Finance and Debt Tax Shields

2147 Words Apr 10th, 2009 9 Pages
Case Discussion: The Wm. Wrigley Jr. Company: Capital Structure, Valuation and Cost of Capital

1. Dobrynin plays the role of the financial entrepreneur, exploiting inefficiencies in investment valuation and corporate finance. She seeks to profit by restructuring firms with “lazy financing” or too much cash and unused debt capacity relative to the (low) risks faced by the firms. By pressuring directors and managers to adopt more efficient policies, she hopes to reap an investment gain. The larger issue is whether or not Wrigley is inefficiently financed. If so, how much capital structure change will bring it to more efficient operation?

2a. A recapitalization based on a dividend will have no effect on the number of shares
…show more content…
Equity accounts for 89% of Wrigley’s book value of capital before the recapitalization. But the book value per share is $5.49,[1] less than one-tenth of Wrigley’s current share price of $56.37. This huge disparity is the possibility that book values are backward-looking and ignore important economic considerations, such as the value of brands, intellectual property, and customer franchise as well as the debt tax shields.

In contrast, finance theory and best practice rely on the firm’s current market value as a guide to compute the capital weights. Before the recapitalization, Wrigley’s market value of equity accounted for 99% of its capital. And, after the recapitalization, that ratio fell to 78%. The increase in leverage will imply a change in Wrigley’s cost of capital.

WACC before recapitalization

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
Open Document