Wrigley’s prerecapitalization WACC is 10.9%. The cost of equity assumes a risk-free rate of 5.65% for 20-year U.S. Treasuries (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.1 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.2
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.3 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