Your name is Blake Chandler, a fresh graduate from New York University, now working for a prestigious hedge fund , Clark Asset Management. You were called in to see your boss this morning, Michael Clark, the managing partner. Interest rates are at their lowest point in 50 years. Yet the use of debt financing by corporations is declining this happens anyway in recession. And some deleveraging is due to strategic changes in an industry, such as technological innovation or other developments that increase business risk. But corporate deleveraging seems to have gone too far. CEOs are missing valuable opportunities to create value for their shareholders in extreme case you have mature firms who use no debt at all! Take WWJ Company for instance. It has a leading market share in a stable low-technology business it makes chewing gum and yet has no debt. I bet that if we could persuade WWJ sport to do a leveraged recapitalisation through a dividend or major share purchase, we could create significant new value. Blake, please run some numbers on the potential change in value. And get me the names and phone numbers of all of WW Jays directors. FINA2222 2022 Sem 2 Joey Yang 2 With these words, Michael asked you to initiate the research for a potential investment in company named WWJ. The operation model for Clark Asset Management is to identify opportunities for a corporation to restructure, invest significantly in the stock of the target firm, and then undertake a process of persuading management and directors to restructure. You noted that WWJs market value of common equity was about $13.1 billion. You also discussed with Michael the current capital-market conditions and decided to focus on the assumption that WWJ could borrow $3 billion at a credit rating of AAA with a yield of 9.31% in the current market. WWJ company overview WWJ was the worlds largest manufacturer and a distributor of chewing gum. The firms industry, branded consumer foods and candy was intensely competitive and was dominated by a few large players. Its revenues had grown at an annual compound rate of 13% and earnings at 10% reflecting the introduction of new products and foreign expansion (Exhibit 1: Income Statement in Excel). Historically, the firm had been conservatively financed. At the end of 2021, it had total assets of $1.66 billion and no long-term debt (Exhibit 2: Balance Sheet in Excel). WWJs stock price (Exhibit 4: Other Information in Excel) had significantly outperformed the S&P 500 composite index and was running slightly ahead of its industry index. Estimating the effect of leveraged recapitalization Under the proposed leveraged recapitalisation, WWJ would borrow $3 billion and use it either to pay an equivalent dividend or to re-purchase an equivalent value of shares. You knew that this combination of actions could affect the firms share value, cost of capital, debt coverage, and earnings per share. Accordingly, you thought to evaluate the effect of the capitalisation on these areas. The impact on valuation and share price You recalled that debt increased the value of a firm by means of shielding cash flows from taxes. Thus, the present value of debt tax shields could be added to the value of the underlying unlevered firm to yield the value of the levered enterprise. The marginal tax rate proposed to use was 25%, reflecting the sum of federal state and local taxes. The impact on the cost of capital You also knew that the maximum value of the firm was achieved when the weighted average cost of capital (WACC) was minimised. Thus, you intended to estimate what the cost of equity FINA2222 2022 Sem 2 Joey Yang 3 and the WACC might be, if WWJ pursued this capital structure change. The projected cost of debt (rD) would depend on the assessment of the firms debt rating, AAA given the current capital market rates (Exhibit 3: Credit Rating in Excel). The cost of equity (rE) could be estimated by using a capital asset pricing model (CAPM). Exhibit 4 gives yields on U.S. Treasury instruments which afforded possible estimates of the risk-free return (rf) and the equity market risk premium (rm rf) of 7%. WWJs beta would also need to be re-levered to reflect the projected recapitalisation. The impact on reported earnings per share You intended to estimate the expected effect on earnings per share (EPS) that would occur at different levels of operating income (EBIT) with a change in leverage. You planned to draw a graph to illustrate this. Other effects Lastly, you wondered whether your analysis covered everything. Where, for instance, should you consider potential costs of bankruptcy and distress or the effects of leverage as the signal about future operations? More leverage would also create certain constraints and incentives for management. Where should those be reflected in the analysis?

You use sensitivity analysis to examine the effect on earnings per share (EPS) of issuing $3 billion of new debt and using the proceeds to repurchase existing shares or pay a special dividend. The worst case is where EBIT drops by $400 million, and the best case is where EBIT increases by $400 million, from the current level. What do you conclude from this analysis? Should WWJ go with share repurchase or dividend?

Q4. EPS versus EBIT Analysis All values are in millions except for share price and percentages Q4. EPS versus EBIT Analysis All values are in millions except for share price and percentages