Managing the Corporate Capital Structure

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Introduction

The case under analysis considers the pros and cons of the decision that W M. Wrigley Jr. Company is to make between adopting and waving the active investment strategy offered by the manager of a hedge fund as a means of benefiting both in the form of income growth for the fund manager and added value to the company.

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Active Investor Strategy

Theory

To decide on the necessity of implementing the active investment strategy in W M. Wrigley Jr. Company, it is vital to consider the theoretical ideas about this type of investment. Thus, according to the data provided by Index Funds Advisors (2009), active investing is the strategy that managers, usually in hedge funds, use to boost their income through the four basic practices including the stock picking, time picking, managers’ picking, and styles picking ().

This strategy, as Campbell and Cochrane (2000, p. 208) and Rappaport (2001), is used when the hedge funds need to beat the market, i. e. to increase the return on investment (Rappaport, 2001). Needless to say, to achieve the latter, hedge funds using the active investment are interested in providing added value to the companies they cooperate with. The higher the rates of the company’s income are, the more income the hedge fund can have as it works for the percentage of income deal.

General Application to the Case

Applied to the case of W M. Wrigley Jr. Company, the theory of active investment can interpret the incentives of the manager of the mentioned hedge fund as trying to benefit through prior value addition to the company by way of active investment and the procedure of W M. Wrigley Jr. Company’s capital restructuring (Bruner, 2008, p. 400). In more detail, the hedge fund manager, according to Bruner (2008), offers an active investment strategy to W M. Wrigley Jr. Company that involves the issue of the new debt for $3 billion and use of proceeding to complete the subsequent dividend repayment or repurchase of shares (Bruner, 2008, p. 401). Given the idea by Bierman (2009), according to which the ideal balance for the business company is the zero ratios of debt and equity (p. 167), the hedge fund manager’s plan, in this case, can be generally assessed as the attempt to benefit without actual care about W M. Wrigley performance.

New Debt Issuing Effects

Thus, in case if W M. Wrigley Jr. Company issues $3 billion of new debt and uses proceeds to pay dividends, the state of the company’s shares outstanding will not be affected and remain at the level of 232.4 million as these shares are controlled by outside investors and dividends are paid for common shares of the company, i. e. shares owned by the company shareholders (Cable, 2008, p. 31). If proceeds are used to repurchase shares at the price of $61.53 per share, the number of shares outstanding will decrease by about 1/5 as the debt-funded share repurchase will allow Wrigley to get back 48.755 million of shares outstanding, leaving them at the level of 183.686 million according to the calculations (Bierman, 2009, p. 11):

$3 billion (new debt)/$61.53 (repurchase price) = 48.755 million shares outstanding

232.4 million – 48.755 million = 183.686 million shares outstanding

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Wrigley’s book value of equity will be negatively affected by both divided repayment and share repurchase. The major point here is that by issuing the $3 billion of new debt, Wrigley will direct $1.2 billion to debt tax shields, while the rest $1.8 will be the sum for which the company’s value of equity will in fact decline (Simkins, 2000, p. 118).

The price per share for Wrigley’s shares will grow as a result of issuing new debt and the subsequent company’s recapitalization. This will be the result of the increase of Wrigley’s equity for $1.2 after the issuance of the $3 billion debt and the work of debt tax shields (Irvine, 2000, pp. 17 – 18). The price per share for Wrigley shares is $56.37, while after the recapitalization this price (Pa) will grow and amount to the sum of the present per share price (Pp) plus the debt tax shields (Dt):

Pa = Pp + Dt

Pa = $56.37 + $5.16

Pa = $61.53

Concerning the earnings per share (EPS) aspect, it will also increase as a result of the new debt issuance (Simkins, 2000, p. 118). EPS is calculated by dividing the net profit (Pn), or earnings, of the company by the total number of its shares outstanding (So). The latest net profit figure for Wrigley is $362,986 million, while the pre-recapitalization number of shares outstanding is 232.4 million. Accordingly:

EPS = Pn/ So

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EPS = $362,986 million/232.4 million shares outstanding

EPS = $1.56

After the new debt is issued, if Wrigley uses proceeds to pay dividends, the price per share will decrease as the total assets of the company will decline. However, if Wrigley chooses to repurchase shares, the EPS will grow following the decrease of shares outstanding number to 183.686 million after the new debt is issued:

EPS = Pn/ So

EPS = $362,986 million/183.686 million shares outstanding

EPS = $1.98

The debt interest coverage rates will be negatively affected by the issuance of the new $3 billion debt. The financial flexibility of the company will, however, increase. Calculation of financial flexibility (F) involves the addition of the difference between the debt at a minimum rate (Dm) and the debt outstanding (Do) to the sum of the excess cash (Ce) (Bruner, 2008, p. 394):

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F = Ce + (Dm – Do)

Given Wrigley’s debt at the minimum rate at the level of 47%, i. e. $829,854 million, while the debt outstanding rate is 21%, i. e. $307,786 million. The excess cash of the company equals $307,785 million. Accordingly:

F = Ce + (Dm – Do)

F = $307,785 million + ($829,854 million – $307,786 million)

F = $307,785 million + $522,068 million

F = $829,853 million

Thus, it is observable that the recapitalization might positively affect the company analyzed, expose it to wider business development opportunities, and provide larger funds for the completion of these operations.

Finally, the issuance of new debt might affect the voting power of the Wrigley family only if the debt is used to fund the repurchase of the company’s shares outstanding. The point is that shares outstanding present voting power to its owners, and if Wrigley repurchases the substantial part of these shares, the voting power of the Wrigley family will increase as a result of the decline in the number of people outside the company with that voting power (Irvine, 2000, pp. 17 – 18).

Weighted-Average Cost of Capital (WACC) of W M. Wrigley Jr. Company (WWY)

WACC Calculation

The current Weighted-Average Cost of Capital (WACC) of W M. Wrigley Jr. Company (WWY) is 10.9% as estimated through the use of the data on the company’s debt, equity, and common stock (Wrigley, 2009). As well, such factors as risk premium and the company’s beta were considered. Thus, the risk-free rate for W M. Wrigley Jr., based on the 20-Year US Treasury yields is 5.65%; current Wrigley’s beta is 0.75, while the risk premium is about 7% (Wrigley, 2009).

Impact of New Debt Issuing on WACC

The potential influence of the recapitalization of Wrigley’s structure might include three main points, i. e. the change of the cost of capital, change of the capital weights, and the modification of the company’s current beta. First, the cost of debt will change as a result of the higher risk involved in the issuance of new debt. Accordingly, the currently observed AAA debt ratio of 5% will amount to the range between BB and B rates, i. e. 12.73% and 14.66% respectively. As a result, the new, post-recapitalization, cost of Wrigley’s debt will be observed in this range.

The effect of the recapitalization on the company’s WACC will also be observed in the change of capital weights. The current ratio is 78% to 22%, with 78% being the proportion of the company’s equity (Irvine, 2000, pp. 17 – 18). However, reputable experts report that the debt issuance and the increased risk connected with this fact might retrieve the substantial part of equity weight, about 12%, from Wrigley’s capital structure and reduce it to 66% simultaneously increasing the debt part to 34%. Finally, the implementation of the recapitalization initiative proposed by the hedge fund will increase the company beta to the level of 0.87 reflecting the increase in debt and the change of the company’s cost of equity.

W M. Wrigley Jr. Company (WWY) Performance between 2002 and 2008

Another important point in deciding on the reasonability of recapitalization for Wrigley is the performance of the company between 2002 and 2008. According to Woodhall (2009), during this period the company managed to achieve the compounded growth rate of 11.3%. The total market share of W M. Wrigley Jr. Company in the international confectionery market amounted to 63% (Woodhall, 2009; Wrigley, 2009).

The market share of the company in the area of chewing gum far exceeded the points earned by Cadbury Schweppes, Wrigley’s main competitor. W M. Wrigley Jr. Company owned 87% of the market, while Cadbury controlled only 12% (Woodhall, 2009). Finally, in 2008 the operating income of W M. Wrigley Jr. Company amounted to $867 million, while the operating margin totaled 18.5% (Woodhall, 2009; Wrigley, 2009).

Recapitalization Decision

Thus, the above-presented discussion and calculations allow assuming that recapitalization can be a favorable process for W M. Wrigley Jr. Company as the added value provided by the active investment strategy proposed by the hedge fund will potentially amount to 9%. Although not a large figure, 9% is an appropriate result for the company whose current debt is rather small and original business value is already rather high. Based on the changes that recapitalization might cause to the major financial factors of Wrigley’s operation, the recapitalization process can be implemented and the manager of the hedge fund should take an effort to achieve the allowance for this process.

Reference List

Bierman, H. (2009) Explaining Earnings per Share Growth. The Journal of Portfolio Management, 35(4), 166 – 169.

Bruner, R.F. (2008) Case Studies in Finance: Managing for Corporate Value Creation, 5edition. New York: McGraw-Hill.

Cable, J. (2008) Testing for Persistence of Profits’ Differences across Firms. International Journal of the Economics of Business, 41, 1 – 49.

Campbell, J. and Cochrane, J. (2000) By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior , Journal of Political Economy, 107, 205 – 251.

Index Funds Advisors. (2009) Active Investors. IFA. [online] What is Active Investing? Web.

Irvine, P. (2000) Raising Capital Using Monthly Income Preferred Stock: Market Reaction and Implications for Capital Structure Theory. Financial Management, 29(2), 5 – 20.

Rappaport, A. (2001) Does It Pay to Be an Active Investor? EI. [online] Expectations Investing. Web.

Simkins, B. (2009) The Cost of Capital. Case Studies in Corporate Finance, 3, 1 – 13.

Woodhall, S. (2009) W M. Wrigley Jr. Company (WWY). WI. [online] WikInvest. Web.

Wrigley. (2009) W M. Wrigley Jr. Company. WWY. [online] Corporate Web Site. Web.

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