The Wm. Wrigley Jr. Company Capital Structure, Valuation, And Cost Of Capital Harvard Case Solution & Analysis

The Wm. Wrigley Jr. Company Capital Structure, Valuation, And Cost Of Capital Case Study Solution

Current WACC (Pre Re-Capitalization)

The current WACC of Wrigley’s company is 10.1% (calculated in attach excel sheet). The current capital structure of the company is entirely consisting of the equity, which indicates that the cost of the company’s equity is equivalent to WACC. However, the cost of equity is calculated by using the CAPM model. The risk free rate of 10 years US treasury is 4.860%, as mentioned in exhibit-7 of the case, used in the calculation of the CAPM. The un levered beta of the company is 75 mention in the exhibit-5 of case. The market risk premium of the company is 7% as mentioned in the case. (pg#3).(See appendix 2 for Current WACC). (A Farber, RL Gillet & A Szafarz , 2006)

Post-Capitalization WACC

After the re-capitalization, the WACC of the company is 10.3%. The Post-Capitalization structure of the company is composed of 23%of debt and 77% of equity. The pretax cost of debt is 13% as mentioned in the case. However, the tax rate is 40%,which is also mentioned in the case.After deducting the tax rate from the pretax cost of debt, the extracted cost of debt is 8%. The cost of equity is calculated by using CAPM model. The un levered beta was given in the case which is converted into levered beta. The levered beta is calculated by taking debt to equity ratio on the basis of the market value in which debt is taken as 3 billion, while equity is taken as 10.1. The levered beta of the company, after the re-capitalization is 88, while the pre-capitalization beta was 75, which shows that by adding debt in the capital structure; beta would increase as the risk level increases. The risk free rate is of 10 years US treasury is 4.86%, and the market risk premium is 7%. (mentioned in the case). The cost of equity is calculated as 11%.(See appendix 3 for post capitalization WACC)

Note: Calculation is given in excel sheet

Sensitivity Analysis

Sensitivity analysis of all the three given conditions have been performed. The result indicates different firm condition under three different scenario- worst cases, most likely and best case. All the results are consistent with the appropriate situations, such as best case shows a higher income level in all the situations. (All three tables are given in appendices section)

WACC on different debt levels

WACC on different debt levels were calculated by assuming the debt level from 0 to 3 billion. The results shows an increased WACC on minimum debt level, indicating that the higher is the WACC, the lower the firm’s value is.

Recommendations

The company should take the debt of $3 billion, because it would increase the firm’s value and lowers the cost of capital by providing tax shield.

It is recommended to Wrigley Company to re-purchase its shares, because it will increase the EPS if the profits remain the same, and it would give a hint to the shareholders about having undervalued shares.Furthermore, it will increase the net worth of Wrigley family.

Conclusion

Jr. Wrigley Company is the largest chewing gum producer, which is enjoying good profits but is also suffering from lower firm’s value and higher cost of capital because it has an equity based capital structure. The decision of re-capitalization is worth it for creating the capital a mix of equity and debt, which will increase the firm’s value and lowers the WACC.

Appendices

Appendix: 1

Calculations:
a. Value of Firm Market Value Book Value
Value of Unlevered Firm 13.1 1.75
Value of Levered Firm 14.3 2.95
b. Share Price at Market Value at Book Value
Unlevered Firm 56.36 7.53
Levered Firm 79.79 16.46
c. EPS Unlevered Firm Levered Firm
Net Income 0.362986 0.362986
no. of Outstanding Shares 0.232441 0.179210237
EPS 1.56 2.03
d. Voting Control Common Stock B shares Total
Current Shares of family 58% 21%
No. of Stocks 0.1898 0.042641
Votig Rights per share 1 10
Total Voting Rights 0.1898 0.42641 0.61621
Total Voting Rights (Family) 0.110084 0.0895461 0.19963
Current Voting Control 32%
Voting Control in (Levered Firm):
No. of Stocks Sold 0.053230763
Voting Rights Sold 0.053230763 (As Common Stocks have been sold)
Voting Rights (Family) UL 0.1996301
Voting Rights (Family) L 0.146399337
Total Voting Rights Levered 0.562979237
Voting Control Family in Levered Firm 26%

Appendix: 2

Pre Capitalization WACC:
Beta 0.75
RF 4.86%
Risk Premium 7%
Cost of Equity 10.1%
WACC 10.1%

Appendix: 3

Post Capitalization:
Beta Unlevered 0.75
Beta Levered 0.88
Pre Tax Cost of Debt 13%
Cost of Debt After Tax 8%
Cost of Equity 11%
RF 4.86%
Risk Premium 7%
Weight of Equity 77%
Weight of Debt 23%
Tax Rate 40%
WACC 10.30%

Appendix: 4

Pre-Recapitalization (Status Quo)

Scenario Summary
Current Values: Worst case Most Likely Best case
Changing Cells:
EBIT 513356 214000 514000 814000
Result Cells:
TAXINCOME         527,366         228,010         528,010         828,010
TAXES         164,380           71,071         164,581         258,091
NETINCOME  $     362,986  $     156,939  $     363,429  $     569,919
EPS1  $           1.56  $           0.68  $           1.56  $           2.45
shares         232,440         232,440         232,440         232,440

Appendix: 5

Post-Recapitalization (Share Repurchase)

Scenario Summary
Current Values: Worst case Most Likely Best case
Changing Cells:
EBIT1 513356 214000 514000 814000
Result Cells:
INTEREST_EXP        (390,000)        (390,000)        (390,000)        (390,000)
TAX_INCOME         137,366        (161,990)         138,010         438,010
I_TAX           54,946          (64,796)           55,204         175,204
NI           82,420          (97,194)           82,806         262,806
REPUR_OUT_SHARES         179,213         179,213         179,213         179,213
EPS2 0.460 -0.542 0.462 1.466
debt_EBIT 382599 382599 382599 382599
debt_yeild           0.1711           0.0713           0.1713           0.2713
SHARE_PRICE 79.79 79.79 79.79 79.79
MKT_VALUE 14.3 14.3 14.3 14.3

Appendix: 6

Post-Recapitalization (Dividend Payout)

Scenario Summary
Current Values: Worst case Most Likely Best case
Changing Cells:
EBIT1         513,356         214,000         514,000         814,000
Result Cells:
NI           82,420          (97,194)           82,806         262,806
I_TAX           54,946          (64,796)           55,204         175,204
TAX_INCOME         137,366        (161,990)         138,010         438,010
INTEREST_EXP        (390,000)        (390,000)        (390,000)        (390,000)
Debt_EBIT 382599 382599 382599 382599
Debt_yeild           0.1711           0.0713           0.1713           0.2713
Out_shares         232,444         232,444         232,444         232,444
EPS3 0.355 -0.418 0.356 1.131
SHARE_PRICE 79.79 79.79 79.79 79.79
MKT_VALUE 14.3 14.3 14.3 14.3

Appendix: 7

WACC on different debt levels

Stock Price ($) 56.36 56.36 56.36 56.37 56.37 56.37 56.38
Number of shares (Million) 0.232441 0.232432128 0.232423256 0.232414385 0.232405513 0.232396641 0.232387769
MV Equity (or Firm) 13.1 13.1002 13.1004 13.1006 13.1008 13.101 13.1012
EBIT ($ Million) 514 514 514 514 514 514 514
Tax Rate 40% 40% 40% 40% 40% 40% 40%
Beta 0.75 0.75 0.75 0.75 0.75 0.75 0.75
Risk Free Rate 4.86% 4.86% 4.86% 4.86% 4.86% 4.86% 4.86%
Risk premium on the Market 7% 7% 7% 7% 7% 7% 7%
Debt ($ Million) 0 0.5 1 1.5 2 2.5 3
MV 13.1 12.6002 12.1004 11.6006 11.1008 10.601 10.1012
D/MV 0 0.0397 0.0826 0.1293 0.1802 0.2358 0.2290
Yield 0 1028 514 342.6666667 257 205.6 171.3333333
Interest (INT) ($ Million) 0 0.065 0.13 0.195 0.26 0.325 0.39
EBIT/INT (Coverage) 0 7907.692308 3953.846154 2635.897436 1976.923077 1581.538462 1317.948718
Levered beta* 0.75 12.09 6.20 4.23 3.25 2.66 2.27
Cost of equity 10% 89% 48% 34% 28% 23% 21%
After Tax Cost of Debt 7.80% 7.80% 7.80% 7.80% 7.80% 7.80% 7.80%
Weight in Equity 100% 96% 92% 87% 82% 76% 70%
Weight in Debt 0% 4% 8% 13% 18% 24% 30%
WACC 10.1% 86.2% 44.9% 31.0% 24.0% 19.8% 16.9%
Interest Rate 13% 13% 13% 13% 13% 13% 13%
Tax Sheild 0 0.026 0.052 0.078 0.104 0.13 0.156
PV of Tax Sheild (Perpetuity) 0 0.2 0.4 0.6 0.8 1 1.2

 

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