It is highly instructive to guide students through a rating exercise for Wriggles pro formal rationalization. This requires computing the range f measures included in case Exhibit 6 and determining where in the ratings range the firm would fall.
Comparing Wriggler’s projected results to the benchmarks given in case Exhibit 6 suggests that 88/8 is a reasonable call. Turning to the yields by credit rating given in case Exhibit 7, one can interpolate between B (12. 73%) and B (14. 66%) to obtain a cost of debt. The cost used in the remainder of this analysis Is 13%, Blank Doubloon’s choice.
Yields rise almost linearly across the Investment- grade spectrum (AAA to BIB) and then rise curvilinear at lower debt ratings?this nits at the problem that we will encounter In estimating the cost of equity. 2. Beta: You should unlived Wriggler’s current beta of 0. 75, assuming the current values of book debt and the market value of equity. This gives an estimate of the unleavened beta of 0. 75, reflecting the fact that Wrigley has almost no debt. This beta then needs to be relived to reflect the addition of $3 billion in debt. Sing the formula produces a levered beta of 0. 87. All in all, this is not much off change. Why? The answer is twofold: first, the market value of Wriggles equity is so large that $3 billion ore in debt does relatively little to change the debt/equity ratio.
Second, the levered beta formula is a linear model that accounts for debt tax shields but not the costs of financial distress. Thus, the curvilinear relationship between risk and yield observed in case Exalt 7 Is not reflected in the estimate of the levered beta. 3.
Capital weights based on the market value of equity and the book value of debt: These were calculated earlier as 78% equity and 22% debt. Best practice and finance theory require the use of long-term target weights in calculating WAC.
Are those weights hanged as Wrigley repays its debt? For the sake of simplicity and the illustration of extreme change, the balance of this note will assume the 78/22 percentage mix. Delivering beta to reflect the new mix of capital and otherwise assuming similar risk- free rate and equity-market risk premium will yield an estimated cost of equity for Wrigley of 1 1 . %. We could dwell on the modest increase of 80 basis points in the cost of equity. This reflects the impact of the higher debt tax shields and does not incorporate the costs of financial distress relative to the levered beta as discussed earlier.
Another way is to compare the estimated cost of equity with the cost of debt. Assumed at 13%, the cost of debt does incorporate a financial risk premium (as reflected in the changed credit rating). Yet the equity, which has a Junior claim on the assets of the firm, bears a lower cost.
Again, the paradox is explained by the fact that the estimated cost of equity ignores costs of financial distress. Combining the costs of equity and debt with the revised capital weights yields a post rationalization WAC of 10.
91 unchanged from the pre rationalization WAC. The company is manifestly riskier in financial terms. Why doesn’t the estimate of WAC reflect this? Basically, the tax benefit of using more debt is virtually offset by the higher cost of equity, but most importantly, the estimate of the levered beta post rationalization fails to reflect costs of financial distress.
Effect of rationalization on reported earnings per share Case Exhibit 8 gives a template for your analysis. This compares the status quo PEPS (assuming no rationalization) with an PEPS after the addition of $3 billion in debt and draws on data in case Exhibits 2 and 3. The focal point for this analysis is the operating income of $514 million, which is the value for the year 2001 (see case Exhibit 2).
The pro formal interest expense assumes $390 million at an interest rate of 13%. No adjustment is made for any possible amortization of the debt.
The key issue is what will be the expected BIT next year and thereafter. If one assumes $514 million, the issuance of $3 billion in debt reduces the expected PEPS from $1. 33 to $0. 41 with repurchase, or $0.
32 with dividend. This results simply from increased interest expense and the variation in the number of shares outstanding. Clearly, shareholders should brace for much worse PEPS results after the rationalization. At BIT values of $514 million and above, the repurchase produces higher PEPS values than does the dividend-based rationalization. Does the worsening PEPS matter?
A wide range of research in financial economics suggests that investors see through reported PEPS to base their investing decisions on cash flow. 5.
Analysis suggests that the rationalization will create returns on the order of already. As shown in case Exhibit 5, Wrigley trades at a price/earnings multiple that is eternally larger than its peers. Leveraged rationalizations have the greatest impact on value when the target firm is trading at depressed values. Also, given the very large asset value underlying the debt, the costs of financial distress appear to be negligible.
Other effects, including signaling, investment, and clientele considerations, are more difficult to gauge but probably balance out to a mildly positive set of considerations.
Reported earnings per share will be diluted significantly, but as argued above, PEPS may not be a sufficient metric to guide corporate financial decision-making. On those grounds, it would appear that a leveraged rationalization would be attractive.
With the addition of the new debt, Wriggles share price should quickly and fully reflect the changes in investors’ perceptions stemming from the repurchase once the company publicly discloses its intentions. One way to frame the issues is?immediately upon the announcement?the stock price should change to reflect the following: Post-irreconcilability’s value I = Pre recap. Equity value I Present value+ Debt tax shields I Present value oftentimes-relatedness I Signaling, incentive, & clientele effects | $61. 53 | $56.
7 | x Debt 0. 4 x $1,200 or+ $5. 16/SSH I Challenging tuberose? I Unobservable? I The effect of the present value of debt tax shields: It shows that adding $3 billion in debt to Wriggles capitalization and returning a like amount to shareholders will add $1. 2 billion in equity value due to tax effects. The tax benefits are estimated assuming that Wrigley commits to maintain the $3 billion in debt in perpetuity. The et revised value per Wrigley share is $61.
53. Debt grows from zero to $3 billion. Assets grow by $1. Billion, equal to the present value of the debt tax shields. B.
Book equity becomes negative as a result of the large payout under the dividend or share repurchase. Market value of equity declines by $1. 8 billion, the result of the payout of $3 billion, which is offset by the benefit of the debt tax shields ($1. 2 billion). Note that the accounting values give no attention to the value of debt tax shields and to the possibility that the market value of fixed assets may be greater than the satirical value.
Under the share repurchase, the shrinkage in shares outstanding might alter the influence of control groups. In some tax environments, investors may have a income (which might be taxed more aggressively. 3. Beginners will often turn to book values as the basis for determining the weights of capital for use in the weighted-average calculation.
Equity accounts for 89% of Wriggles book value of capital before the rationalization. But the book value per share is $5. 49, less than one-tenth of Wriggles current share price of $56. 37.
This age disparity is the possibility that book values are backward-looking and ignore important economic considerations, such as the value of brands, intellectual property, and customer franchise as well as the debt tax shields. In contrast, finance theory and best practice rely on the firm’s current market value as a guide to compute the capital weights.
Before the rationalization, Wriggles market value of equity accounted for 99% of its capital.