost of capital: .................................................................................................. 7
3.4 Impact on reported earnings per share: ............................................................................ 9
3.5 Impact on voting control:..................................................................................................10
3.6 Comparable analysis .......................................................................................................11
4. Conclusion .........................................................................................................................13
5. Recommendation ...............................................................................................................14
Appendix: ..................................................................................................................................16
Executive summary
During a period of low interest rates, CEO’s begin to neglect debt financing. Aurora
borealis an activist investor company saw this as an opportunity. They would look to previously
unleveraged companies as possible value generators, they found WM. Wrigley Jr Company. A
top industry performer who used no debt. Susan chandler was tasked with running the numbers
and giving some insights based on their situation. We will conduct her analysis pointing out the
method and flaws in her analysis as we go. We will then provide a conclusion and insights
based on the analysis. What we found is while the analysis had holes in it was accurate enough
for the purpose of our analysis, and would be widely accepted in the industry. While the theory
and reasoning sound the level of debt purposed by the CEO, would leave the company so
heavily leveraged as to actually destroy value in the long run, and concentrate ownership to
making their job more difficult. We would recommend a further analysis to find the optimal debt
level of the firm. To issue the debt but only for a one-time cash dividend which will offset some
of the negative signal in the reduction EPS, and not concentrate ownership in the firm. This
would allow the company to generate additional shareholder value well leaving it open for the
restructuring efforts. This would not generate as much value as believed but would still be a
good investment.
 1. Summary of the situation/context
Summary
WM. Wrigley Jr. Company is a mature firm that currently has no debt. By issuing debt for either
a share repurchased or a dividend, the firm can generate additional value for shareholders.

Context
Interest rates reached the bottom in 50 years, the use of debt financing has fallen as a result.
CEO have taken this too far and missed valuable opportunities to create value for different
shareholders. Aurora Borealis LLC, acting as an activist investor, looked for companies that
could generate value through restructuring. They then invested heavily in the stock and began
persuading management to undertake the strategy.

They identified a mature company that currently holds no debt at all, the William Wrigley Jr.
Company. They believe that if they analyze the firm, they will be able to create additional
shareholder value by leveraging the firm for a dividend or share recapitalization.

Company
Wrigley is the world’s largest manufacturer and distributor of chewing gum. The industry was
consumer foods and candy, intensely competitive and dominated by a few large firms. Revenue
growth was 10% while earning grew at 9%, reflecting the introduction of new products and
foreign expansion. The company had 1.76 billion no debt, the stock significantly outperformed
S&P composite index and was running slightly ahead of its industry index.

With a market value of equity at 13.1 billion, Aurora estimated that they could borrow 3 billion
with a credit rating of BB/B to yield 13%.

2. Identification of the problems/issues

Is it possible for WM Wrigley to issue $3 billion bonds at 13% and estimating the effect of the
leveraged recapitalization on firm’s share value, cost of capital, debt coverage, earnings per
share, and voting control?
From this analysis what profit insights could be gleaned from the analysis.
 3. Proposed solution/recommendations

3.1 Impact on market value of the firm

Modigliani- Miller’s Theorem reflects the effect of capital structure on the value of companies. 1

The theorem assumed that there are no taxes and bankruptcy costs. The market is efficient,
and thus companies are access to symmetric information. In this case, capital structure cannot
affect the value of companies. However, WM Wrigley is subject to tax rate (40%) in the real
world. According to Modigliani-Miller model proposition Ⅱ, tax allows a deduction of interest,
which increases the value of companies. Individuals or corporations are able to reduce their tax
by adopting tax allowance such as interest rate and medical expenses. This is called tax shield.
2
Therefore, after the recapitalization, the market value of WM is by adding tax shield to pre-
recapitalization market value of WM.

$ In Billions Pre Capitalization Post Capitalization

Market value 13.1 13.1

Tax shield (Debt*tax rate) 0 3*0.4=1.2

Total market value 13.1 14.3

From the table, WM can increase its market value to $14.3 billion from $13.1 billion by issuing
debt.

In the real world, firms might go bankrupt with a high leverage level. The costs of financial
distress or the bankruptcy due to the high leverage hevel erodes the value of the firm(Chart 1).
Likewise, the increasing amount of debt can increase the cost of capital at higher levels (Chart
2). Because of a large amount of debt, the cost of debt could rise due to the increased default
risk of the company’s bond. Hence, Susan Chandler is suggested to show the disadvantages of
the high leverage level and the hurdles of issuing bonds.

1
(n.d.). Modigliani-Miller Theorem (M&M) - Investopedia. Retrieved December 5, 2017, from
https://www.investopedia.com/terms/m/modigliani-millertheorem.asp
2
(n.d.). Tax Shield - Investopedia. Retrieved December 5, 2017, from
https://www.investopedia.com/terms/t/taxshield.asp
Chart 1. 3

Chart 2. 4

3.2 Impact on debt rating:

Susan Chandler estimated WM is able to issuing bonds which yield at 13%. One approach to
estimate the cost of debt is It is reported that

3
(2013, September 19). Capital structure 1 - SlideShare. Retrieved December 5, 2017, from
https://www.slideshare.net/RakeshKumar296/capital-structure-1-26337000
4
(2013, September 19). Capital structure 1 - SlideShare. Retrieved December 5, 2017, from
https://www.slideshare.net/RakeshKumar296/capital-structure-1-26337000
 Investment Grade Non-Investment WM with debt
Grade

AAA AA A BBB BB B

EBIT interest 23.4 13.3 6.3 3.9 2.2 1.0 1.352

coverage (x)

Funds from 214.2 65.7 42.2 30.6 19.7 10.4 13.0%

operations/total debt
(%)

Free operating cash 156.6 33.6 22.3 12.8 7.3 1.5 7.2%
flow/total debt (%)

Return on capital 35.0 26.6 18.1 13.1 11.5 8.0 16.6%

(%)

Operating 23.4 24.0 18.1 15.5 15.4 14.7 21.1%

income/sales (%)

Long-term (1.1) 21.1 33.8 40.3 53.6 72.6 63.0%

debt/capital (%)

Total debt/capital, 5.0 35.9 42.6 47.0 57.7 75.1 69.9%

incl. short-term debt
(%)

As most of the ratios we calculated to determine where the company stand put them at a
BB/B rating. With a few higher values we believe they are closer to a BB rating putting the 13%
estimate as quite accurate.

3.3 Impact on cost of capital:

Susan chandler determined to use Capital Asset Pricing Model to estimate the cost of equity
and we use CAPM to calculate cost of equity of WM. CAPM reflects the extent to which
investors are exposed to risk and how much the return of the investment they expect.
Meanwhile, Beta measures the degree to which specific company is affected by systematic risk.
CAPM is an equilibrium of supply and demand in capital market and offer an accurate insight of
the capital market to managers determining capital budgeting and capital structure of the
company. The CAPM formula is:

Rm- Rf, which is also called risk premium, measures how much the return of the specific
company exceeds the geometric returns of the market. Aurora Borealis determined the risk
premium is 7%. For risk free rate, we used the 10-year U.S. Treasury rate, 4.86% this was to
match the kd analysis. The unlevered Beta is 0.75, according to Susan’s estimate. It is well
accepted that Beta should be levered due to the effect of debt on the volatility of the company in
comparison to the market as a whole. Tax shield increases the volatility of the company’s return
to the overall market. Although the levered Beta is meaningless under the equilibrium theory in
the capital market, it is accurate enough reveal the return of company’s stock against the return
of the overall market.
The levered Beta formula is:
βL = βu (1+ ((1-t)D/E))
The Beta of a financial-leveraged company is influenced by the tax rate and D/E ratio of the
company. WM is recommended to borrow $3 billion and its current market value is $13.1 billion,
and then the D/E ratio is 3/13.1=0.2290.

Hence, levered Beta of WM is: 0.75*(1+(1-0.4)*0.229)=0.85 As a result, cost of equity is:

4.86%+0.85*7%=10.81%
4.86%+.75(7%)=10.11
Based on the MM theory discussed above, the total market value of the firm after restructuring
would be 14.303. Ging us the following debt and equity values 3 million and 11.303 million.

Weighted Average Cost of Capital:

With the cost of debt calculated in the previous part, we calculated the WACC is:
11.303/(3+11.303)*10.81%+3/(3+11.303)*13%*0.6=10.17%.

What is interesting to note here is that the company actually had a lower WACC before the
issuance of debt as it would only contain the Ke.

3.4 Impact on reported earnings per share:

There are two uses of the borrowed fund: paying dividends or repurchasing outstanding shares.
Earnings Per share (EPS) is influenced by shares repurchasing due to the change in the
outstanding shares. Moreover, EPS is a ratio investors to adopt to evaluate company’s
performance. A company with a higher EPS is more attractive to investors, and thus it results in
a high stock price. According to the case, the compounded growth rate of WM is 10%. Hence,
we assumed that WM can grow at 10% in the best case, while its revenue would drop by 10% in
the worst case.
Before the restructuring, WM’s share price is $56.37/share and the outstanding shares are
232.441 million. In the share-repurchasing alternative, WM can repurchase 3000/232.441=53.2
million shares and shares outstanding will reduce to 232.441-53.2=179.2 million. The new price
per share would New stock price is new equity value/shares outstanding
11.303billion/179.2million= 63.07477

We assumed another alternative is all cash payout ratio, and thus the stock price and
outstanding shares remain the same, with $56.37/share and 232.441 million, respectively.

EPS

Worst case Most likely Best case

Before recapitalization $ 1.23 $ 1.36 $ 1.50

 After recapitalization $ 0.28 $ 0.46 $ 0.64
(repurchasing outstanding
shares)

After recapitalization $ 0.22 $ 0.35 $ 0.49

(dividend payout)

From the table, it is concluded that debt could decrease EPS because of the less Net Income
resulted from interest expenses. Additionally, repurchasing can reduce the impact of debt on the
change in EPS due to reduced shares outstanding.

3.5 Impact on voting control:

There are 10 votes for each share of Class B stock and so the total votes are 616.21 million,
which are different from the shares outstanding. Wrigley family’s votes totaled 287.1758 million.
We divided Wrigley family’s votes by total votes to calculate the ownership of Wrigley family.

Before recapitalization

in millions except ownership and common stock class B stock total

votes

shares outstanding 189.8 42.641 232.441

votes outstanding 189.8 426.41 616.21

Wrigley family shares 39.858 (189.8*0.21) 24.73178 64.58978

(42.641*0.58)

Wrigley family votes 39.858 247.3178 287.1758

% ownership 46.6%

After recapitalization
 in millions except ownership and common stock class B stock total
votes

shares outstanding 146.3337216 32.87574406 179.2094656

votes outstanding 146.3337216 328.7574406 475.0911622

Wrigley family shares 39.858 24.73178 64.58978

Wrigley family votes 39.858 247.3178 287.1758

% ownership 60.4%

The dividend payout alternative would not change the ownership of WM family because we
assumed pay out the dividend by cash, which does not change the stock price and outstanding
shares. Therefore, the ownership of WM family in dividend payout is the same as that before
recapitalization.

From the table, Wrigley family’s vote control will increase to 60.4% from 46.6% due to a drop of
total votes outstanding. Wrigley family will increase its voting control by the repurchasing. This
would actually give the owners complete control over the direction of the firm.

3.6 Comparable analysis

When we looked for a comparable firm after our analysis to check against it was clear
that first there was no close comparable firm and second after the strong EPS dilution following
the borrowing we would be sitting worse of than any of the somewhat comparable firms. With a
strong negative signal from the repurchase and a lowering of performance outlook investors
would likely flee from this company,

Before
 Com
mon LT LT LT
Shares Total Debt/ (LT Debt/ Debt /
Outstan Market Book LT Debt + (LT Debt LT Mkt
ding Value of Value of Debt Book + Mkt Debt/Boo Value
Company Recent (million Equity Equity (million Value of Value of k Value of
Name Price s) (millions) (millions) s) Equity) Equity) of Equity Equity
Cadbury
Schweppes $ $
plc $ 26.66 502.50 13,397 $ 5,264 2,264 30.07% 14.46% 43.01% 16.90%
Hershey $ $
Foods Corp. $ 65.45 136.63 8,942 $ 2,785 869 23.77% 8.85% 31.18% 9.71%
1,735.0 $ $
Kraft Foods $ 38.82 0 67,353 $ 39,920 8,548 17.64% 11.26% 21.41% 12.69%
Tootise Roll
Industries $ $
Inc. $ 31.17 51.66 1,610 $ 509 8 1.45% 0.46% 1.47% 0.47%
Wm.
Wrigley Jr. $
Co. $ 56.37 232.44 13,103 $ 1,276 $ - 0.00% 0.00% 0.00% 0.00%
S&P 500
Composite $1,148.08 18.23% 8.76% 24.27% 9.94%

After
Com
mon LT LT LT
Shares Total Debt/ (LT Debt/ Debt /
Outstan Market Book LT Debt + (LT Debt LT Mkt
ding Value of Value of Debt Book + Mkt Debt/Boo Value
Company Recent (million Equity Equity (million Value of Value of k Value of
Name Price s) (millions) (millions) s) Equity) Equity) of Equity Equity
Cadbury $ $
Schweppes $ 26.66 502.50 13,397 $ 5,264 2,264 30.07% 14.46% 43.01% 16.90%
plc
Hershey $ $
Foods Corp. $ 65.45 136.63 8,942 $ 2,785 869 23.77% 8.85% 31.18% 9.71%
1,735.0 $ $
Kraft Foods $ 38.82 0 67,353 $ 39,920 8,548 17.64% 11.26% 21.41% 12.69%
Tootise Roll
Industries $
Inc. $ 31.17 51.66 1,610 $ 509 $ 8 1.45% 0.46% 1.47% 0.47%
Wm.
Wrigley Jr. $ $
Co. $ 63.07 179.20 11,303 $ 1,276 3,000 70.16% 20.97% 235.07% 26.54%
S&P 500
Composite $1,148.08 18.23% 8.76% 24.27% 9.94%

4. Conclusion
It is common that companies repurchase outstanding shares since they believe their shares are
undervalued. However, currently, the firm is actually outperforming the S&P, which means they
are likely overvalued. It is an inappropriate time for WM to repurchase shares.

Share-repurchasing also leads to the loss in control. Although the owners may accumulated
voting right, end up being over 50% stake in the company after share-repurchasing, share-
repurchasing may be beneficial to an activist investor. They purchase a stake in the firm then try
to get the changes implemented, which means they would be totally reliant on the current
owners. If they butted heads on restructuring, it could greatly increase the chance of a loss in
the investment for an activist investor. This sends a signal that the deal may not be beneficial.

Additionally, while it would artificially increase the value of the overall firm ever other effect is
negative. We see an increased WACC, they would be a chance of bankruptcy costs with only a
BB rating which we did not even calculate as the deficiencies in this strategy were apparent
without additional calculation, a strong dilution in EPS sending a negative signal to the market,
and the consolidation of control. These signal that for the activist investor this would be a bad
investment and should not be attempted.
Further the best and worst case analysis proposed is not the best use of time i believe an
analysis showing the different EPS and EBIT would have been better showing the diffference in
proposed amount of debt. This would have allowed a better comparison of what would have
been the actual optimal debt structure for them firm not just a wild guess.

5. Recommendation
It is recommended for WM to issue less debt. I would analyze the effects of only 500,000 million
or 1 billion dollar debt on the ratios which are used to rate securities. By borrowing those
amount of debt, WM can capture an AA or an A rating respectively. As shown in chart 2, this
would push them lower on the wacc line and result in a lower cost of capital. The less reduction
in earnings should push up the EPS to be more in line, which is still not ahead of the
comparable firms. WM is not suggested to use this debt for share-repurchase which
concentrates ownership and sends a negative signal in the market. we recommend WM to issue
a one time dividend to stockholders, which will actually send a positive signal to the market
negating some of the negative signal in the falling EPS.
Tables below shows the higher credit ratings available from this strategy of less debt. Therefore,
we recommend WM to issue less debt to reduce the cost of debt and thus fully benefit from
financial leverage. The proposed plan would not be as profitable as hopped, but WM could still
generate substantial returns by having this firm restructure with less debts.

1 billion in debt

EBIT interest coverage ratio 4.056662 BBB/B

FFO/Total Debt 33% A/BBB

FOCF/Total Debt 19% A/BBB

Return on Capital 32% AA/A

operating income/Sales 21% AA/A

Long-term debt/Capital 36% A/BBB

Total debt/capital&short term
debt 48% BBB/BB

500 million in debt

EBIT interest coverage ratio 8.113323 AA/A

FFO/Total Debt 54% AA/A

FOCF/Total Debt 30% AA/A

Return on Capital 32% AAA/AA

operating income/Sales 21% AA/A

Long-term debt/Capital 22% AA/A

Total debt/capital 37% AA/A

Appendix:

U.S. Treasury obligations Yield

3 mos. 1.670%

6 mos. 1.710%

1 yr. 2.310%

2 yr. 3.160%

3 yr. 3.660%

5 yr. 4.090%

7 yr. 4.520%

10 yr. 4.860%

20 yr. 5.650%

Corporate debt obligations (10 year) Yield

AAA 9.307%

AA 9.786%

A 10.083%

BBB 10.894%

BB 12.753%
B 14.663%

Before recapitalization Worst case Most likely Best case

Operating income (EBIT) $ 474,629.40 $ 527,366.00 $ 580,102.60

Interest expense $ - $ - $ -

Taxable income $ 474,629.40 $ 527,366.00 $ 580,102.60

Taxes $ 189,851.76 $ 210,946.40 $ 232,041.04

Net income $ 284,777.64 $ 316,419.60 $ 348,061.56

Shares outstanding 232440 232440 232440

Earnings per share $ 1.23 $ 1.36 $ 1.50

After recapitalization Worst case Most likely Best case

Operating income (EBIT) $ 474,629.40 $ 527,366.00 $ 580,102.60

Interest expense $ 390,000.00 $ 390,000.00 $ 390,000.00

Taxable income $ 84,629.40 $ 137,366.00 $ 190,102.60

Taxes $ 33,851.76 $ 54,946.40 $ 76,041.04

Net income $ 50,777.64 $ 82,419.60 $ 114,061.56

Shares outstanding 179209.4656 179209.4656 179209.4656

Earnings per share $ 0.28 $ 0.46 $ 0.64

After recapitalization Worst case Most likely Best case

Operating income (EBIT) $ 474,629.40 $ 527,366.00 $ 580,102.60

Interest expense $ 390,000.00 $ 390,000.00 $ 390,000.00

Taxable income $ 84,629.40 $ 137,366.00 $ 190,102.60

Taxes $ 33,851.76 $ 54,946.40 $ 76,041.04

Net income $ 50,777.64 $ 82,419.60 $ 114,061.56

Shares outstanding 232440 232440 232440

Earnings per share $ 0.22 $ 0.35 $ 0.49

 Financial Management Concentration Integration FINA 5521-A Fall
2017 (F2)
Group Project Grading Sheet

Please complete the following form and attach this page to the end of every group
assignment.

Project Name: The WM. WRIGLEY

Project Type:

0 1
Presentation

Report

Submission Date: 2017-12-06

Grade Assigned by Instructor:

Grade Assigned by Group

Members

Member Name (Last Name, First Name) Grade (0 to 100)

Katherina Dao 100

Lucas (Weitong) Liu 100

David Drouin 100

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