The firm does not have debt. Therefore, the firm value is the outstanding number of shares multiplied by market share price.
Value of Wrigley’s = 232.44 million *56.37 = 13.103 billion dollars
We assume that Wrigley uses the debt that has been raised to pay dividends to shareholders
Value of Wrigley’s = Market value of Equity + Debt Value
Value of Wrigley’s = 13.103 billion + 3 billion = 16.103 billion dollars
The proposed coupon rate is 13 percent. After the re-capitalization, the total debt ratio will be 73 percent. Therefore, the Bond will be rated between grade BB and grade B. The effective debt yield for a grade B debt security is 14.67 percent while that if grade BB is 12.75 percent. Therefore, the proposed coupon rate is reasonable since it is between those values.
The size of the debt is not reasonable. The debt significantly increases the debt ratio. More than 50 percent of the assets of the firm will be financed by debt. Therefore, the firm faces a high bankruptcy and liquidity risks. It was significantly reducing the debt rating of Wrigley’s from AAA to between BB and B. Therefore, Wrigley’s will face a high finance costs. Consequently, the net income of Wrigley’s will be affected adversely.
There are various advantages associated with the issue of debt in this case. Firstly, issue of debt can allow Wrigley’s to take advantage of any profitable projects that may exist. In the event that there are profitable projects that require financing, the company can use the proceeds from the issue of debt to finance those projects. Secondly, in case Wrigley’s used the debt proceeds to pay out dividends, it can apply the retained earnings that would have otherwise been paid out as dividends to finance those projects. Consequently, present value of the firm will increase. Secondly, debt is associated with a lower cost because it bond-holders bear less risks and interest expense is an allowable expense for tax purposes. Therefore, issue of debt can reduce the financing costs of the firm. Thirdly, the issue of debt also allows Wrigley’s to raise additional funds without diluting ownership and voting powers of existing shareholders. Debt holders do not have any voting rights that are accorded to equity shareholders. Lastly, issue of debt can result in an increase in the market price of share Wrigley’s through various channels. The issue of debt may signal potential investors that Wrigley’s has profitable projects that will increase the net income in future. Payment of dividends using the proceeds may also signal investors that the company is performing well. Consequently, it will result in an increase in demand for Wrigley shares that will increase the market price. Besides, in case the proceeds are used to repurchase shares, it will reduce the outstanding number of shares which will prop up shares upwards.
WACC = Weight of Equity*Cost of Equity + Weight of Debt*Cost of Debt
Before, recapitalization there is no debt. Therefore, Equity has a weight of 100 %
Cost of Equity = Risk-free rate + Beta*(Market Rate-Risk free rate)
Cost of Equity = 1.73% + 0.75*7% = 6.98%
WACC before recapitalization is 6.98%
After recapitalization
After tax cost of debt = (1-0.4) *13% = 7.8%
The WACC is higher after recapitalization compared to before recapitalization. Therefore, recapitalization reduces the value of the firm based on the CAPM model.
Recapitalization reduces the earnings per share. This is because the financing costs in form of interest expenses increases drastically.
The movement of share prices cannot be calculated since it depends on the equity market which is affected by a multitude of factors. However, based on theory we can predict that the share price will increase. This is because of the various signaling effects that will increase demand for Wrigley shares. Ceteris peribus, the share price will increase.
The Wrigley family will be affected like other shareholders. The will experience a decline in the value of their equity. The family will prefer a repurchase of shares if the shares will be purchased from the market. This is because it will increase their ownership and voting rights.
Conclusion and Recommendations
An analysis of the recapitalization reveals that the financial risks will increase, the financing costs will increase, the EPS will decline and firm value will decline. The only potential positive effect is an increase in share price that is uncertain. Therefore, it would be prudent not to go ahead with the recapitalization.
