Debt Policy At Ust

Debt Policy at UST Inc.

1. What are the primary business risks associated with UST Inc.? What are the attributes of UST Inc.?

Evaluate from the viewpoint of a bondholder. (Your answer should be more qualitative than

quantitative!)

The following factors weave into the risks and attributes of the company from the creditors’

point of view:

A. UST had seven pending health related lawsuits at the end of 1998. The outcomes of

these suits are uncertain. Despite the major Medicaid state settlements, lawmakers

are expected to continue to push for new laws to combat youth tobacco use. Other

litigation against tobacco companies is expected to continue, especially suits filed by

individuals. This uncertain litigation and legislative environment makes the future

cash flows of UST risky

B. UST is a dominant player and market leader and its strategy is to combat entrants by

launching similar products, rather than cutting prices. But the recent market erosion

by small companies has raised concerns. And UST’s “counter attack” has not been

effective in competing against price-value brands. The resignation of his CFO and

President of tobacco unit further raise the uncertainty of the company’s efficiency of

solving the market erosion problem.

C. The previous uncertainty is enhanced by a lawsuit that alleged that UST had violated

antitrust and advertising laws and participated in anti-competitive conduct. Should

UST lost the suite, it will be more vulnerable with competitors.

D. Although the current scientific research that ties tobacco to cancer is not conclusive,

it’s uncertain that future research result will jeopardize the tobacco industry.

E. There is a chance of a cultural shift against tobacco, and UST is unlikely to expand

to international market.

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

debt policy? (Your answer should be more qualitative than quantitative!)

A. UST wants to increase the firm value by enjoying the huge tax shield provided by

more leverage. Previously, they were too concerned about the default risk thus

adopting a conservative capital structure strategy. Now they want to be more

aggressively levered since the chance of bankruptcy is rather low.

B. Presumably, the company managers are also shareholders. The recapitalization helps

to decrease the total shares outstanding, thus increases the relative percentage owning

of the remaining shareholders. Consequently, the insiders will have more weights on

the voting of the major policies of the company. Since the value players form a major

competing force with UST, in the foreseeable future, UST might choose to lower the

price of its products. But his is not in the favor of the stockholders who are looking

for short-term income as opposed to long term capital gain. In order for such

decisions to pass, the management team has to upgrade their own weights by buying

back some of the outstanding stocks through issuing debt.

C. UST wants to signal to shareholders that it still commits to provide generous

dividend returns. By issuing more debt and repurchasing stock shares, UST can increase

the upfront stock dividend paid to shareholders (Note that whether UST can maintain its

dividend policy is the issue discussed in question 4). Although this will not affect the

decision of rational investor because by increasing its leverage the investment is also

riskier, the higher dividend will appeal to irrational investors and quick cash seekers.

3. Should UST Inc. undertake the $1 billion recapitalization? Calculate the marginal (or incremental)

effect on UST's value, assuming that the entire recapitalization is implemented immediately

(January 1, 1999). (Your answer should rely on quantitative analysis supported by an explanation.)

(a)Assume a 38% tax rate.

(b)Prepare a pro-forma income statement to analyze whether UST will be able to make interest payments.

(c)For the basic analysis, assume the $1 billion in new debt is constant and perpetual.

UST should undertake the $1 billion recapitalization.

The marginal effect on UST’s value of implementing the recapitalization, assuming

that the plan is implemented immediately on January 1, 1999, is equal to the sum of

the tax shield minus the present value of financial distress.

VL = VU + Tax Shield вЂ" Expected Bankruptcy Cost

Ð" VL = VU + tD - PV (Financial Distress)

Ð" VL = VU + tD - (probability of bankruptcy * cost of bankruptcy)

Ð" VL = VU + tD - (probability of bankruptcy * (g * VU))

Where g is some constant that is usually valued between 5% and 30%

Therefore, the marginal

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