THE WM. WRIGLEY JR.

COMPANY: RECAPITALIZATION ANALYSIS

Yiming Chen
Overview
As one of the worlds largest chewing candy manufacture and distributor in the consumer
foods industry, Wrigley achieved satisfactory performance in the past five years (1998-2002).
With a compound 9% growth of earnings per share, higher than Cadbury Schweppes or
Hershey Foods, the companys stock price had significantly outperformed the S&P 500
Composite Index. With a P/E ratio higher than its peers, investors were expecting higher
earnings growth in the coming year. Moreover, Wrigleys strong competitive position was
achieved with a very conservative capital structure. It was the only company among its peers
without any long term debt. This exercise analyzes the effect of recapitalization by raising $3
billion debt to pay dividend or repurchase outstanding shares. The financial impact of the
leveraged recapitalization on Wrigleys value, earnings, stock price, cost of capital, and
credit ratings is discussed. Recommendation is provided to conclude the case.
Company Valuation
Due to the change of capital structure, the intrinsic value of Wrigley before and after the
recapitalization is calculated under the frame work of Adjusted Present Value. Detailed
analysis is shown in Exhibit 1. Before the recap, Wrigley was purely funded by equity, with a
market value of $13.1 billion. After the recap, Wrigleys intrinsic value will increase to $14.3
billion, containing $11.3 billion of equity and $3 billion of debt. Leverage will increase
firms value by $1.2 billion, which is the tax shield benefit from the debt. The benefit comes
from the reduction in income tax, which results from taking an allowable interest expense
deduction from the firms taxable income.
Financial Effect of Leverage
The increase of the firm value should have a positive effect on Wrigleys share price.
Assume the $3 billion debt is used to repurchase outstanding shares. As discussed in Exhibit
2, at the current market value, 52.2 million shares will be repurchased, leaving 179.2 million
shares outstanding with an intrinsic equity value of $11.3 billion. This suggests a new share
value of $61.53 per share, a 9% increase compare to the original market price.
The benefit doesnt come without a price. Take weighted cost of capital as an example
(detailed analysis shown in Exhibit 3), before recapitalization, the cost of capital was the cost
of equity, which can be estimated by required return on stock. Using capital asset pricing
model, the required return is estimated as 10.1%. After recapitalization, with a 13% cost of
debt and 40% forward tax rate, WACC will reach 10.3%. The increased cost of capital is
mainly caused by increased cost of equity and the high cost of debt, presumably from issuing
Non-Investment grade debt. The increase of beta from 0.75 to 0.87 also is in accordance with
the increased volatility due to an increased leverage.
A side-by-side comparison of the income statement before and after the recapitalization is
shown in Exhibit 4. In normal case, a 9% revenue growth would be expected. That said,
income data of 2001 was used as a worst case scenario analysis for the 2002 performance.
This also allows better comparison analysis with other major confectionary firms
performance in 2001. Before recapitalization, Wrigley reported $527 million earnings before
interest and taxes, which corresponded to $1.61 earnings per share and a P/E ratio of 41.4. If

recapitalization occurred, it will not change the EBIT, as the fund will be used to repurchase
stock instead of invest in operations for better profit. Net earnings, however, will be reduced
due to a $390 million increase in interest expense. This effect outweighs the income tax
savings, which reduces the net earning significantly. The $0.46 EPS and a P/E ratio of 136.7
post recapitalization demonstrate the dramatic change caused by leverage.
Competitive Analysis
The financial characteristics of Wrigley are also compared to other major confectionary
firms in the industry, as shown in Exhibit 5. After the proposed leveraging with the $3 billion
boost on debt, Wrigleys value of debt is raised to the industrial average, but the D/E ratio
increases significantly to a level well above the industrial average. We also observe a much
higher EBITDA multiple and a much lower EPS than Wrigleys peers. This indicates an
increase of financial risk notably more than the industrial norm.
Credit Ratings
Last but not least, key financial ratios are calculated to analyze the impact of
recapitalization on Wrigleys credit ratings. As shown in Exhibit 6, the outstanding
performance of key financial ratios before recapitalization should put Wrigley in an A above
rating. After recapitalization, the significant drop of EBIT interest coverage and FFO to total
debt ration will impact Wrigleys credit negatively. The new credit rating of BB/B is likely,
which means Chandlers assumption of 13% cost of debt was reasonable.
Conclusion
To summarize, the proposed leveraged recapitalization will increase the value of the firm
because of the tax shield benefit. This will increase the stock price by 12% if Wrigley
chooses to repurchase the outstanding stock. The incurred debt at the same time will increase
the firms cost of capital, beta, and reduce earnings per share significantly. It is yet hard to
predict how Wrigleys investors will respond to the additional risk, as some investors may be
concerned on the potential financial distress, while others may embrace the higher expected
return down the road. Given the worst case scenario analysis of Wrigleys potential income
and the sufficient current assets on its balance sheet, it seems that the firm has sufficient
funds to cover the additional cost of debt. The risk of default is very low for Wrigley. It is
still alarming the leveraged recapitalization will reduce Wrigleys credit rating, especially if
it will cause the firm to downgrade to a Non-Investment grade. This will send a worrying
signal to potential investors.
Although Wrigleys original zero debt structure was too conservative, it doesnt mean
that the proposed plan is the most optimum option for Wrigleys management. Aurora
Borealis, the hedge fund, will see significant financial reward from the proposed
recapitalization. However for Wrigley, given the revenue growth in the past two years from
introduction of new products and foreign expansion, a better use of capital would be to
sponsor organic growth of the company. In reality, some corporations do buyback stocks,
which is sensible when there is extra cash and limited new growth opportunity. When cost of
debt is low, some corporations do engage in issuing debt to buy back stocks, which has been
a controversial strategy. In Wrigleys case, when potential cost of debt is even higher than
the required return on its equity, it is not a good strategy to use high cost debt for aggressive
financial engineering.

Exhibit 1. Analysis of Firm Value

Before recapitalization, the company is purely financed by equity

=
(1 + )
=1

After recapitalization, assume the company will continue to operate in the exact same fashion,
under the frame work of Adjusted Present Value:
=
+

=
+

(1 + )
(1 + )
=1

=1

Assume constant debt level after recapitalization, using perpetuity formula

=
=
= = 0.4 3000 = $1,200

(1 + )

=1

= + = 13,103 + 1,200 = 14,303

= + = 3000 +
New value of equity can be calculated as
= $11,303
Exhibit 2. Analysis of Share Value
When the value of the firm increases for $1.2 billion, each shares price will increase for
1200
=
= $5.16
232.44
Thus results in a share price of
= 56.37 + 5.16 = $61.53
When $3 billion is used to repurchase stock, new common shares outstanding will be
3000
= 232.44
= 183.68
61.53
Exhibit 3. Analysis of Cost of Equity
As before recapitalization,
= 0.75
Take 10 year Treasury bond yield as risk-free rate, unlevered cost of equity is estimated as:
= = + ( ) = 4.85% + 0.75 7% = 10.1%

After re-capitalization:

= [1 + (1 ) ] = 0.75 [1 + (1 0.4) 26.54%] = 0.87

= + ( ) = 4.85% + 0.87 7% = 10.94%

Weighted average cost of capital is then calculated as:

= (1 ) +

3000 0.6
11303
=
0.13 +
0.1094 = 10.3%
11303 + 3000
11303 + 3000
Exhibit 4. Analysis of Income Statements
(in thousands)
Net sales
Cost of sales
Gross profit
Selling, general and admin expenses
Operating income
Investment income
Other expense
EBIT
Interest expense
Income taxes
Net earnings

Before recap
$2,429,646
(977,054)
1,432,592
(919,236)
513,356
18,553
(4,543)
527,366
(0)
(164,380)
$362,986

After recap
$2,429,646
(977,054)
1,432,592
(919,236)
513,356
18,553
(4,543)
527,366
(390,000)
(54,946)
$82,420

Based on the estimates of net earnings, earnings per share can be calculated
362.986
=
= 1.56
232.44
82.420
=
= 0.45
183.68
Exhibit 5. Financial Characteristics Comparison in Confectionary Industry

Market Value of Equity (millions)

Market Value of Debt (millions)
D/E
Beta
Cost of Equity
Cost of Debt
WACC

Before Recap
$13,103
0
0
0.75
10.1%
0
10.1%

After Recap
$11,303
$3,000
26.54%
0.87
10.94%
13%
10.3%

EPS
P/E
(in millions)
Cadbury Scheweppes
Hershey Foods Corp.
Kraft Foods
Tootise Roll Inc.
Wm. Wrigley Jr. Co.
(before recap)
Wm. Wrigley Jr. Co.
(after recap)
Industry Average

$1.36
41.4
Ve

Vd

D/E

$0.45
136.7
Beta

EPS

13,379
8,942
67,353
1,610
13,103

2,264
869
8,548
8
-

16.92%
9.72%
12.69%
0.50%
-

0.60
0.60
0.65
0.75

1.39
2.74
1.17
1.3
1.61

FirmValue/
EBITDA
10.3
11.4
10.1
14.6
22.6

11,303

3,000

26.54%

0.87

0.45

27.1

20,517

2,937.8

13.27%

0.68

1.41

14.7

Exhibit 6. Analysis of Credit Rating

Key Industry Financial
Ratios
EBIT interest coverage
Funds from
operations/total debt
Return on Capital
Operating income/sales
Total debt/capital

BB

B
1.0
10.4

Wrigley
before
-

Rating
before
AAA
AAA

Wrigley
after
1.32
21.8

Rating
after
B
BB

2.1
19.7
11.5
15.4
57.7

8.0
14.7
75.1

4.0
21.1
-

Below B
A
AAA

3.7
21.1
21.0

Below B
A
AA

Detailed calculations listed below. Note that market value of equity instead of book value was
used to estimate the ratings:

513.356
=
=
= 1.32

0.13 3000
+
=


82.420 + 571.717
=
= 21.8%
3000

527.366
=
=
= 3.7%
+ 3000 + 11303

513.365
=
= 21.1%

2429.646

3000
=
= 21.0%
3000 + 11303