Debt Policy at Ust Inc.

Executive Summary Holding nearly 80% of the grocery store tract in the smokeless tobacco industry, UST Inc. has been generating large and stable income. However, the leading social club in a certain industry tends to react s firstly to mart donation corroding by competing secures and lack of creativity in the introduction of new product, a situation UST Inc. is now undergoing. Concerning the declining sales growth and gradual loss of the merchandise sh atomic number 18, UST Inc. is now pick outing recapitalizing by issuing debt amounts to $1 billion.By recapitalizing, it can create a total $380 one thousand thousand interest tax shield to add up firm hold dear and, at the same time, string shareholders better clear up by using the proceeds from the issuance of debt to buyback outstanding shares. Although declining sales growth and judicial proceeding problem might be hidden repairs for UST Inc. , after many analysis about the attributes of the familiarity such as busin ess risk, capital expression as well as have a bun in the ovenout policy, I still believe that UST Inc. s heading toward the right direction. And we can also observe that, after the adjustment of capital structure, its handed-down dividend payout policy entrust not be hampered in the near future. Analysis of Business Risks (from bondholders viewpoint) Bondholders only care about the ability of the company to take a leak interest payments and whether they can get the guinea pig value when the bond matures. Therefore, we collapse to consider the factors that contribute to the amount and stability of future EBIT.In the situation of UST, several factors have more of an impact on the companys business risk, such as sales growth, competition faced owing to other competitors erosion into their grocery share and the effect of judicial proceeding problem and government regulations. Since the smokeless tobacco are considered less harmful to health and increased prevalence of smoking bans, expect of smokeless tobacco has undergone a continued growth, which would contribute good prospect to UST since its products strategy focus primarily on smokeless tobacco.However, as a possessive player in the industry, UST seems to be less creative on the introduction of new product and react too s gloomyly to other competitors erosion into their market share. So far, UST has been increasing the price of their product as a way to boost their annual earning, which gives other players a perfect chance to gain some market share by using price value strategy. Despite the steady decline of market share might turn into future concern for UST, it still holds 77% of the market share. Besides, UST has started to make effort in new product development and renew their marketing and promotion strategy.On the other hand, although litigation and mandate problems have impacts on sales of UST, these problems has been there for a persistent time, which means that it shouldnt create new tu rbulence on the prospect of UST. To conclude, the attributes of UST are steadily growing EBIT(approximately 9% compounded), dominant market share in the industry. Therefore, although there are some disadvantages toward their future earning power, such as increasing competition and litigation problems, bondholders shouldnt care too much on them since the interest expense is still a minor portion of the total EBIT.The Timing of Recapitalization It is publicly cognize that, through leverage, companies can lower their WACC and receive benefit from interest tax shield in order to boost their firm value. This is exactly what UST Inc. is doing right now. By issuing debt and use the fund to buy back outstanding shares, it is boosting their production line price higher(prenominal). I reckon that the reason they choose to do so at this specific time is because the company has been facing more and more vigorous competition these years and undergoing declining rate of sales growth.By adoptin g leverage recapitalization, UST can still make the stockholder better off even its sales growth is not high enough. Besides, USTs debt to asset ratio is currently at a low level compare to other competitors in the industry. Therefore, they can adopt the recapitalization strategy without worrying too much about the default risk problem. Capital complex body part after the Recapitalization From the pro forma income statement (exhibit 1) in the appendix, we can see that even if the bond is issued at a rating of BBB (higher cost of debt), the EBIT/interest coverage ratio is still 10. 21, which shows that UST as sufficient amount of EBIT to make the interest payments. And the adjustmental effect on USTs firm value would be the total debt ($1 billion) multiplied by the corporate tax rate (38%), which is $380 million. Dividend Payout Policy From Exhibit 2, we can observe that, under current condition, the payout ratio is around 63%, which is the division UST has long been paying out i n the past. Therefore, it is safe to draw the conclusion that the recapitalization will not hamper future dividend payment under current condition. However, we are not sure whether the market share and the growth of sales will continue to drop.If they do, it will become more and more difficult for UST to stick to their conventional pleasing payout policy. Likely, we are not sure whether the litigation problem will be more of a concern for UST in the future. Ultimately, despite the fact that the opponents erosion into USTs market share and litigation problem are both hidden concerns, it takes time for both problems to pose a threat to USTs tralatitious payout policy. Appendix Exhibit 1 Pro Forma Income Statement Exhibit 2 Dividend Calculation after the Buyback Program Corporate Finance Case ponder Assignment Debt Policy at UST Inc.Debt Policy at Ust Inc.Executive Summary As the leading producer in the moist smokeless tobacco industry, UST Inc. has long been recognized by its abil ity to generate high profit using low financial leverage. With a dominant market share of 77%, the company maintains a pricing power that allows it to institute annual price increases without losing costumers. However, USTs market share was eroded significantly in recent years by price-value competitors who enter the market with lower prices. Although UST responded to these threat by introducing new products, market share still decreased by 1. 6% over past 7 years.In addition, UST is also exposed to an unfavorable legislative environment, in which the company is under advertising and product promotion restrictions. The increasing business risks force perplexity of UST to consider a recapitalization plan in which UST borrows up to $1 billion to repurchase its stocks. The marginal effect of the recapitalization will be a $380 million increase in firm value, which is the present value of interest tax shield. Besides the recapitalization benefit, management also needs to notice the cos t of recapitalization, which include higher bankruptcy costs and a potential of lower credit rating.UST has a high and constant dividend payout history since 1912. The recapitalization will expose more risks to shareholders since revenues will be used to pay interest before pay dividends. Thus, the recapitalization may hamper future dividend payments. Background Having long been the leading company in the moist smokeless tobacco industry, UST Inc. was noted for its product innovation, dominate market share, and pricing adjusting power. However, as the competition of the moist smokeless tobacco industry became more intense and the legislative environment became more unfavorable, UST is facing several business risks . Lose of market share. Relying on its superior products and innovation ability, UST used to control most of the moist smokeless tobacco market and was able to increase the price of its products year by year without losing its customers. The historical pricing flexibility gave UST a robust earning performance and bumped up its stock prices. However, as the speed of product innovation became slower, UST is facing the threat of price-value competitors, who enter the market by charging a lower price. Although later UTS responded to the threat by introducing new products, the companys market share still dropped from 86. % in 1991 to 77. 2% in 1998. 2. Increase exposure to legislative environment. Moist smokeless tobacco manufactures used to face fewer lawsuits than cigarette manufactures due to less scientific evidence liking smokeless tobacco to cancer. However, the legislative environment has become more unfavorable to smokeless tobacco manufactures since the industry has agreed on a ban on advertising in order to settle state Medicaid lawsuit. Also, UST was the only main manufacturer that signed an agreement on promotion restrictions that aim to reduce youth exposure.Recapitalization UST has been widely known for its conservative debt policy, which a llows the company to generate high returns with very low financial leverage. However, as business risks such as market share erosion and unfavorable legislation exposure increase, UST has an incentive to agitate its capital structure in order to benefit from interest tax shield and increase the firm value. Recapitalization will also benefit shareholders in a way of higher company stock price since the proceeds from debt will be used to repurchase outstanding stocks.Also, although UST has a very high gross profit margin and return on assets on its core business compared to other smokeless tobacco manufactures, the poor performance of its non-core operations such as market wine-coloured and premium cigars give UST a low to zero profit contribution. USTs management needs to diversify its product line and bump up earnings by investing more in the non-core operations using debt funds. Marginal Effect of Recapitalization To analysis if UST should undertake the $1 million recapitalizat ion, management needs to manoeuvre the value of the firm before and after ecapitalization. In a market with taxation, the value of the levered firm equals to the value of the unlevered firm plus the present value of interest tax shield. Because management assumes that the new debt is constant and perpetual, the present value of interest tax shield equals to the amount of debt multiplied by the effective tax rate, which is 38%. Thus, the present value of USTs future tax saving should be 38% * $ 1 billion, which is $380 million. At the end of 1998, the market equity of UST was $6,470. 8 million based on the average shares outstanding and year-end stock price.If UST borrows $1 billion debt immediately, the total value of the levered firm would be $6,470. 8 million unlevered value plus $380 million tax shield, which is $6,850. 8 million. Because firm value will rise to $6,850. 8 million immediately after the recapitalization announcement, original shareholders will amaze the full bene fit of interest tax shield since they are able to sell their stocks at a higher price. The new stock price is compulsive by dividing the value of the levered firm by the number of shares outstanding at the end of 1998.Since there were 185, 516,055 shares outstanding at year end 1998, the new stock price after the announcement of recapitalization would be $6,850. 8 million divided by 185, 516,055, which is $36. 93. Compared to the original stock price of $34. 88, each pre-existing shareholder will benefit $2. 05 from the increase in leverage. If taxation is the only issue that management should take into condition, the marginal effect of raising debt will be increase in company value by $380 million.However, as financial leverage increases, default risk on debt also increases, thus leads to a potential increase in bankruptcy costs. UST has been maintained an A-1 credit for its low debt / capital ratio of 28. 2%, which is a competitive advantage over its competitors who are highly l everaged. If UST decides to increase its leverage ratio, it will cause rating agencies to revalue its capital structure and cash flow generating ability in order to assign an appropriate rating.The potential change in rating will significantly affect USTs cost of capital. Thus, management should balance the tax benefit with the expected cost of bankruptcy to maximize form value. Besides its conservative debt policy, UST was also famous for its stable and constant dividend payout since 1912. The recapitalization may hamper future dividend payments since earnings should be used to pay off debt and interest expense before they are delivered as dividends to stockholders.Because debt is risk-free and debt holders have first claim on a companys asset, levered equity a great deal carries a higher risk premium than unlevered equity to compensate stockholders. The remaining balance of earnings after paying interest may also be retained for operating purpose. Thus, the possibility of an inte rruption of cash dividends payout may occur. Summary In summary, facing the increase business risks of losing market share and exposing to unfavorable legislations, the management of UST Inc. s considering changing the companys capital structure by raising $1 billion debt and accelerating its stock buyback program. The benefit of recapitalization will be an increase in firm value of $380 million and increase in stock price by $2. 05 each share. However, management should also take into consideration the potential increase in bankruptcy costs and changes in credit rating. Last, the constant divided payout may be hampered by recapitalization since earnings need to be used to pay interest to debt holders first.