Finance and Debt Tax Shields

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Case Discussion: The Wm. Wrigley Jr. Company: Capital Structure, Valuation and Cost of Capital

1. Dobrynin plays the role of the financial entrepreneur, exploiting inefficiencies in investment valuation and corporate finance. She seeks to profit by restructuring firms with “lazy financing” or too much cash and unused debt capacity relative to the (low) risks faced by the firms. By pressuring directors and managers to adopt more efficient policies, she hopes to reap an investment gain. The larger issue is whether or not Wrigley is inefficiently financed. If so, how much capital structure change will bring it to more efficient operation?

2a. A recapitalization based on a dividend will have no effect on the number of shares outstanding. But with a repurchase, the number of shares will change materially. If we adjust the current stock price only for our estimate of tax benefits, the repurchase price would be $61.53. Wrigley currently has 232.4 million shares outstanding. At that price, 48.755 million shares will be repurchased ($3 billion/$61.53), leaving 183.686 million shares outstanding.

2c.With the addition of the new debt, Wrigley’s share price should quickly and fully reflect the changes in investors’ perceptions stemming from the repurchase once the company publicly discloses its intentions.

One way to frame the issues is—immediately upon the announcement—the stock price should change to reflect the following:

| | | | | | |Post-recapitalization |= Prerecap. |Present value |Present value of |Signaling, incentive, & | |equity value |equity value |+ Debt tax shields |distress-related |clientele effects | | | | |costs | | | | | | | | | |= $56.37 |+ Tc ' Debt |Challenging to |Unobservable | | | |0.4 ' ($3,000) |observe | | |$61.53 |= $56.37 |+ $1,200 or |? |? | | | |+ $5.16/sh | | |

The effect of the present value of debt tax shields: It shows that adding $3 billion in debt to Wrigley’s capitalization and returning a like amount to shareholders will add $1.2 billion in equity value due to tax effects. The tax benefits are estimated assuming that Wrigley commits to maintain the $3 billion in debt in perpetuity. The net revised value per Wrigley share is $61.53.

Debt grows from zero to $3 billion.

Assets grow by $1.2 billion, equal to the present value of the debt tax shields.

2b. Book equity becomes negative as a result of the large payout under the dividend or share repurchase.

Market value of equity declines by $1.8 billion, the result of the payout of $3 billion, which is offset by the benefit of the debt tax shields ($1.2 billion).

Note that the accounting values give no attention to the value of debt tax shields and to the possibility that the market value of fixed assets may be greater than the historical value.

2f. Under the share repurchase, the shrinkage in shares outstanding might alter the influence of control groups. In some tax environments, investors may have a preference for capital gains (triggered by a repurchase) as opposed to dividend income (which might be taxed more aggressively.

3. Beginners will often turn to book...
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