1.ASSESS THE IMPACT ON THE WEIGHTED AVERAGE OF COST OF CAPITAL (WACC) ,EPS .
Chandler knew that the maximum value of the firm was achieved when the weighted average cost of capital was minimized. Thus she intended to estimate what the cost of equity and the wacc might be if wrigley pursued this capital structure change. The projected cost of debt would depend on her assessement of wrigley’s debt rating after recapitalization and on current capital market rates. WACC before recapitalization
Wrigley’s pre recapitalization WACC is 10.9%, the cost of equity assumes a risk free rate of 5.65% for 20 years US treasuries in the case exhibit 7; a risk premium is assumed 7% (or 5%), and uses Wrigley’s current beta of 0.75 (case Exhibit 5).
4. WACC after recapitalization
The increase in leverage will affect Wrigley’s WACC in at least three ways:
1. Cost of debt: Wrigley’s debt rating will change from AAA (consistent with no debt) to a BB/B rating reflecting the higher risk. The postrecapitalization credit rating is a matter of judgment. It is highly instructive to guide students through a rating exercise for Wrigley’s pro forma recapitalization. This requires computing the range of measures included in case Exhibit 6 and determining where in the ratings range the firm would fall. Comparing Wrigley’s projected results to the benchmarks given in case Exhibit 6 suggests that BB/B is a reasonable call. Turning to the yields by credit rating given in case Exhibit 7, one can interpolate between BB (12.73%) and B (14.66%) to obtain a cost of debt. The cost used in the remainder of this analysis is 13%, Blanka Dobrynin’s choice. Yields rise almost linearly across the investment-grade spectrum (AAA to BBB) and then rise curvilinearly at lower debt ratings—this hints at the problem that we will encounter in estimating the cost of equity. 2. Beta: You should unlever Wrigley’s current beta of 0.75, assuming the current values of book debt and the market value of equity. This gives an estimate of the unlevered beta of 0.75, reflecting the fact that Wrigley has almost no debt. This beta then needs to be relevered to reflect the addition of $3 billion in debt. Using the formula produces a levered beta of 0.87. All in all, this is not much of a change. Why? The answer is twofold: first, the market value of Wrigley’s equity is so large that $3 billion more in debt does relatively little to change the debt/equity ratio. Second, the levered beta formula is a linear model that accounts for debt tax shields but not the costs of financial distress. Thus, the curvilinear relationship between risk and yield observed in case Exhibit 7 is not reflected in the estimate of the levered beta. 3. Capital weights based on the market value of equity and the book value of debt: These were calculated earlier as 78% equity and 22% debt. Best practice and finance theory require the use of long-term target weights in calculating WACC. Are those weights the long-run target capitalization for Wrigley or a short-run peak that will gradually change as Wrigley repays its debt? For the sake of simplicity and the illustration of extreme change, the balance of this note will assume the 78/22 percentage mix.
Delivering beta to reflect the new mix of capital and otherwise assuming similar risk-free rate and equity-market risk premium will yield an estimated cost of equity for Wrigley of 11.7%. We could dwell on the modest increase of 80 basis points in the cost of equity. This reflects the impact of the higher debt tax shields and does not incorporate the costs of financial distress relative to the levered beta as discussed earlier. Another way is to compare the estimated cost of equity with the cost of debt. Assumed at 13%, the cost of debt does incorporate a financial risk premium (as reflected in the changed credit rating). Yet the equity, which has a junior claim on the assets of the firm, bears a lower cost. Again, the paradox is explained by the...
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