William Wrigley Jr. Company is exploring whether it is optimal to recapitalise with taking on $3 billion of debt. Three options are revised; borrow and repurchase shares, dividend payouts or continue to function with full equity. Debt will provide a tax shield of $1.2 billion given the tax rate is 40%, this should increase the market share price to $61.53 per share. The viable method for the company is to utilize this debt to repurchase shares. The will not only increase Wrigley’s market value, via the debt shield, but also signal to market that management believes Wrigley’s is undervalued, something the dividend payment won’t achieve. Introduction:
This case study will examine the option for William Wrigley Jr. Company to acquire $3billion of debt and the effects it can have on the business’s capital structure. Viable opportunities for a recapitalization encompass the repurchasing of shares or to pay a dividend to current shareholders. Financial theory and calculations will illustrate the financial effects between the tax benefits of debt and the associated costs involved. It will also administer the signalling and the clientele effects for the corporation. General Effects of Debt
Modigliani & Miller (1958) states that the leverage does not affect firm value and as such Wrigley should not prefer any particular capital structure. As payments made towards debt are tax deductable the issuing of debt will increase firm value by providing a tax shield. As the role of management is to maximise firm value, the amount of debt in Wrigley should be maximised (Sharp, 1964). Management should also consider a safe level of debt though to prevent risks of liquidity and operating restrictions. To recapitalise with $3 billion of debt the firm will benefit from a tax shield of $1.2 billion. This will result in the market share price increasing to $61.53/share. Using Hamada’s (1972) equation, leveraging the firm would result in an increasing beta from 0.75 to 0.877 (see appendices 1.1, 1.2 and 1.3). By issuing debt, Wrigley’s increases its level of risk as its sensitivity to market fluctuations increases. Although a potential for insolvency has risen, its correlation is still less than an equal measure of change and as such debt increase doesn’t present a considerable risk.
With equity being preferred behind debt, the cost of equity will rise to 11.788% (see appendix 1.3). The WACC changes to 10.91% as the inclusion of debt of $3 billion changes it from 10.9% and the return on capital of 11.785% is achieved (see appendix 1.4). According to the ratings of Standard & Poor, the return on capital falls between a BB and B range (Brigham,F, &Ehrhardt, 2008, p.181-183). This indicates that the quality of debt obligations would just fall in the grade of investment level. This is a positive signal to stakeholders due to both the monitoring benefits received by the issuance of debt and the investment quality of the debt issued.
Rejection of Debt
Debt provides tax benefits is conditional to its’ financial engineering. To undertake debt, it increases the risk of insolvency (Altman & Hotchkiss, 1993). With the rejection of debt, the firm has at its disposal more equity in the future if positive NPV projects were to arise. This positions Wrigley to currently have financial flexibility and also endeavor to avoid financial distress. Repurchase Shares
With a share repurchase program, the debt raised would be used to repurchase $3 billion in shares from the market. As discussed, the introduction of $3 billion debt to the capital structure would increase the share price. This would theoretically mean the share price would remain at $61.53 (see appendix 1.2). However, Bartov (1991) found that there are unexpected positive annual earnings following the share repurchase. This supports the hypothesis that a share repurchase can be a signaling mechanism in a business due to asymmetrical...