WACC before recapitalization Wrigleys prerecapitalization WACC is 10.9%. The cost of equity assumes a risk free rate of !."!

% for #0 year $.%. Treasuries &case '(hi)it *+, a risk premium is assume- *% &or !%+, anuses Wrigleys current )eta of 0.*! &case '(hi)it !+. 4. WACC after recapitalization The increase in le.erage /ill affect Wrigleys WACC in at least three /ays0 1. Cost of debt0 Wrigleys -e)t rating /ill change from AAA &consistent /ith no -e)t+ to a 1121 rating reflecting the higher risk. The postrecapitalization cre-it rating is a matter of 3u-gment. 4t is highly instructi.e to gui-e stu-ents through a rating e(ercise for Wrigleys pro forma recapitalization. This requires computing the range of measures inclu-e- in case '(hi)it " an- -etermining /here in the ratings range the firm /oul- fall.1 Comparing Wrigleys pro3ecte- results to the )enchmarks gi.en in case '(hi)it " suggests that 1121 is a reasona)le call. Turning to the yiel-s )y cre-it rating gi.en in case '(hi)it *, one can interpolate )et/een 11 &1#.*5%+ an- 1 &16.""%+ to o)tain a cost of -e)t. The cost use- in the remain-er of this analysis is 15%, 1lanka 7o)rynins choice.# 8iel-s rise almost linearly across the in.estment gra-e spectrum &AAA to 111+ an- then rise cur.ilinearly at lo/er -e)t ratings9this hints at the pro)lem that /e /ill encounter in estimating the cost of equity. #. Beta0 8ou shoul- unle.er Wrigleys current )eta of 0.*!, assuming the current .alues of )ook -e)t an- the market .alue of equity. This gi.es an estimate of the unle.ere- )eta of 0.*!, reflecting the fact that Wrigley has almost no -e)t. 5 This )eta then nee-s to )e rele.ere- to reflect the a--ition of :5 )illion in -e)t. $sing the formula pro-uces a le.ere)eta of 0.;*. All in all, this is not much of a change. Why< The ans/er is t/ofol-0 first, the market .alue of Wrigleys equity is so large that :5 )illion more in -e)t -oes relati.ely little to change the -e)t2equity ratio. %econ-, the le.ere- )eta formula is a linear mo-el that accounts for -e)t ta( shiel-s )ut not the costs of financial -istress. Thus, the cur.ilinear relationship )et/een risk an- yiel- o)ser.e- in case '(hi)it * is not reflecte- in the estimate of the le.ere- )eta. 5. Capital weights based on the market value of equity and the book value of debt 0 These /ere calculate- earlier as *;% equity an- ##% -e)t. 1est practice an- finance theory require the use of long term target /eights in calculating WACC. Are those /eights the
1 =atio -efinitions are gi.en in case '(hi)it ", )ut the ratings agencies rely entirely on )ook .alues. # >essimistic analysts /ill lean to/ar- a 1 rating an- ? 7 of 16.""%. This pro-uces a postrecapitalization WACC that is materially /orse than the prerecapitalization WACC, an- that pro.es to )e a further -isincenti.e to implement the recap. 5 @or comparison, you might unle.er the )etas for Wrigleys peers &see case '(hi)it !+ an- take the a.erage. This gi.es an a.erage unle.ere- )eta of 0.!*. The reasons for the -ifference in the unle.ere- )etas are -ifficult to assess un-er the )est of circumstances an- .irtually impossi)le gi.en the a))re.iate- information in the case. @or more a-.ance- analysts, /e can assign the comparison of Wrigley an- its peer group9the competiti.e implication of lo/er capital cost for its peers.

long run target capitalization for Wrigley or a short run peak that /ill gra-ually change as Wrigley repays its -e)t< @or the sake of simplicity an- the illustration of e(treme change, the )alance of this note /ill assume the *;2## percentage mi(. =ele.ering )eta to reflect the ne/ mi( of capital an- other/ise assuming similar risk free rate an- equity market risk premium /ill yiel- an estimate- cost of equity for Wrigley of 11.*%. We coul- -/ell on the mo-est increase of ;0 )asis points in the cost of equity. This reflects the impact of the higher -e)t ta( shiel-s an- -oes not incorporate the costs of financial -istress relati.e to the le.ere- )eta as -iscusse- earlier. Another /ay is to compare the estimate- cost of equity /ith the cost of -e)t. Assume- at 15%, the cost of -e)t does incorporate a financial risk premium &as reflecte- in the change- cre-it rating+. 8et the equity, /hich has a 3unior claim on the assets of the firm, )ears a lo/er cost. Again, the para-o( is e(plaine- )y the fact that the estimate- cost of equity ignores costs of financial -istress. Com)ining the costs of equity an- -e)t /ith the re.ise- capital /eights yiel-s a postrecapitalization WACC of 10.91%9virtually unchanged from the prerecapitalization WACC. The company is manifestly riskier in financial terms. Why -oesnt the estimate of WACC reflect this< 1asically, the ta( )enefit of using more -e)t is .irtually offset )y the higher cost of equity, )ut most importantly, the estimate of the le.ere- )eta postrecapitalization fails to reflect costs of financial -istress.