The Wm. Wrigley Jr. Company: Capital Structure, Valuation, and Cost of Capital

Abstract

In June 2002, a managing director of an “active investor” hedge fund is considering the possible gains from increasing the debt capitalization of The Wm. Wrigley Jr. Company. Wrigley has been conservatively financed, and at the date of the case, carries no debt. The tasks for the student are to: •Estimate the potential change in value from re-levering Wrigley using adjusted present value analysis; •Assess the impact on weighted average cost of capital, earnings per share, the credit rating of the firm, and voting control of the Wrigley family; •Consider the merits of dividend or share repurchase as a means of returning cash to shareholders. The central teaching objective of the case is to explore the financial effects of capital structure change. Key here is the trade-off between the tax benefits of debt and the associated costs in the form of financial distress and loss of flexibility. Related issues include signaling to investors, clientele effects (control considerations for the Wrigley family), and incentives created for directors and managers. Finally, the case affords a comparison of dividends and share repurchases.

Excerpt

UVA-F-1482

Version 3.1

The Wm. Wrigley Jr. Company: capital structure,

valuation, and cost of capital

Interest rates are at their lowest point in 50 years. Yet the use of debt financing by corporations is declining—this happens anyway in a 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 the extreme case, you have mature firms who use no debt at all! Take William Wrigley Jr. 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 Wrigley's board to do a leveraged recapitalization 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 Wrigley's directors.

With those words, Blanka Dobrynin, 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 recapitalizations. Dobrynin had immigrated to the United States from Russia in 1991, and had risen quickly to become partner at a major 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, Dobrynin could look back on the large returns from the use of that strategy.

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Keywords: capital structure evaluation, leverage effects, ratio analysis