Executive Summary
Aurora Borealis LLC is an activist Hedge fund. They are trying to buy a large stake in the company and thereby force the management to reorganize the capital structure by raising the debt and using it to pay the dividends or buy back the shares. The effect of restructuring on various financial parameters will be discussed in the concluding parts.
Hedge Fund Strategy

The buyback of shares would increase the EPS for the firm as a natural consequence of reduction in number of shares outstanding. The increase in EPS will signal towards a positive market sentiment, which would result in increase in share price. Also, raising debt at lower cost of debt i.e. at good credit ratings lowers the WACC due effect of the tax shield and hence the value of the firm. Aurora Borealis LLC, like any other hedge fund, banks on instantaneous rise and fall in stock prices than the long term investment in growth and stability of the firm. The hedge fund plans to short the stock at the moment it rises to the optimal level due to strong signals the hedge fund is trying to pursue.

Effect of recapitalization on WACC

The current WACC of Wrigley is 10.9%. Since it is all equity firm the WACC is same as cost of equity. Raising $3billion debt for repurchase of stock or dividend would change the capital structure of the firm. The raised debt, because of the debt tax shield under good credit ratings, would reduce WACC and hence increase value of the firm. But in our case, the WACC after including the debt structure almost remains the same(10.9 to 10.91). The reason of this change is the increase in Beta due to re-levering at new debt level, which consequently brings the beta up to the same level at relevant debt ratios. Hence although re-levering shows no effect on value of the firm, the EPS rises and the stock price rises due to the repurchase. A possible explanation for this would be the decreasing financial stability of the firm and its ability to make profits in the future.

Effect of recapitalization on Financial Indicators

The effect of using the new debt to repurchase shares would result in reduction in number of outstanding shares by and decrease in book value by $3,222,250. We understand that the stockholders are mostly mature investors desiring gains from growth of the firm, instead of short-term yields from dividends. Wrigley’s share prices in the past have shown consistent growth against S&P500. The calculated price paid for stock repurchase is $62, which will be The EPS will increase to 1.97 from 1.61 due to decrease in number of outstanding shares. The debt interest coverage would decrease to 1.2, but this still keeps the company within acceptable industry standards from Standard & Poor's CreditStats. Moreover, other key financial ratios like Long-term debt/capital will still remain on high end of the credit spectrum (A to AA).

Financial Flexibility

The dividend payout, in our view is an ongoing commitment, as once the dividend is paid, stockholders expects at least the same dividends in the future. The reduction in dividends in future may disappoint many of the stakeholders and the stock price may drop significantly after an announcement or in anticipation of any such announcements. A share repurchase is a temporary phenomenon and the company remains more flexible in terms of its financial decisions in the future.

Financial Stability

Any adverse factors on like loss in sales due to economic recession or sudden rise in prices, may hit the bottom line of the company hard. If the company is levered at those times, the effective WACC would become much higher because of increased cost of equity due to re-levered WACC and cost of debt without the tax shield.

Valuation by DCF and APV

The value of the firm is $15.3b by APV valuation as compared to $13.6b by DCF analysis using the WACC after relevering. The difference in the analysis is because the bankruptcy risk and agency costs which APV method is unable to realize. This risk is covered and evaluated by credit rating agencies by increasing the marginal cost of debt.

Decision on recapitalization

It will be favorable for hedge funds if the company re-levers itself to raise the price of the stock. But from the long-term growth perspective of the firm, the best policy would be to re-invest in the firm for growth in form of sales or pursuing more profitable acquisitions. The share buyback would although raise the price of the firm, but if control of the firm is not an issue of urgency and the management do not plan an appropriate utilization of the retained earnings and the new debt, then the company should refrain from adding on additional debt. Moreover, using debt to payout the dividends would result in decrease the value of the firm and hence the share price using assuming market to be efficient.

Author: Anuj Varshney

HBS Open Source Case: Salvation or Suicide

Harvard Business School recently published a case on whether a software game company, KMS, which makes a device which permits amateurs to sound like professional musicians should adopt an open source business model.http://harvardbusinessonline.hbsp.harvard.edu/b02/en/common/item_detail.jhtml?id=R0804XThe case demonstrates the increased recognition of the strategic importance of decisions about the adoption of the open source software business model. Unfortunately, the case does not reflect the developments in business models for commercial open source software. The case focuses on an open source business model based primarily on providing technical services. Yet most commercial open source companies have adopted a dual distribution model. Moreover, as Marten Mickos noted in his 2007 keynote at OSBC, commercial open source companies have thirteen ways to make money, with four of them which he identifies as “scalable”. In addition, the analysis in the case if confused because KMS’ product includes hardware as well as software. Such hardware could give KMS a substantial advantage against competitors trying to provide an open source version of the product. In my experience, virtually all decisions about the adoption of open source business model deal solely with software products. Consequently, I think that the case would have been more powerful (and more realistic) to focus on case in which the product was solely software.

The Case Commentaries are very interesting. Jonathan Schwartz of Sun Microsystems, Inc. makes the critical point that KMS needs to determine its business goals before the company can make a meaningful decision about adopting an open source business model. He draws a contrast between Apple and Nokia in the handset market: Apple is trying to define what a handset should be and they sold 4 million iPhone handsets last year. On the other hand, Nokia is trying to be the largest handset maker in the world, has adopted an open platform and sold 400 million handsets last year.

Gary Pisano of Harvard Business School was also very insightful about the necessary elements for success in converting to an open source business model: ensuring that your software architecture is “modular” and creating a developer community. The creation of a developer community is a significant challenge for a new product and quite different from the skills required for developing and distributing proprietary software. He also notes that natural advantages conferred on KMS by its role as the creator of the “platform”. Finally, he focuses on the new reality for all “proprietary” software vendors: they need to be prepared for competitors who adopt an open source model.

Eric Levin makes good points about the importance of being able to control the brand and the strategic life cycle, but concludes that KMS has alternatives to adopting an open source business model such as adding personalization. However, I think that this alternative is an illusion and it seems to contradict his prior points.

The final Case Commentary by Michael Bevilacqua focuses on legal issues and, from his view, the significant additional risk of intellectual property infringement in an open source business model. I don’t agree with his conclusions. First, most “proprietary software” includes significant amounts of open source code which would carry risks similar to a pure open source business model. Second, he notes the increased risk of patent infringement in open source software. I disagree that the risk of patent infringement is greater in open source companies than in proprietary software companies. Most proprietary software companies do not undertake patent searches prior to writing software, so both types of companies are equally at risk of infringing a third party’s patents. However, the open source business model does entail legal risks: the scope of many important open source licenses (such as the GPL) are unclear because they use terms, such as derivative works, which are poorly defined in copyright law when applied to software and the licenses have never been interpreted by courts. In addition, the remedies available under open source licenses, whether injunctive relief or only monetary damages, are not clear. Consequently, many companies limit the use of open source software based on the open source license under which it is provided.