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 rate
P = 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 Debt
EBIT 373,511,997 373,511,997
- interest 0 50,000,000
EBT 373,511,997 323,511,997
- tax (38%) 141,934,558 122,934,559
EAT 231,577,439 200,577,438
No.of shares outstanding 214,169,725 185,500,000
EPS 1.08 1.08
For EBIT lower than breakeven point:
stock Debt
EBIT 200,000,000 200,000,000
- interest 0 50,000,000
EBT 200,000,000 150,000,000
- tax (38%) 76,000,000 57,000,000
EAT 124,000,000 93,000,000
No.of shares outstanding 214,169,725 185,500,000
EPS 0.57 0.50
For EBIT higher than breakeven point:
Stock Debt
EBIT 500,000,000 500,000,000
- interest 0 50,000,000
EBT 500,000,000 450,000,000
- tax (38%) 190,000,000 171,000,000
EAT 310,000,000 279,000,000
No.of shares outstanding 214,169,725 185,500,000
EPS 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 1999
EBIT 753.3 753.3
Less: Interest (2.20) 50
EBT 755.5 703.3
Less: Tax (38%) 287.09 267.254
EAT 468.41 436.046
# of shares outstanding 185.5 156.83
EPS 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 5,790.4
Market Value of firm(1+2) 6,470.8 6,790.4
(in millions, except per share data)
1998 1999
Market Value of Firm 6,470.8 6,790.4
Price per Share 34.88 43.3
Shares Outstanding 185.5 156.83
Dividends per Share 1.62 1.92
Price per Share = Market Value of Firm/Shares Outstanding
Dividends 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 1999
Sales revenues 1,423.2 1,464.6
COGS 283.5 292.92
Gross Profit 1,139.70 1,171.68
Operating Expense 386.4 395.44
EBIT 753.30 776.24
Interest (Expenses) Income 2.20 (50.00)
PBT 755.50 726.24
Taxes(0.38) 287.09 275.97
Net Income 468.41 450.27
Dividends 300.51 300.00
Retained 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= EBIT
Interest
Interest coverage ratio = 776.24 = 15,52x
50.00
=> 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....

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