The Wm. Wrigley Jr. Company: Capital Structure, Valuation, and Cost of Capital
1. Background of Wm. Wrigley Jr. Company
Wm. Wrigley Jr. Company is a well-known leader that manufactures confections such as gums, mints, hard and chewy candies, lollipops, and chocolates. The company was founded in 1891 and its headquarters is based in Chicago, Illinois. It has operations in over 40 countries and distributes many of its world famous brand such as Double mint, Extra, Skittles, Orbit to more than 180 countries.
2. Overview of Case Study
Blanka Dobrynin, who is a managing partner of Aurora Borealis LLC, plays the role of a financial entrepreneur by seeking to profit from companies that ...view middle of the document...
The scope of study will focus on two alternatives that the $3 billion debt should be used for, namely to either pay an equivalent dividend or to repurchase an equivalent value of shares.
3. Analysis of the effects of introduction of debt to Wrigley’s Capital Structure
First our team calculated the WACC before and after issuing $3 billion debt to determine whether Wm. Wrigley should recapitalize or not. We move one step further by varying the amount of debt issuance to get the minimum WACC and the amount of debt issuance needed if recapitalize to maximize shareholder’s value. Second, we compare the pros and cons of payout dividend versus share repurchase to determine which one is the better option.
3.1. Estimate the cost of Debt
In order to verify whether $3 billion debt can be issued at 13% cost of debt, we began with analyzing Wrigley’s key financial ratios such as EBIT Interest Coverage, FFO/Total Debt. Then we compare these ratios with credit rating agency ratio to verify its reasonableness. We also move a step further by changing the amount of debt issuance which will lead to different capital structures, and get the threshold cost of debt under various capital structures. The estimated cost of debt at various threshold debt ratios was shown in Table-1 below (refer to excel spreadsheet for details). Notice that the cost of debt goes up as leverage and the threat of bankruptcy increase.
3.2. Estimate the cost of Equity
An increase in the debt ratio also increases the risk faced by shareholders, and this has an effect on the cost of equity, rs. Recall from Hamada Equation that the beta of equity increases with financial leverage.
Here D is the market value of the debt and E is the market value of the equity.
We apply the procedure to Wm. Wrigley. First, we use 10-year treasury yield as a proxy of the risk-free rate, rRF= 4.860%. Second, the equity market risk premium, MRP= 7% which is given in the case. Next, the unlevered beta, bu= 0.75 , which is its current beta without debt. Therefore, Wrigley’s current cost of equity is 10.11%:
If Wrigley changes its capital structure by issuing debt, this would increase the risk stockholders bear. That, in turn, would increase the leveraged beta as well as the cost of equity. Refer to Column 4 and 5 of Table-2 for the leveraged beta and cost of equity under different debt ratios.
3.3. Estimating the Weighted Average Cost of Capital, WACC
Column 6 of Table-2 shows Wrigley’s weighted average cost of capital, WACC, at different capital structures. Currently, it has no debt, so its capital structure is 100 percent equity, and at this point WACC =rs= 10.110%. As Wrigley begins to issue less amount of debt with higher rating, the after-tax cost of debt is far less than cost of equity, the WACC declines. However, as the debt ratio increases, the costs of both debt and equity rise. Eventually, at 4.73% debt ratio, the WACC hits a minimum of...