Debt Policy at UST Inc: Should UST undertakes debt recapitalization?Recap: What the pro-side said about the company value?Tax Shield: UST wants to increase the firm value by enjoying the huge tax shield provided by more leverage.Tax shield: tD = (0.38)($1 billion) = $0.38 billion

1. What are the primary business risks associated with UST Inc.? What are the attributes of UST Inc.? Evaluate from the viewpoint of credit analyst or bond holder.

UST Inc. is a smokeless tobacco company with a long tradition and a recognizable brand name. A strong brand name can have lots of associations with high quality, revenues, soundness, growth, etc. But, this is one of the characteristics that can be like two edged sward. On one side, company with long tradition is expected to to operate in a stable and prosperous way as it always did, but on the other side, company itself can get too self confident and fail to see the newcomers and other threats. UST has ignored newcomers, and now they all have a growing market shares, while only UST Inc. total share, consequently, decreases. Smaller players are expanding their market share primarily by cutting prices, something that UST ignored. UST Inc. decided to fight competition not by decreasing prices, but with overstretching it product lines. However, this might not be the best solution. As the main player in the market, they had the better position to take on and win in the price war. If UST Inc. had been able to take this step, competitors probably would not be able to follow the price decrease imposed by the UST Inc and at least some of them would be shut down. So as one of the biggest drawbacks of UST's policy can be slow reaction to new market conditions and worse of all when they react the reaction is inappropriate.

However, financial situation of the firm plays a very important role in the decision of the bondholder and this company has been one of the most profitable companies America in terms of ROE, ROA ad gross profit margin. Apart from decrease in earnings and cash flow in 1997, UST had continuous increases in sales (10-year compound annual growth rate of 9%), earnings (11%) and cash flow (12%). They are generating their cash flows out of the operations. Thanks to their premium pricing, they are achieving more than average gross profit margin. So, over the years UST's revenues are stable and positive, and generally its statements are positive. The company does not have any problems with its cash flow.

Nonetheless, there is no product differentiation. This can be a negative aspect for the company, since the lawsuits against tobacco industry are mounting and are increasing threat for the company.

One other drawback of the UST Inc. is that they are not in a very good position concerning international expansion. This is because the use of non-smoke tobacco is not widely present outside the North America. Moreover, it is very risky to invest in cigarettes, which made only 2.1% of their sales in 1998, because this investment may be more of a loss than a gain.

The US tobacco industry is characterized by declining volumes, legal challenges, marketing restrictions, taxes, discounting and consolidation, and so the long-term view is not so clear. But still, the company has stable growth, high profits and most likely will not present a problem for the bondholder.

2. Why is UST Inc. considering a leveraged recapitalization after such a long history of conservative debt policy?

Recapitalization is often undertaken with the aim of making the company's capital structure more stable, and sometimes to boost the company's stock price (for example, by issuing bonds and buying stocks, like UST did). Companies that do not want to become hostile takeover targets might undergo a recapitalization by taking on a very large amount of debt, and issuing substantial dividends to their shareholders (this makes the stock riskier, but the high dividends may still make them attractive to shareholders).

3. Should UST, Inc., undertake the $1 billion recapitalization? Calculate the marginal (incremental) effect on UST's value, assuming that the entire recapitalization is implemented immediately (January 1, 1999).a. Assume a 38% tax rate.b. Prepare a pro-forma income statement to analyze whether UST will be able to make interest pay-ments.c. For the basic analysis, assume that the $1 billion in new debt is constant and perpetual. Should UST, Inc., alter the new debt via a different level or a change in the amount of debt through time?

In order to answer the question, I calculated if financing through debt was the right choice. I used EBIT-EPS analysis. Two choices were analyzed: debt or equity financing.I thought that 5% would be cost of debt, taking into account the company's high S&P credit rating (AAA investment grade).

EPS = earnings per share,EBIT = earnings before interest and taxes,I = interest expense,T = tax rateP = preferred stocks,S = number of common shares outstanding

=> EBIT=373.511997*a - $1bil was divided by price of shares in order to get how many shares would have to be sold to raise $1 bil

Breakeven point of EBIT is at $373.511997 mil. If EBIT is higher than this number (and it is:$753.3 mil), than debt should be chosen. But for EBIT lower than $373.5 mil equity financing would be wiser choice.

Breakeven point of EBIT:

stock DebtEBIT 373,511,997 373,511,997- interest 0 50,000,000EBT 373,511,997 323,511,997- tax (38%) 141,934,558 122,934,559EAT 231,577,439 200,577,438No.of shares outstanding 214,169,725 185,500,000EPS 1.08 1.08

For EBIT lower than breakeven point:

stock DebtEBIT 200,000,000 200,000,000- interest 0 50,000,000EBT 200,000,000 150,000,000- tax (38%) 76,000,000 57,000,000EAT 124,000,000 93,000,000No.of shares outstanding 214,169,725 185,500,000EPS 0.57 0.50

For EBIT higher than breakeven point:

Stock DebtEBIT 500,000,000 500,000,000- interest 0 50,000,000EBT 500,000,000 450,000,000- tax (38%) 190,000,000 171,000,000EAT 310,000,000 279,000,000No.of shares outstanding 214,169,725 185,500,000EPS 1.45 1.50

After analyzing the results, we can conclude that the most favorable solution for the firm at this moment is to use debt financing. And their choice to raise debt in order to repurchase shares was good choice as well. By using debt to repurchase shares, UST is creating tax shield, which will result in increasing the value of the firm and make shareholders more satisfied because their dividends will rise too. These few last points we will show in next calculations.

(in millions, except per share data)1998 1999EBIT 753.3 753.3Less: Interest (2.20) 50EBT 755.5 703.3Less: Tax (38%) 287.09 267.254EAT 468.41 436.046# of shares outstanding 185.5 156.83EPS 2.52 2.78

From this table we can see that in 1999 the company can expect to have lower earnings after taxes than in 1998, but to have higher earnings per share.

Cost of equity in 1998 is 4.65%, and since the cost of equity is always higher than cost of debt, we can conclude that cost of debt in 1998 would be around 4%. And as we assumed, based on the company's S&P rating, that the cost of debt in 1999 would be 5%, we can say that the cost of equity won't be higher than 5.2%.

Market Value of Debt = Interest/Cost of Debt ( kd = 5% in 1999)Market Value of Equity = Dividends/Cost of Equity (ke = 5.2% in 1999, Dividends = 301.1)

(in millions, except per share data)1998 1999(1)Market Value of Debt 0 1,000(2)Market Value of Equity 6,470.8 5,790.4Market Value of firm(1+2) 6,470.8 6,790.4

(in millions, except per share data)1998 1999Market Value of Firm 6,470.8 6,790.4Price per Share 34.88 43.3Shares Outstanding 185.5 156.83Dividends per Share 1.62 1.92

Price per Share = Market Value of Firm/Shares OutstandingDividends per Share = Dividends/Shares Outstanding

Recapitalization would have a few positive effects:

- Market value of the firm will increase by 319.6 million after the recapitalization takes place.- Price per share will increase from 34.88 to 43.3- Dividends per share will increase too from 1.62 to 1.92

In order to prepare a pro forma income statement, I used percentage of sales method. In order to predict the sales revenue for 1999, the growth over the last three years was used. The growth in last three years was 5%, 2.2% and 1.5% respectively. For the prediction of sales revenues I used the average of 2,91%. COGS and Operating expenses were calculated as a percentage of sales revenue in 1998.

= 20%

= 27%

Year 1998 1999Sales revenues 1,423.2 1,464.6COGS 283.5 292.92Gross Profit 1,139.70 1,171.68Operating Expense 386.4 395.44EBIT 753.30 776.24Interest (Expenses) Income 2.20 (50.00)PBT 755.50 726.24Taxes(0.38) 287.09 275.97Net Income 468.41 450.27Dividends 300.51 300.00Retained Earnings 167.90 150.27

To find out if UST would be able to make its interest payments, we can use the interest coverage ratio:

Interest coverage ratio= EBITInterest

Interest coverage ratio = 776.24 = 15,52x50.00=> this means that for every dollar of interest UST will have $15.52 to cover it. As we can conclude from this result, UST will be able to make interest when they are due.

4. UST has paid uninterrupted dividends since 1912. Will the recapitalization hamper future div. payments?

As far as the dividends pay-outs are concerned I believe that they should continue their tradition. Since they have very strong position and net income, they can pay the dividends as they always did, this would increase their value as a company and keep the shareholders satisfied....From: http://www.123helpme.com/case-study-on-ust-view.asp?id=164108