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:
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