This Report investigates the financial effects on Wrigley’s with the issuance of $3bn debt. It explores two alternate means of allocation for the funds; pay out a one-time dividend or carry out a share repurchase. Both methods are analyzed in regards to an optimal capital structure and maximizing share holder value (value of the firm). A compilation of historical data and future predictions were used for the basis of this report, and recommendations.
The following paper will draw on Modigliani and Miller’s (1958) theorem of capital structure to determine whether an ‘optimal’ level for Wrigley’s can in fact be reached. A further discussion of agency costs and incentives by Jensen, Meckling (1976), and Lenland (1998) will evaluate the relative impact of these risks on re-structuring. Finally, Chambers, Harris and Pringle (1982) distinguish the approaches in valuation used for Wrigley’s.
Optimal Capital Structure
The Modigliani and Miller (1958) theorem has been widely touted as the basis for capital structure theory (M&M Propositions). While previously rationalizing that a firm should be indifferent between various levels of financial leveraging – a further study ‘optimal’ level of capital structure which enhances the use of a tax shield to best offset the cost of debt. It is important to note however, that there are several implicit considerations & limitations that are imposed with the increase of leverage (Modigliani and Miller, 1963).
Financial Distress & Flexibility
Financial distress and corporate performance is a widely debated topic. Although literature has portrayed financial distress as costly and important in concluding on a firm’s optimal capital structure, Opler and Titman (1994) discovered that it is substantially difficult to quantify. While Wrigley’s has been given a B/BB rating, due in part to their interest coverage ratio of 1.47; due to the fact that WACC has only increased 0.01%, it can be assumed that financial distress would be relatively trivial.
Incentive & Agency Costs
Another factor has been found by Jensen and Meckling (1976) to fall under consideration is that of agency costs. They found the costs associated with a ‘value transfer’ to bondholders – although essentially unobservable - are offset to a much larger degree by the tax advantage gained by equity holders (Leland, 1998).
Adjusted Present Value
With the proposed restructuring at a set amount of $3bn, APV is used to measure the tax benefit associated with debt separately to that of the firm’s operations (Chambers, Harris and Pringle, 1982). Under this method, the value of Wrigley’s post-restructuring increases by an amount equal to that of the tax benefit: VL = VU + PV of Tax benefits. Once distributed between shareholders, reflects the following: Post-recapitalizationequity value
| = Prerecap.equity value
| Present value+ Debt tax shields
| Present value ofdistress-relatedcosts
| Signaling, incentive, & clientele effects
| = $56.37
| + $5.16/sh
In terms of WACC - currently at 10.90% - the effect of leveraging should (in theory) result in an overall reduction in the cost of capital thus optimizing both the value and structure of the firm (Modigliani and Miller, 1963). However, WACC is seen to increase marginally by 0.01%. This can be attributed to a possible insufficiency of the debt tax shield to offset the costs of interest payments, along with the levered beta of 0.87 bearing higher systematic risk than that of the un-levered beta at 0.75.
With a dividend payout of $3bn, the book value of total assets/capital will remain unchanged. However, common equity decreases by the debt amount, causing the book value per share to drop the exact dividend payout of $12.91. Similarly, the market value of common equity sees a decline of $3bn. Total capital on the other hand, sees an increase of $1.2bn due to the tax shield;...
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Myers, S. C. (2001). Capital Structure. The Journal of Economic Perspectives, 15(2), 81-102. Accessed: 15/08/2011 05:26
Modigliani, F., & Merton, H
Modigliani, F., & Merton, H. M. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review, 48(3), 261-297.
Leland, H. E. (1998). Agency Costs, Risk Management, and Capital Structure. The Journal of Finance, 53(4), 1213-1243.
Jensen, Michael C., and Meckling, William H. "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure." J. Financial Ecoti. 3 (October 1976): 305-60.
Chambers, D. R., Harris, R. S., & Pringle, J. J. (1982). Treatment of financing mix in analyzing investment opportunities. Financial Management, 11(2), 24-24. Retrieved from http://search.proquest.com/docview/208182435?accountid=13380
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