Case Study Starts Here:


Interest rates are at their lowest point in 50 years. Yet the use of debt financing by corporations is declining—thishappens anyway in a recession. And some deleveraging is due to strategic changes in an industry, such astechnological innovation or other developments that increase business risk. But corporate deleveraging seems tohave gone too far. CEOs are missing valuable opportunities to create value for their shareholders. In the extremecase, you have mature firms who use no debt at all! Take William Wrigley Jr. Company, for instance. It has aleading market share in a stable low-technology business—it makes chewing gum—and yet has no debt. I betthat if we could persuade Wrigley’s board to do a leveraged recapitalization through a dividend or major sharerepurchase, we could create significant new value. Susan, please run some numbers on the potential change invalue. 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, toinitiate the research for a potential investment in Wrigley. Aurora Borealis was a hedge fund with about $3 billion undermanagement and an investment strategy that focused on distressed companies, merger arbitrage, change-of-controltransactions, and recapitalizations. Dobrynin had immigrated to the United States from Russia in 1991, and had risen quicklyto 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 ofthe 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.
Chandler noted that Wrigley’s market value of common equity was about $13.1 billion. Dobrynin and Chandler discussed thecurrent capital-market conditions and decided to focus on the assumption that Wrigley could borrow $3 billion at a creditrating between BB and B, to yield 13%. Chandler agreed to return soon to discuss the results of her research.

The William Wrigley Jr. Company
Wrigley was the world’s largest manufacturer and distributor of chewing gum. The firm’s industry, branded consumer foodsand candy, was intensely competitive and was dominated by a few large players.

Exhibit 1 gives product profiles of Wrigleyand its peers. Over the preceding two years, revenues had grown at an annual compound rate of 10% (earnings at 9%),reflecting the introduction of new products and foreign expansion (Exhibit 2). Historically, the firm had been conservativelyfinanced. At the end of 2001, it had total assets of $1.76 billion and no debt (Exhibit 3). As Exhibit 4 shows, Wrigley’s stockprice had significantly outperformed the S&P 500 Composite Index, and was running slightly ahead of its industry index.

Estimating the Effect of a Leveraged Recapitalization

Under the proposed leveraged recapitalization, Wrigley would borrow $3 billion and use it either to pay an equivalentdividend or to repurchase an equivalent value of shares. Chandler knew that this combination of actions could affect thefirm’s share value, cost of capital, debt coverage, earnings per share, and voting control. Accordingly, she sought to evaluatethe effect of the recapitalization on those areas. She gathered financial data on Wrigley and its peer companies (Exhibit 5).

Impact on share value

Chandler recalled that the effect of leverage on a firm could be modeled by using the adjusted present-value formula, whichhypothesized that debt increased the value of a firm by means of shielding cash flows from taxes. Thus, the present value ofdebt tax shields could be added to the value of the unlevered firm to yield the value of the levered enterprise. The marginaltax rate Chandler proposed to use was 40%, reflecting the sum of federal, state, and local taxes.

Impact on debt rating
A key assumption in the analysis would be the debt rating for Wrigley, after assuming $3 billion in debt, and whether the firmcould cover the resulting interest payments. Dobrynin had suggested that Chandler should assume Wrigley would borrow $3billion at a rating between BB and B. Was a rating of BB/B likely? In that regard, Chandler gathered information on theaverage financial ratios associated with different debt-rating categories (Exhibit 6). Dobrynin thought that Wrigley’s pretaxcost of debt would be around 13%. Chandler sought to check that assumption against the capital-market information given in Exhibit 7.

Impact on cost of capital

Chandler knew that the maximum value of the firm was achieved when the weighted average cost of capital (WACC) wasminimized. Thus, she intended to estimate what the cost of equity and the WACC might be, if Wrigley pursued this capital-structure change. The projected cost of debt would depend on her assessment of Wrigley’s debt rating after recapitalizationand on current capital-market rates (summarized in Exhibit 7). The cost of equity (KE) could be estimated by using the capital asset pricing model.
Exhibit 7 gives yields on U.S. Treasury instruments, which afforded possible estimates of the risk-free rate of return. The practice at Aurora Borealis was to use anequity-market risk premium of 7.0%. Wrigley’s beta would also need to be relevered to reflect the projected recapitalization.
Chandler wondered whether her analysis covered everything. Where, for instance, should she take into account potentialcosts of bankruptcy and distress or the effects of leverage as a signal about future operations? More leverage would alsocreate certain constraints and incentives for management. Where should those be reflected in her analysis?

Impact on reported earnings per share
Chandler intended to estimate the expected effect on earnings per share (EPS) that would occur at different levels ofoperating income (EBIT) with a change in leverage. The beginnings of an EBIT/EPS analysis are presented in Exhibit 8.

Impact on voting control

The William Wrigley Jr. Company had 232.441 million shares outstanding. A repurchase of shares would alter that amount.The Wrigley family controlled 21% of the common shares outstanding and 58% of Class B common stock, which hadsuperior voting rights to the common stock. Assuming the Wrigley family did not sell any shares, how would the share-repurchase alternative affect the family’s voting-control position in the company?


Although Susan Chandler’s analysis followed a familiar path, each company that she had analyzed differed in importantrespects from previous firms. Blanka Dobrynin paid her to run numbers and, more importantly, to find the differenceswherein hidden threats and opportunities lay. Running the numbers was easy for Chandler; drawing profitable insights fromthem was not.


Exhibit 1

Description of Industry Peer Firms

Cadbury Schweppes plc

Cadbury Schweppes plc made and distributed confectionary and beverage products worldwide.
Sold 51% stake in Coca-Cola and Schweppes Beverages Ltd. in 1997; beverage brands in 160
international markets in 1999. In 1998, owned 40% of American Bottling. Licensed Cadbury to
Hershey in U.S. Acquired Dr. Pepper/7Up in ’95; Hawaiian Punch in ’99; and Snapple in ’00.
Segment sales/operating profits in ’01: beverages, 43%/61%; confectionary, 57%/39%. Sales by
region: U.K., 21%; U.S., 42%; Australia, 10%; other (including Europe), 27%. Had 36,460
employees. Bond rating: BBB/Baa2.

Hershey Foods Corp.

Hershey Foods Corp. was the largest U.S. producer of chocolate and nonchocolate confectionary
products (major brands: Hershey’s, Reese’s, Cadbury, Kit Kat, Sweet Escapes, TasteTations, Jolly
Rancher, Good & Plenty, and Milk Duds). Sold majority of pasta operations in 1/99. Acquired
I IC adbury U.S. in 9/88; Henry Heide in 12/95; and Leaf North America in 12/96. Advertising costs:
4.2% of ’01 sales. ’01 depreciation rate: 6.6%. Had 14,400 employees; 40,300 shareholders.
Hershey Trust Co. owns 11.5% of common stock and 99.6% of Class B. Bond rating: A+/A1.

Kraft Foods Inc.

Kraft Foods Inc. was the largest branded food and beverage company headquartered in the U.S.
and second largest worldwide. The company marketed many of the world’s leading food brands,
including Kraft cheese, Maxwell House coffee, Nabisco cookies and crackers, Philadelphia cream
cheese, Oscar Mayer meats, and Post cereals. Its products were sold in more than 145 countries.
North American sales accounted for 74% of ’01 sales; international, 26%. Acquired Nabisco in
12/00. Had about 14,000 employees. Philip Morris owns 84% of its common stock(3/02 proxy).
Bond rating: BBB+/A3.

Tootsie Roll Industries, Inc.

Tootsie Roll Industries, Inc., produced candy. Products include Tootsie Roll, Tootsie Pop, Tootsie
Bubble Pop, and Mason Dots. Acquired Brach’s Confections’ Andes Candies in 5/00; Warner-
Lambert’s former chocolate/caramel brands (Junior Mints, Sugar Daddy, Charleston Chew, and
Pom Poms) in 9/88; Cella Confections in 7/85. Five plants in U.S., one in Mexico. Int’l ops.
(Mexico and Canada): 7% of ’01 sales. Had about 1,950 employees. M. J. & E. R. Gordon control
74% of voting power. Bond rating: N/A.

The Wm. Wrigley Jr. Company

The Wm. Wrigley Jr. Company was the world’s largest manufacturer and seller of chewing gums,
specialty gums, and gum base. Principal brands: Doublemint, Spearmint, Juicy Fruit, Big Red,
WinterFresh, Extra, Orbit, Freedent. Amurol Products subsidiary made novelty gums, including
Bubble Tape, Big League Chew; markets Hubba Bubba bubble gum. Foreign sales: 58% of 2001
total, 58% of pretax profit. Had 10,800 employees; 38,701 common shareholders. William
Wrigley Jr. owned 21% of common stock and 58% of Class B. Bond rating: N/A.
Sources of information: Value Line Investment Survey; Bloomberg LP.

Exhibit 2

The Wim. Wrigley Jr. Company
Statement of Earnings
year ended December 31
(in thousands, except per-share amounts) 2001 2000 1999
Net sales $ 2,429,646 $ 2,145,706 $ 2,061,602
Cost of sales 997,054 904,266 904,183
Gross profit 1,432,592 1,241,440 1,157,419
Selling, general and admininstrative expenses 919,236 778,197 721,813
Operating income 513,356 463,243 435,606
Investment income 18,553 19,185 17,636
Other expense (4,543) (3,116) (8,812)
Earnings before income taxes 527,366 479,312 444,430
Income taxes 164,380 150,370 136,247
Net earnings $ 362,986 $ 328,942 $ 308,183
Per-share amounts
Net earnings per share of common stock $ 1.61 $ 1.45 $ 1.33
Dividends paid per share of common stock $ 0.745 $ 0.70 $ 0.66
Source of data: Company regulatory filings.


Exhibit 3

The Wim. Wrigley Jr. Company
Consolidated Balance Sheet
(in thousands of dollars) 2001 2000
Current assets:
Cash and equivalents $ 307,785 $ 300,599
Short-term investments, at amortized cost 25,450 29,301
Accounts receivable 239,885 191,570
Finished goods 75,693 64,676
Raw materials and supplies 203,288 188,615
278,981 253,291
Other current assets 46,896 39,728
Deferred income taxes – current 14,846 14,226
Total current assets 913,843 828,715
Marketable equity securities, at fair value 25,300 28,535
Deferred charges and other assets 115,745 83,713
Deferred income taxes – noncurrent 26,381 26,743
Property, plant, and equipment (at cost)
Land 39,933 39,125
Buildings and building equipment 359,109 344,457
Machinery and equipment 857,044 756,050
1,256,086 1,139,632
Less accumulated depreciation 571,717 532,598
Net property, plant and equipment 684,379 607,034
TOTAL ASSETS $ 1,765,648 $ 1,574,740
Current liabilities:
Accounts payable $ 91,225 $ 73,129
Accrued expenses 128,406 113,779
Dividends payable 42,711 39,467
Income and other taxes payable 68,437 60,976
Deferred income taxes – current 1,455 859
Total current liabilities 332,234 288,210
Deferred income taxes – noncurrent 43,206 40,144
Other non-current liabilities 113,921 113,489
Common stock 12,646 12,558
Class B convertible stock 2,850 2,938
Additional paid-in capital 1,153 346
Retained earnings 1,684,337 1,492,547
Treasury stock (289,799) (256,478)
Accumulated other comprehensive income (134,900) (119,014)
Total stockholders’ equity 1,276,287 1,132,897
Source of data: Company regulatory filings.


Exhibit 4

Chart showing The Wim. Wrigley Jr. Company outperforming S&P Food, Beverage & tobacco index and the S&P 500.

Exhibit 5

Financial Characteristics of Major Confectionary Firms
Company Name Recent Price Common Shares Outstanding (millions) Market Value of Equity (millions) Book Value of Equity (millions) Total LT Debt (millions) LT Debt/ (LT Debt + Book Value of Equity) LT Debt/ (LT Debt + Mkt Value of Equity) LT Debt/Book Value of Equity LT Debt / Mkt Value of Equity
Cadbury Schweppes plc $ 26.66 502.50 $ 13,397 $ 5,264 $ 2,264 30.07% 14.46% 43.01% 16.90%
Hershey Foods Corp. $ 65.45 136.63 $ 8,942 $ 2,785 $ 869 23.77% 8.85% 31.18% 9.71%
Kraft Foods $ 38.82 1,735.00 $ 67,353 $ 39,920 $ 8,548 17.64% 11.26% 21.41% 12.69%
Tootise Roll Industries Inc. $ 31.17 51.66 $ 1,610 $ 509 $ 8 1.45% 0.46% 1.47% 0.47%
Wm. Wrigley Jr. Co. $ 56.37 232.44 $ 13,103 $ 1,276 $ – 0.00% 0.00% 0.00% 0.00%
S&P 500 Composite $ 1,148.08 18.23% 8.76% 24.27% 9.94%
Company Name Beta EPS Price/ Earnings Cash Dividend Dividend Payout Dividend Yield Interest Coverage Before Tax Compound Growth of EPS Past 5 Yrs Firm Value/ EBITDA
Cadbury Schweppes plc 0.60 1.39 15.20 $ 0.67 44.0% 2.50% 4.6x 6.50% 10.3
Hershey Foods Corp. 0.60 2.74 20.40 $ 1.16 41.0% 2.00% 11.1x 6.50% 11.4
Kraft Foods nmf 1.17 18.70 $ 0.26 12.0% 1.50% 3.4x nmf 10.1
Tootise Roll Industries Inc. 0.65 1.30 24.00 $ 0.28 22.0% 0.90% nmf 12.50% 14.6
Wm. Wrigley Jr. Co. 0.75 1.61 29.30 $ 0.75 46.0% 1.50% nmf 9.00% 22.6
S&P 500 Composite 1.00 18.78 40.55 -49.57%
Source of data: Value Line Investment Survey.


Exhibit 6

Key Industrial Financial Ratios (Three-year medians 2000-2002)
Investment Grade Non-Investment Grade
EBIT interest coverage (x)
23.4 13.3 6.3 3.9 2.2 1.0
Funds from operations/total debt (%)
214.2 65.7 42.2 30.6 19.7 10.4
Free operating cash flow/total debt (%)
156.6 33.6 22.3 12.8 7.3 1.5
Return on capital (%)
35.0 26.6 18.1 13.1 11.5 8.0
Operating income/sales (%)
23.4 24.0 18.1 15.5 15.4 14.7
Long-term debt/capital (%)
(1.1) 21.1 33.8 40.3 53.6 72.6
Total debt/capital, incl. short-term debt (%)
5.0 35.9 42.6 47.0 57.7 75.1
Source of data: Standard & Poor’s CreditStats, September 8, 2003.
EBIT interest coverage divides earnings before interest and taxes (EBIT) by gross interest expense (before subtracting capitalized interest and interest income).
FFO/total debt divides funds from operations (FFO) by total debt. FFO is defined as net income from continuing operations, depreciation and amortization, deferred income taxes, and other noncash items/Long-term debt + current maturities + commercial paper, and other short-term borrowings.
Free operating cash flow/total debt. Free operating cash flow is defined as FFO – capital expenditures – (+) increase (decrease) in working capital (excluding changes in cash, marketable securities, and short-term debt)/Long-term debt + current maturities, commercial paper, and other short-term borrowings.
Total debt/EBITDA. Long-term debt + current maturities, commercial paper, and other short-term borrowings/Adjusted earnings from continuing operations before interest, taxes, and depreciation and amortization.
Return on capital. EBIT/Average of beginning of year and end of year capital, including short-term debt, current maturities, long-term debt, noncurrent deferred taxes, minority interest, and equity (common and preferred stock).
Total debt/capital. Long-term debt + current maturities, commercial paper, and other short-term borrowings/Long-term debt + current maturities, commercial paper, and other short-term borrowings + shareholders’ equity (including preferred stock) + minority interest.
Source: Standard & Poor’s Corporate Ratings Criteria 2005, New York: Standard & Poor’s Corporation, page 42.


Exhibit 7

Capital Market Conditions, June 7, 2002
U.S. Treasury obligations Yield Other instruments
3 mos. 1.670% U.S. Federal Reserve Bank discount rate 1.730%
6 mos. 1.710% LIBOR (1 month) 1.840%
1 yr. 2.310% Certificates of deposit (6 month) 1.980%
2 yr. 3.160% Prime interest rates 4.750%
3 yr. 3.660%
5 yr. 4.090% U.S. Treasury yield curve – upward sloping
7 yr. 4.520%
10 yr. 4.860%
20 yr. 5.650%
Corporate debt obligations (10 year) Yield
AAA 9.307%
AA 9.786%
A 10.083%
BBB 10.894%
BB 12.753%
B 14.663%
Sources of data: Bloomberg LP, Federal Reserve Bank Reports


Exhibit 8

EPS v. EBIT Analysis
Before recapitalization
After recapitalization
Interest rate on debt Interest rate on debt
Pre-recap debt Pre-recap debt
Tax rate Tax rate
Before recapitalization Worst case Most likely Best case After recapitalization Worst case Most likely Best case
Operating income (EBIT) Operating income (EBIT)
Interest expense Interest expense
Taxable income Taxable income
Taxes Taxes
Net income Net income
Shares outstanding Shares outstanding
Earnings per share Earnings per share