VALUATION and cost of capital
Blanka Doborynin a managing partner of AURORA BOREALIS LLC tries to initiate a research for a potential investment in Wrigleys. They are trying to recapitalize the firm. Wrigley’s which is 100% equity financed has a market value of $13,103,000,000 the question begins if it is totally equity financed is it running at its efficient level? Or Is it better to recapitalize the structure and thereby bring out more efficient operational levels. They are planning to get a debt of 3,000,000,000 using it to extract the profit out of the low risk (BBB) forecast that the company possesses. They are potentially investigating, if it is good to recapitalize is it right to repurchase the shares with the debt or to pay dividends with the entire debt.
There are major changes that take place in the following list of questions given to us and the following answers are answered according to the questions order. The answers are tabulated below. | Dividends| Repurchase of stock|
Outstanding shares| 232,440,000| 183,686,000|
Book value of equity| $(1724)| $(1724)|
Price per share| $48.63| $61.53|
Earnings per share| 0.32| 0.40|
Table 1: describes the effect of issuing debt and using the proceeds to pay dividend or to repurchase stock.
The number of outstanding shares in Wrigley’s would vary only if the shares were to be repurchased. The number of shares remaining after the repurchase is 183,686,000 i.e. a change of 48,754 shares.
The book value of equity is the difference between the book value of assets and the book value of liabilities.From ExhibitTN2 we come to know that the book value of equity becomes negative. Negative book value to equity should not be used for taking decisions in the business because it uses historical data. It does not say anything about the risks faced by the companies (negative book value does not mean a risky situation). Hence business decisions should be taken wisely with respect to market value of equity. The Book value which is calculated according to accounting standards does not consider the increase in the value of equity brought about by Tax shield or the current trend in the market which is considered in the market value of equity.
The price per share changes significantly if the company pays dividends and if it repurchases stock. If the company pays dividends, the price of each share is $48.63. This decrease in the value of the stock is because as debt increases with the same amount of share holders then the value will drop as $3 billion out of the capital structure transfers to the debt holders. Price of the share on repurchase increases to $61.53, The reason is according to MM theory the value of levered firm is higher. This is because of tax shield playing an important role; This extra value is reflected on the shareholders asset.
The question at this point maybe, why does value increase in the case of repurchase and decrease when the company pays dividend? The answer is pretty straightforward the number of shares that the company holds explains the answer (refer ExhibitTN 2)
With reference to Exhibit TN7 which is the comparison between EBIT and EPS at various levels of operational income. Where the operational income for 2001 (514 million) was used under the year 2001in the XL sheet and various calculations were made. After recapilazation i.e. getting $3 billion in debt, the Earning per share reduces from 1.33 to .40 for repurchase and .32 if the company decides to pay dividends. Adding to that, with respect to the graph we can see that EPS of repurchase is higher than EPS of dividends paid. The reduction in EPS is due to the fact that there is a reduction in the number of shares after repurchase. The interest expenses raises which reduces the earnings for the shareholders when the dividends are paid.
Financial flexibility refers to a firm's ability to take...