I bet that If we could persuade Wriggler’s board to do a leveraged rationalization through a dividend or major share repurchase, we could create significant new value. Susan, please run some numbers on the potential change in value. And get me the names and phone numbers of all of Wriggles directors. With those words, Blank Doubloon, managing partner of Aurora Borealis LLC, asked Susan Chandler, an associate, to Initiate the research for a potential Investment In Wrigley.
Aurora Borealis was a hedge fund with about $3 billion under management and an investment strategy that focused on distressed companies, merger arbitrage, change-of-control transactions, and rationalizations. Dobbin had immigrated to the United States from Russia in 1 991, and had risen quickly to become partner at a ajar Wall Street firm. In 2000, she founded Aurora Borealis to pursue an “active- Investor” strategy.
Her typical mode of operation was 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. Now, in June 2002, Dobbin could look back on the large returns from the use of that strategy. Chandler noted that Wriggles market value of common equity was about $13. 1 billion. Dobbin and Chandler discussed the current capital-market conditions ND decided to focus on the assumption that Wrigley could borrow $3 billion at a credit rating between B and B, to yield 13%.
Chandler agreed to return soon to Sean D. Carr, research assistant, from public data about the Whom. Wrigley Jar. Company. Other persons and events are fictional. Copyright 2005 by the University of Virginia Darned School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenbusinesspublishing. Com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, r transmitted in any form or by any means-?electronic, mechanical, photocopying, recording, or otherwise-?without the permission of the Darned School Foundation.
Page 1 of 11 -2- VA-F-1482 The William Wrigley Jar. Company Wrigley was the world’s largest manufacturer and distributor of chewing gum. The firm’s industry, branded consumer foods and candy, was intensely competitive and was dominated by a few large players. Exhibit 1 gives product profiles of Wrigley and its peers. Over the preceding two years, revenues had grown at an annual compound rate of 10% (earnings at 9%), reflecting the introduction of new products and foreign expansion (Exhibit 2). Historically, the firm had been conservatively financed. At the end of 2001, it had total assets of $1. 6 billion and no debt (Exhibit 3). As Exhibit 4 shows, Wriggles stock price had significantly outperformed the S 500 Composite Index, and was running slightly ahead of its industry index. Estimating the Effect of a Leveraged Rationalization Under the proposed leveraged rationalization, Wrigley would borrow $3 billion and use it either to pay an equivalent dividend or to repurchase an equivalent value of shares. Chandler knew that this combination of actions could affect the firm’s share alee, cost of capital, debt coverage, earnings per share, and voting control.
Accordingly, she sought to evaluate the effect of the rationalization on those areas. She gathered financial data on Wrigley and its peer companies (Exhibit 5). Impact on share value Chandler recalled that the effect of leverage on a firm could be modeled by using the adjusted present-value formula, which hypothesized 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 unleavened firm to yield the value of the fleeting the sum of federal, state, and local taxes.
Impact on debt rating A key assumption in the analysis would be the debt rating for Wrigley, after assuming $3 billion in debt, and whether the firm could cover the resulting interest payments. Dobbin had suggested that Chandler should assume Wrigley would borrow $3 billion at a rating between B and B. Was a rating of B/B likely? In that regard, Chandler gathered information on the average financial ratios associated with different debt-rating categories (Exhibit 6). Dobbin thought that Wriggles pretax cost of debt would be around 13%. Chandler sought to check that assumption against the capital-market information given in Exhibit 7.
Impact on cost of capital Chandler knew that the maximum value of the firm was achieved when the weighted average cost of capital (WAC) was minimized. Thus, she intended to estimate what the cost of equity and the WAC might be, if Wrigley pursued this capital-structure change. The projected Page 2 of 11 -3- cost of debt would depend on her assessment of Wriggles debt rating after rationalization and on current capital-market rates (summarized in Exhibit 7). The cost of equity (EKE) could be estimated by using the capital asset pricing model. Exhibit 7 gives yields on U. S.
Treasury instruments, which afforded possible estimates of the risk-free rate of return. The practice at Aurora Borealis was to use an equity- market risk premium of 7. 0%. Wriggles beta would also need to be relieved to reflect the projected rationalization. Chandler wondered whether her analysis covered everything. Where, for instance, should she take into account potential costs of bankruptcy and distress or the effects of leverage as a signal about future operations? More leverage would also create retain constraints and incentives for management. Where should those be reflected in her analysis?
Impact on reported earnings per share Chandler intended to estimate the expected effect on earnings per share (PEPS) that would occur at different levels of operating income (BIT) with a change in leverage. The beginnings of an BIT/PEPS analysis are presented in Exhibit 8. Impact on voting control The William Wrigley Jar. Company had 232. 441 million shares outstanding. A repurchase of shares would alter that amount. The Wrigley family controlled 21% of the common shares outstanding and 58% of Class B common stock, which had NY shares, how would the share-repurchase alternative affect the family’s voting- control position in the company?
Conclusion Although Susan Chandler’s analysis followed a familiar path, each company that she had analyzed differed in important respects from previous firms. Blank Dobbin paid her to run numbers and, more importantly, to find the differences wherein hidden threats and opportunities lay. Running the numbers was easy for Chandler; drawing profitable insights from them was not. Shares of Class B common stock had 10 votes each; ordinary common shares had one vote each. Class B shares were restricted in their sale or transfer and could be converted into ordinary common shares on a 1:1 basis.
