The William Wrigley Jr. Company Essay

1.0 footIdentifying opportunities for corpo target monetary restructuring was typical for Blanka Dobrynin, a managing partner of the hedge monetary fund Aurora Borealis LLC. In 2002, with the then debt free William Wrigley Jr. Comp whatsoever (Wrigley) in her sights, she asked her associate Susan Chandler to conduct research on the imp be active of a $3 billion debt re big(p)isation on the beau monde. This case report aims to make an informed pass on whether Wrigley should pursue the $3 billion debt proposal.2.0 Optimal bully twistAccording to Miller and Modiglianis (1958) first pro put down, the apprise of a smashed is independent of its enceinte construction, assuming no corporate taxationes. It was later demo that the existence of debt in the detonator structure creates a debt cuticle that ontogenys the survey of the firm by the insert place of the tax shield (Miller & Modigliani, 1963). This debate of reasoning implies that debt financing adds signifi masst lo ok upon to the firm and an optimal detonating device structure occurs with 100% debt. However, this is an unlikely outcome in reality with restrictions enforce by lending institutions, bankruptcy damage and the need for preserving financial flexibleness implying that management ordain of importtain a substantial reserve of resumeing power (Miller & Modigliani, 1963). These imperfections fork over since been discussed as additional factors when determining an optimal uppercasestructure.The trade off theory suggests that an optimal slap-up structure may be achieved by determining the trade-off between tax shields and the cost of financial distress (Kraus & Litzenberger, 1973). The presence of tax shields means that the optimal bully structure decision is unique for each firm (DeAngelo & Masulis, 1980). High levels of debt can lead to indirect bankruptcy be and financial distress costs which relate generally the costs associated with going bankrupt or avoiding bankruptcy. At high up debt levels, the benefit of debt may be offset by financial distress costs. It appears that the optimal interchange structure exists somewhere in the middle.Jensen and Meckling (1976) storied the existence of representation costs of debt. These costs arise when equity holders act in their own sake rather than the firms interest. As Wrigley is a family owned come with it is unlikely that agency costs allow be an cut back.3.0 Weighted Average exist of Capital (WACC)The question that underlies the decision to pursue the debt proposal is whether Wrigley is efficiently financed without debt. In this report, the WACC pass on be the main factor when determining whether Wrigley is efficiently financed. The WACC is the minimum throw that a corporation needs to satisfy all of its investors, which is to a fault the it is the required rate of return on the overall firm. The value of Wrigley give be maximized when its WACC is minimized. This report will examine the optima l capital structure as the one that produces the utmost possible WACC.WACC is one of the most important methods in assessing a confederacys financial health, both for internal occasion, such as capital budgeting, and external use, such as valuing investments or companies. It is able to provide an brainstorm into the cost of financing and can be utilise as a hurdle rate for investment decisions. It can also be used to find the best capital structure for the company. The WACC can be used as a rough guide to the interest rate per monetary unit of capital (Pratt & Grabowski, 2008).The WACC method can be considered a better indicator than other methods such as earnings per assign (EPS) or earnings before interest and tax (EBIT) because it takes into consideration the sexual congress weight of each component of a companys capital structure (Armitage, 2005). The calculation uses the grocery set of the components rather than the book values as these values may differ significantly. The components WACC takes into consideration accept internal and external factors such as equity, debt, warrants, pickaxs, pension liabilities, executive farm animal options and government subsidies (Hazel, 1999) whereas the EPS and EBIT calculations merely take into consideration the internal factors, such as total earnings. of the company and However, the earnings reported by a company may non be a reliable value, as they run to report more favourable values as opposed to the genuine amounts.However, as the WACC is calculated according to M&M theory, some of the foreplay parameters can be difficult to ascertain. This is due to the uncertainty that exists in the market that would influence the outcome. Another issue limitation with the WACC, is that it relies on the assumption make in the M&M propositions, which do not necessarily accommodate in the real world. Some assumptions that do not apply admit the fact that transaction costs exist and individuals and corporations do not suck in at the same rate.Referring to Appendix 1, the calculations show a slight increment in the WACC by and by the $3 billion debt is acquired. This change is more heavy(p) when using the 10 year US treasury rate as the essay free return an increase from 10.11% to 10.28% for the WACC. Therefore it appears that the optimal capital structure for Wrigley would be one containinginclude no debt as this provides the lowest WACC.4.0 Estimating the tack of the recapitalisation on4.1 Share valueIn an efficient market, it is assumed that the package bell will changequickly to reflect investors changing perceptions somewhat the tender debt issue. The install of the recapitalisation on the share price can be summarised by Miller and Modiglianis adjusted NPV formulaPost-recapitalisation equity value = Pre-recapitalisation equity value + Present value of debt tax shields + Present value of distress related costs + SignalingSignalling, incentive & clientele effects assumptive the debt will continue into perpetuity, the present value of the $3 billion debt would be $1.2 billion. Using the post recapitalisation value of equity incorporating the tax shield of $1.2 billion, the bourgeon price is increased from $56.37 to $61.51. The remaining factors of this equation are real difficult to ascertain. The present value of the distress related costs could be assumed to be the value of a put option on the debt. Nevertheless, it could be assumed that financial distress costs would be negligible in Wrigleys situation, as it is a market attraction with a strong financial position. It is very difficult to estimate the cost of signalingsignalling and clientele effects and it is necessary to bear this in mind when flavor at the increase on share price as it does not fully reflect all relevant considerations. 4.2 Level of Flexibility financial flexibility refers to the ability of a firm to respond in a timely and value-maximizing manner to unexpected changes in the firms cash flows or investment opportunity set (Dennis, 2011). Chief Financial Officers surveyed by Graham and Harvey (2001) state that financial flexibility is the most important decisive of corporate capital structure (Graham and Harvey, 2001).A flexible capital structure can be achieved by preserving access to low-cost sources of capital. DeAngelo and DeAngelo (2011) argue that firms should optimally maintain low levels of leverage in most periods in ready to be better equipped to cope with the adverse consequences of exogenous shocks. They also argue that firms should maintain low leverage and high dividend payouts in typical periods in order to preserve the option to borrow or issue equity in future abnormal periods characterised by earnings compactfalls and/or lucrative investment opportunities.The financial flexibility of Wrigley will be reduced as borrowing $3 billion directly will lower their ability to borrow in the future if thither are any lucrative investment oppo rtunities or cope with any unexpected exogenous shocks to the market and themselves.4.3 Mix of Debt and EquityConsiderations have to be made when evaluating the recapitalisation of Wrigleys capital structure by adding debt. A look up of Wrigley is deciding the debt ratio which optimizes the overall value of the firm. Companies are often tend to choose debt over equity as the cost of debt is cheaper due to the tax shield created.With the addition of $3 billion of debt in Wrigleys capital structure, the tax shields benefit will increase the equity value by $1.2 billion. The estimation of the tax benefits are assumed under the condition that Wrigley will maintain debt value of $3 billion in perpetuity. As a result of $3 billion payout, the value of equity will pooh-pooh by $1.8 billion which will be offset by the present value of the debt tax shield ($1.2 billion).Wrigleys debt/equity level after recapitalisation will be 78% and 22% debt. The traditional view is that taking on high er levels of debt could potentially generate more earnings on positive NPV projects which could increase the companys value. Although it should be noted that considerations have to be made at what which backsheesh, debt becomes more pricey to Wrigley in toll of increased risk to shareholders.Assessing Wrigleys optimal debt level, it suggests that the optimal invest would be not taking on any debt. By taking on debt, Wrigleys credit rating will fall from AAA to BB/B, as it would be increasing its risk levels of financial distress and risk of bankruptcy cost. Assessing From this, it can be recommended that Wrigleys optimal debt level, it suggests that the optimal point would be not taking on any debt.having nominal debt.4.4 account earnings per shareBefore the proposed recapitalisation, Wrigley will have no minimal debt. If Wrigley does not have any income, they still need to pay the interest on the debt, so EPS will be disconfirming. Referring to Appendix 2, the both lines in tersect where EBIT is $1.70 billion and EPS is $12.21. This is the break-even point if EBIT is above this point leverage is beneficial. If Wrigleys income was higher than $1.70 billion, they could should take the $3 billion debt. In fact, the current income is scarcely $0.51 billion therefore according to a breakeven EBIT analysis, Wrigley should not pursue the debt.5.0 other(a) matters for the boards consideration5.1 Effect on Voting falsifyAssuming the $3billion is used either for a dividend payout or share repurchase, only the second option would alter the amount of shares outstanding.The Wrigley family already controlled 21% of the earthy stock and 58% of the Class B common stock, which had superior vote rights attached. A $3 billion share repurchase would good increase the voting control of the Wrigley family, however the family was already in a majority position so voting control would not be substantially different. A strong controlling majority is highly advantageous in deterring potential mergers and acquisitions.5.2 Clientele and Signaling effectsIn general, companies that take on debt signal to investors that the company is in a good financial position as it is able to make future interest repayments.If the debt were used for a dividend payout, this would signal to investors that the company is doing well and increase the stock price.However, using the debt for a share repurchase might have a clientele effecton potential investors that prefer dividend payouts. These investors could potentially sell their remaining stock in reaction to the share buyback resulting in the stock price falling.6.0 ConclusionThe WACC indicated that taking on $3b of debt would reduce the value of Wrigley company. This value could change, provided the Wrigley company had an investment opportunity or plan to use the newly obtained debt of $3b. The WACC value may be disregarded or adjusted if Wrigley had a high NPV project to invest in or provided a specific use for t he funds. However, in the current situation, there is no indication of the reasons for Wrigley to take on the debt and thus they are unnecessarily restricting their financial flexibility. This could prove costly in the future if there are any unexpected negative shocks to the market or Wrigley may miss out on a highly lucrative investment opportunity due to their inability to borrow more. Therefore it is our recommendation that the Wrigley company does not take on the $3b of new debt as it would reduce the total value of the company at this point in time.7.0 ReferencesArmitage, S. (2005). The make up of Capital Intermediate Theory. Cambridge, UK Cambridge University Press. DeAngelo H., & DeAngelo, L., (2006) Capital Structure, Payout Policy, and Financial Flexibility, University of Confederate California working paper. DeAngelo, H., & R.W. Masulis. (1980) Optimal Capital Structure under incorporate and Personal Taxation. Journal of Financial Economics 8, 3-29. DeAngelo, H., DeAng elo, L., & Whited T.M., (2011) Capital structure dynamics and transitory debt. Journal of Financial Economics, 99, 235261.Denis, D J. (2011) Financial Flexibility and bodily Liquidity. Journal of Corporate Finance, 17(3), 667-674.J.R. Graham, & C.R. Harvey., (2001) The theory and practice of corporate finance turn up from the field. Journal of Finance and Economics 60,187243. Jensen, M., & Meckling, W. (1976). Theory of the firm Managerial behavior, agency costs, and ownership structure. Journal of Financial Economics 3, 305-360. Johnson, H. (1999). Determining Cost of Capital The Key to Firm Value. London FT Prentice Hall. Kraus, A., & R.H. Litzenberger. (1973) A bring up Preference Model of Optimal Financial Leverage. Journal of Finance (September), 911-922. Modigliani, F., & M.H. Miller. (1958). The cost of Capital, Corporate Finance, and the Theory of Investment. American Economic Review, 48 (June), 261-297.Modigliani, F., & M.H. Miller. (1963). Corporate Income Taxes and the Cost of Capital A Correction. American Economic Review 53 (June), 433-443. Pratt, Shannon P., & Roger J. Grabowski. (2008) Cost of Capital Applications and Examples. Hoboken, NJ Wiley.