Guidelines for the "WM. Wrigley JR. Company: Capital Structure, Valuation, and Cost of Capital" Case Assignment WM. Wrigley Jr. Company: Capital structure, Valuation, and Cost of Capital The WM. Wrigley was a very conservatively managed company and had zero debt in its capital structure. In 2002, a managing director of an actively managed hedge fund was considering acquiring stock in Wrigley and hoping to increase the stockholder value by forcing the firm to add debt to its capital structure. Review 1. Chapters 14 and 15 of your text (Brigham and Houston, 14th Edition) 2. Module 4 -Lecture Notes and Presentations 04-01 to 04-04 Learning Objectives To understand how capital structure affects firm and equity value. To apply the trade-off theory of capital structure to determine the impact on firm value using the adjusted present value. o Tax benefit from debt o Bankruptcy costs associated with debt? o Other costs and benefits of leverage Signaling, clientele, managerial incentives Use the WACC to calculate the optimal capital structure How does leverage affect the WACC, EPS, credit rating, and voting control?

2/6 Pros and cons of using share repurchases versus dividend payout to recapitalize. How does the choice affect stock price, EPS, credit rating and voting control Please use the following topics/questions as a GUIDELINE ONLY for the Presentation. DO NOT SIMPLY PROVIDE ANSWERS TO THE FOLLOWING QUESTION, BUT YOUR PRESENTATION MUST CONSIDER/ADDRESS THE QUESTIONS GIVEN BELOW. 1. Who is an active investor? What is Ms. Dobrynin's strategy? How does she hope to achieve her objective in the case of WM.Wrigley Company? 2. What is the nature of Wrigley's business? How has Wrigley performed relative to the market, its industry, and other peer companies? Make sure to provide numbers. a. Compare stock price and financial metrics such as EPS, P/E, Capital structure, etc. 3. Adjusted present value approach What will be the effects of issuing $3 billion in debt and using the proceeds to pay a one-time dividend or to repurchase shares? Assume that the value of the levered firm is equal to the value of the unlevered firm plus the present value of tax shield, less the bankruptcy costs, plus other benefits. = + ( ) + (, , ) Where, is the value of the levered firm, is the value of the unlevered firm, is the corporate tax rate, and D is the market value of debt. Assume that the debt is perpetual (i.e., the Company will have $3 billion in debt always in the future). Ignore PV(bankruptcy costs) and PV(benefits due to factors such as signaling, incentives for managers, and clientele effects). a. Wrigley's book and market value of the firm? b. The price per share of Wrigley's stock? c. EPS? d. Voting control by the Wrigley family? e. Provide a qualitative discussion of the bankruptcy costs and benefits due to signaling, incentive, and clientele that are not included. 4. What is Wrigley's current (before re-capitalization) WACC? a. Cost of equity, based on CAPM? i. Beta of stock? ii. Risk-free rate? iii. The risk premium on the market?

3/6 5. What is Wrigley's post-capitalization WACC? Assume a debt maturity of 10 years. a. Cost of equity, based on CAPM i. Beta of stock? (note that the beta has to be levered) ii. Risk-free rate? iii. The risk premium on the market? iv. What are the potential issues when there is a large amount of debt (discuss qualitatively)? b. Cost of debt? i. Debt rating? (use EBIT coverage and exhibit 6) ii. Yield on debt? (use exhibit 7) iii. Tax rate? 6. Provide a sensitivity analysis of the re-capitalization at $3 B debt. Use the following three tables and assume that the numbers given are for EBIT (2001) Pre-Recapitalization (Status Quo) 2001 Worst Case Most Likely Best Case EBIT ($ Million) 214 514 814 Interest Expense Taxable Income Taxes Net Income Shares Outstanding EPS

4/6 Post-Recapitalization (Share Repurchase) 2001 Worst Case Most Likely Best Case EBIT ($ Million) 214 514 814 Debt Rating Based on EBIT Coverage ** Yield on debt Interest Expense Taxable Income Taxes Net Income Shares Outstanding EPS PV tax Shield MV of the Firm Share price Post-Recapitalization (Dividend Payout)) 2001 Worst Case Most Likely Best Case EBIT ($ Million) 214 514 814 Debt Rating Based on EBIT Coverage** Yield on Debt Interest Expense Taxable Income Taxes Net Income Shares Outstanding EPS PV tax Shield MV of the Firm Share price ** Note that in getting the debt rating, you will run into a circularity problem. That is, the debt rating depends on the interest. However, the interest depends on the yield, which in turn depends on the rating. To solve this, you can use a trial and error method. Assume a rating, get the yield, and the interest. Use the EBIT coverage to check whether it is consistent with the rating and the yield.

5/6 7. Optimal Capital Structure Based on Trade-Off Theory In question 3, we examined the impact of debt on firm value by adding the PV of tax shields. However, we ignored the financial distress costs, which can be substantial when there is a large amount of debt. We can incorporate the financial distress costs and evaluate the optimal capital structure by using the WACC as the debt increases. The WACC consists of the cost of equity plus the after-tax cost of debt. As you add more debt to the firm's capital structure, the equity becomes levered, and we can calculate the levered beta and use the CAPM to calculate the equity cost. The cost of debt is equal to the risk-free rate for the given maturity plus a spread. The spread consists of a liquidity premium plus a default risk premium (equivalent to the financial distress costs). For example, based on exhibit 7, the risk-free rate for the 10-year Treasury is 4.86%. A corporate bond with the same maturity and a bond rating of BBB has a yield of 10.894%. Hence the liquidity and default risk accounts for (10.894-4.860) = 6.034%! Next, we know from the capital budgeting lectures that the value of a firm is the present value of the free cash flows discounted at the WACC. If we assume that any re-capitalization does not affect the future free cash flows of the firm, then the only impact on the firm value would be through the WACC. We also know that the lower the WACC, the higher the firm value, and the firm value will be maximized at the lowest WACC. Debt, Firm Value, and WACC In the above chart, the red line is WACC as D/V varies, and the blue line is the firm value. The firm value is maximized, where the WACC is minimum. WACC D/V (%) 0 100% MIN(WACC) Opt (D/V) Max (V)

6/6 For this exercise, assume that the EBIT is 514 million in 2001 at all levels of debt. Next, assume that the debt can be varied in steps of $ 500 million from zero to $3 billion. Determine the WACC for each level of debt and, from this, determine the optimal debt level. Assume that any new debt will be paid out as dividends. Use the following table to determine the optimal amount of debt. Note that you need to assume the rating and then check whether it is consistent with the EBIT/INT coverage. If not, go back and change the rating. You can interpolate between ratings. I would only use the mid-point of the yield close to the coverage. Stock Price ($) Number of shares (Million) MV Equity (or Firm) EBIT ($ Million) Tax Rate Beta Risk Free Rate Risk premium on the Market Debt ($ Million) 0 500 1000 1500 2000 2500 3000 MV D/MV Rating Yield Interest (INT) ($ Million) EBIT/INT (Coverage) Levered beta* Cost of equity After Tax Cost of Debt Weight in Equity Weight in Debt WACC Use the equation = (1 + (1 ) ) 8. Based on your analysis, what is your recommendation regarding the re- capitalization proposal? Make sure you support your recommendation.