Topics: Corporate finance, Finance, Capital structure Pages: 15 (2215 words) Published: June 3, 2014
The William Wrigley Jr. Company
Case Report

Ying Suan Lo
Julianne Mills
Nick Lim
Vinson Chen
Glen Hamilton

Table of Contents

1.0 1.0 Introduction

Identifying opportunities for corporate financial restructuring was typical for Blanka Dobrynin, a managing partner of the hedge fund Aurora Borealis LLC. In 2002, with the then debt free William Wrigley Jr. Company (Wrigley) in her sights, she asked her associate Susan Chandler to conduct research on the impact of a $3 billion debt recapitalisation on the company. This case report aims to make an informed recommendation on whether Wrigley should pursue the $3 billion debt proposal.

2.0 Optimal Capital Structure

According to Miller and Modigliani’s (1958) first proposition, the value of a firm is independent of its capital structure, assuming no corporate taxes. It was later demonstrated that the existence of debt in the capital structure creates a debt shield that increases the value of the firm by the present value of the tax shield (Miller & Modigliani, 1963). This line of reasoning implies that debt financing adds significant value to the firm and an optimal capital structure occurs with 100% debt. However, this is an unlikely outcome in reality with restrictions imposed by lending institutions, bankruptcy costs and the need for preserving financial flexibility implying that management will maintain a substantial reserve of borrowing power (Miller & Modigliani, 1963). These imperfections have since been discussed as additional factors when determining an optimal capital structure.

The trade off theory suggests that an optimal capital structure may be achieved by determining the trade-off between tax shields and the costs of financial distress (Kraus & Litzenberger, 1973). The presence of tax shields means that the optimal capital structure decision is unique for each firm (DeAngelo & Masulis, 1980). High levels of debt can lead to indirect bankruptcy costs and financial distress costs which relate generally the costs associated with going bankrupt or avoiding bankruptcy. At high debt levels, the benefit of debt may be offset by financial distress costs. It appears that the optimal cash structure exists somewhere in the middle.

Jensen and Meckling (1976) noted the existence of ‘agency costs of debt’. These costs arise when equity holders act in their own interest rather than the firm’s interest. As Wrigley is a family owned company it is unlikely that agency costs will be an issue.

3.0 Weighted Average Cost 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 will be the main factor when determining whether Wrigley is efficiently financed. The WACC is the minimum return that a company needs to satisfy all of its investors, which is also the – it is the required rate of return on the overall firm. The value of Wrigley will be maximized when its WACC is minimized. This report will examine the optimal capital structure as the one that produces the lowest possible WACC.

WACC is one of the most important methods in assessing a company’s financial health, both for internal use, such as capital budgeting, and external use, such as valuing investments or companies. It is able to provide an insight into the cost of financing and can be used 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 share (EPS) or earnings before interest and tax (EBIT) because it takes into consideration the relative weight of each component of a company’s capital structure (Armitage, 2005). The calculation uses the market...

References: Armitage, S. (2005). The Cost of Capital: Intermediate Theory. Cambridge, UK: Cambridge University Press.
DeAngelo H., & DeAngelo, L., (2006) Capital Structure, Payout Policy, and Financial Flexibility, University of Southern California working paper.
DeAngelo, H., & R.W. Masulis. (1980) Optimal Capital Structure under Corporate and Personal Taxation. Journal of Financial Economics 8, 3-29.
DeAngelo, H., DeAngelo, L., & Whited T.M., (2011) Capital structure dynamics and transitory debt
Denis, D J. (2011) Financial Flexibility and Corporate Liquidity. Journal of Corporate Finance, 17(3), 667-674.
J.R. Graham, & C.R. Harvey., (2001) The theory and practice of corporate finance: evidence from the field. Journal of Finance and Economics 60, 187–243.
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 State Preference Model of Optimal Financial Leverage. Journal of Finance (September), 911-922.
Modigliani, F., & M.H
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.
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