Wm. Wrigley Jr. Company (Wrigley) is a market leader in confectionary industry that manufactures and markets different confectionery products like: Chewing gum, mints, lollipops, chocolates and hard & chewy candies worldwide. In current scenario Wrigley had operating in more than 40 countries and its products are distributed in about 180 countries. "It includes a variety of global, pan-regional, regional and national labels and is focused entirely on confectionery". Within this industry, company's leading product is gums which comprise approximately 85% of the total global sales (2005 sales report) remaining part is taken by sugar oriented confectionary. Furthermore dividing main product (gums) into different sub-categories where sugar free gum comprise 52%, sugarised gum 20% and remainder is functional gum.
Company's main brands are Orbit, Extra, Doublemint, Freedent and Spearmint. Each product has its own attention and value in terms of marketing and product development. Inspite of primary products the company is also having a good range of secondary products, including "Airwaves, Life Savers, Juicy Fruit, Eclipse, Hubba Bubba and Altoids".
In this case study Blanka Dobrynin is the managing partner of a Hedge fund company called as Aurora Borealis LLC. She is one of the leading financial entrepreneurs looking for some good investment opportunities and her strategy of operations is firstly spot the opportunities for a company to reorganize and restructure, invest considerably in the stock market of the target firm and then influence the management and their directors to restructure and pressuring them to adopt for better resourceful strategy.
The Report here analyse the impact of……
Effect of recapitalization on WACC
WACC before recapitalization
The factors used to calculate the WACC are; a risk premium rate of 7% (case study), cost of equity or CAPM assumes a risk-free rate of 5.65% (case Exhibit 7, 20-year U.S. Treasury Obligations), and uses Wrigley's Unlevered beta of 0.75 (case study Exhibit 5). The interesting part in the whole calculation is that since company is debt free so the value of Wd (weighted debt) is zero and vice versa value of weighted equity is 1 (100% equity and 0% debt) So finally company's WACC before recapitalization is 10.9%.
Tax rate used here is actual tax rate (31.17%) calculated from Wrigley's income statement.
Current Beta = 0.75
CAPM = Rf + βu (Rm-Rf)
CAPM = 0.0565 + 0.75 (0.07)
CAPM = 10.9%
WACC= Ke*We+Kd*Wd (1-t)
WACC= 0.109*1.0+0.0*0.13(1-0.3117)
WACC= 10.9%
WACC after recapitalization
As the above calculations showed that company's current WACC is 10.9%. Since the complete firm runs on equity and free from debt that is why Wrigley's CAPM (Cost of equity) is identical to its WACC.
In general case, Capital structure of a firm would change if it borrows a huge amount. Here Wrigley borrows $3b under good credit ratings, so it would increase the firm's value because of the decrease in WACC. But in our case, the WACC after including the debt structure almost remains the same(10.9 to 10.91). The reason of this change is the increase in Beta due to re-levering at new debt level, which consequently brings the beta up to the same level at relevant debt ratios. Hence although re-levering shows no effect on value of the firm, the EPS rises and the stock price rises due to the repurchase. A possible explanation for this would be the decreasing financial stability of the firm and its ability to make
Relevered Beta = βu* {1+ (1-t)*D/E}
Relevered Beta = 0.87
CAPM = Rf + βl (Rm-Rf)
CAPM = 0.0565 + 0.87 (0.07)
CAPM = 11.7%
WACC= Ke*We+Kd*Wd (1-t)
WACC= 0.117*0.705+0.295*0.13(1-0.3117)
WACC= 10.91%
Impact of Re-capitalization on Share Prices
As the case study says that company can borrow $3 billion, so now they have several choices to use that budget. One may be to reinvest it in paying the "equivalent dividend" (case study) or secondly to buyback the outstanding shares to increase its market value. In first case it is clearly understood that reinvestment in dividends will not have any effect on the number of outstanding shares and there are chances that the shares prices will not show any positive result. This is due to the fact that people might think that the company is increasing its debt to pay its dividend and this would lead to a bad impression on share holders
While on other hand the buyback of outstanding shares would decrease the number of outstanding shares in the market and due to that earning per share would increase. Moreover, due to the same reason dividend paid to each shareholder would also increase (Solution 2). The increase in EPS and DPS will provide an indication towards an encouraging market attitude, and that leads to increase in share price.
Solution 2:
Company's current no. of shares outstanding = 232.4 million
Buyback amount = $3 billion
Current price of one share = current stock price + tax shield
Current price of one share = $61.53 ($56.37 + $5.16)
No. of shares repurchased = (Invested amount/ price of one share)
No. of shares repurchased = $3 billion/$61.53
No. of shares repurchased = 48.755 million
Remaining no. shares = 183.686 million
So the same amount which was earlier divided into 232.4 million shares would now be paid to 183.686 million shares and that increases the DPS.
Conclusion
Decision on recapitalization
It will be favorable for hedge funds if the company re-levers itself to raise the price of the stock. But from the long-term growth perspective of the firm, the best policy would be to re-invest in the firm for growth in form of sales or pursuing more profitable acquisitions. The share buyback would although raise the price of the firm, but if control of the firm is not an issue of urgency and the management do not plan an appropriate utilization of the retained earnings and the new debt, then the company should refrain from adding on additional debt. Moreover, using debt to payout the dividends would result in decrease the value of the firm and hence the share price using assuming market to be efficient
