In June 2002 Blanka Dobrynin, a managing director of Aurora Borealis hedge fund, considers the possible gains from increasing the debt capitalization of The Wm. Wrigley Jr. Company. Blanka suggests Wrigley raise the amount of $3 billion in debt of the capitalization while Wrigley has been conservatively financed and remained no debt at the end of 2001. This report is aiming to analyze whether Wrigley should use $3 billion debt recapitalization to either pay dividends or to repurchase shares.
2.0 Current Capital Structure
Generally, firms can choose among various capital structures in order to maximize overall market value of the company. It is proposed however, that Wrigley issues $3 billion in debt.
According to the trade-off theory, the optimal capital structure does exist (Kraus and Litzenberger, 1973). The higher level of debt may increase both bankruptcy and financial cost that lead the firm to go or avoid bankruptcy. However, there are several advantages of raising debt capital. Firstly, tax-deductions which decrease the cost of debt. Secondly, stockholders do not have to share the profit when the firm has excess, as debt holders are limited to their fixed return. Finally, stockholders do have voting right but debt holders do not which means the stockholders are controlling the business.
3.0 The Impacts of Proposed Changes
The decision to increase $3 billion debt capitalization of the Wm. Wrigley Jr. Company by Blanka Dobrynin is to optimize the total value of the company. Firms are often inclined to choose debt over equity in order to use the tax shield.
As the increasing of $3 billion debt in Wrigley’s capital structure, its equity value will increase by $1.2 billion due to the tax shield. Also this proposal of recapitalization will help Wrigley’s equity decrease by only $1.8 billion when they payout $3 billion debt, due to the offset by the $1.2 billion tax shield.
According to our calculations, through recapitalization Wrigley’s total asset will be $14,459,826, which consists of $3,157,127 debt and $11,302,699 equity. In general, firms prefer to keep a higher level of debt/equity ratio to obtain larger total capital to increase the firm’s total value. But it is obvious that more debt means more risk and more payout.
By assessing the spreadsheet, it suggests several reasons for and against the acquisition of debt. If the Wrigley’s debt increases, its credit rating will drop from AAA to BB, which leads to more cost of future financing and value of stocks.
However, as debt can increase firm value up to a degree, we recommend that Wrigley’s find an optimal capital structure through further analysis of whether $3 billion of debt provides the smallest possible Weighted Average Cost of Capital (WACC) for the firm.
3.1 Flexibility and Reserves
According to Denis (2011), financial flexibility is the ability of a firm to make decisions and handle problems timely. Moreover, the firm should always maximize their firm value on any unexpected changes in investment opportunity and cash flows of the firm. In addition, the firm should prudently raise their capital in the good times to avoid stretching their capabilities too far, and in order to preserve their ability to choose to either borrow or issue equity in future times of need. Therefore, the lower level of firm’s debt, the more financial flexibility a firm has (Investopedia, 2014).
Due to that $3 billion new debt existing, the financial flexibility of Wrigley will decline; this financial activity leads to lower ability to borrow money in the future if there are any profitable investment opportunities or any unexpected internal or external shocks.
3.2 The Book and Market Price per Share
As is visible from the Appendix One, the decision of how to use the funds raised through debt is an important one as it will impact both the price per share and the book value per share. The price per share will decrease to $48.63 if the debt raised is used to pay out a dividend (decrease in the value of equity), whereas the price per share will increase to $61.53 if it is used to repurchase shares. However, the issuance of debt can have signalling effects for investors. Generally, when firms issue debt it signals to investors that the firm is in a good financial situation as the firm is able to undertake repayments of future interest.
Furthermore, the clientele effect can impact the stock price because it assumes that the investors are attracted to the company for its policies and when these change the investors will react and adjust their stock accordingly (Moles & Terry, 2005). In addition to this, the issuance of debt and repurchase of stock could signal to investors that managers believe the stock in undervalued.
Despite this change in price, the Weighted Average Cost of Capital (WACC) will give a more accurate representation of what the change in capital structure implies for the firm, by taking account the costs of debt.
3.3 Weighted Average Cost of Capital
Before recapitalisation Wrigley’s WACC was equal to it’s cost of equity (ke), which was calculated at 10.95%. After capitalisation it was found that Wrigley’s WACC decreased to 10.29%. This follows the general pattern of increasing debt resulting in a lower WACC. The cost of debt (kd) rate of 13% was used after we assessed the key industrial financial ratios and compared them with that of Wrigley’s (See Appendix 2) to conclude that it was in the range between the BB rate of 12.753% and B 14.663% (see Appendices 3 & 4). Although WACC has decreased, which means that every $1 that Wrigley raises in capital from investors it must pay at least $10.30 in return, it’s Beta has increased from 0.75 to 0.87. This means that Wrigley’s investment is still less volatile than the market, but it has become more in line with the market after recapitalisation. However Beta will not incorporate the risk of financial distress that becomes present once Wrigley have taken out the debt. 4.0 Conclusions and Recommendations
Therefore, from our analysis we know that an increase in debt can have adverse affects on flexibility and can have costs associated such as bankruptcy, agency and distress costs, however, due to the tax shield affects and the decrease in WACC we believe there should an increase in the level of debt. In addition, the share price change is not consistent with the change in WACC and it could be assumed that the distress costs associated with the increase in debt would mean the price would actually remain relatively steady to reflect the negligible change. We recommend that Wrigley issue $3 billion of debt in the form of share repurchase plan because this scenario has no defining impact upon WACC – slightly decreasing from 10.95% to 10.29%, and as a company’s main goal is to increase its’ shareholders value. Furthermore there are fewer risks in terms of clientele effect and signalling effect, while also allowing the Wrigley family to maintain their control with their high portion of shares. However, we recommend further analysis to determine what is the optimal level of debt by finding the lowest possible WACC, and therefore maximising the company’s value.
5.0 Reference List
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Investopedia. (2014). Complete Guide To Corporate Finance. Retrieved from http://www.investopedia.com/walkthrough/corporate-finance/5/capital-structure/capital-structure.aspx
Investopedia (2014). Optimal Capital Structure. [ONLINE] Available at: http://www.investopedia.com/terms/o/optimal-capital-structure.asp. [Last Accessed 19 Aug 2014].
Kraus, A. and R. Litzenberger (1973). A State-Preference model of optimal financial leverage. Journal of Finance, Vol. 28, pp. 911-922.
Moles, P., Terry, N. (2005). Clientele effect. The Handbook of International Finance Terms. Retrieved from http://www.oxfordreference.com.ezp01.library.qut.edu.au/view/10.1093/acref/9780198294818.001.0001/acref-9780198294818-e-1351
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