1.

2. Discuss USTs past financial performance. Is the past performance expected to continue in the
future?
UST Historical Financial Performance
5-year CAGR 10-year CAGR
Net Sales 5% 9%
EBIT6% 11%
EPS 9% 13%5
-year Average 10-year Average
Gross Profit Margin 79.7% 77.3%
Net Margin 32.7%31.3%
ROE 122.8% 89.1%
Dividend Pay-out 61.6%57.8%
The historical financial data indicates that that compound annual growth per year has been
declining in the past five year compared with the past ten years in Net Sales, EBIT, and EPS.
Obviously, this is a sign of UST slowing down its financial performance due to factors such as an
increase in competitors, less consumer demand, etc... Nevertheless, it is comforting that within
the past five years, the operating data is generally not moving backwards and is still growing (at
a much slower rate). When analysing the 5-year and 10-year averages, the data indicates that
UST financials are still steady and increasing. Exhibit 2 suggests that the market share of UST has
been slowly decreasing over the past 7-years.Due to the fact that there has been increased
competition in the premium smokeless tobacco market, UST is losing market share with
products in its core operations. Furthermore, the price value products in the industry are
showing a dramatic increase in market share, yet UST only shows a 0.6% market share in 1998
(late mover). For these reasons, UST needs to focus their efforts on attracting the growing
demand with the price value smokeless tobacco products in order to strengthen their long-term
financial performance. Thus, because of the increased competition in the smokeless tobacco
industry, UST has to constantly look for innovative ways in order for them to be a driving force in
the smokeless tobacco industry.
3. Compare USTs financial performance and capital structure to other tobacco firms.
Exhibit TN-3 Summary Financial Information for UST and other Tobacco Companies
UST Phillip Morris North Atlantic RJR Nabisco Dimon Standard Commercial Universal Median
(exUST)
Gross Profit Margin (%)80.141.765.446.212.39.714.328
NetMargin (%)32.910.31.13.52.41.83.02.7
ROE (%)103.449.3NM8.412.522.525.622.5
ROA (%)53.813.20.42.42.73.46.53.1
Debt/Book Cap (%)17.647.590.054.471.972.359.465.7
Debt/Market Cap (%)
1.510.1NA52.168.370.439.248.0
EBITDA/Interest coverage(x)105.612.71.63.73.35.44.44.1
Corporate Credit rating AB+BBB-BB+BB-A-NMUSTs margins were far superior to all of its
competitors; its growth margin was 2.9x the industry median and its net margin was12x the
median. USTs ROE was an astonishing 103.4% and its ROA is equally impressive at 53.8%
compared to a 3.1% median. Its debt/book capitalization and debt/market capitalization is 3.7x
and 32xlower than the median respectively. Its interest coverage of 105.6 xs is 25 xs more than
the industry median.

4. Should UST undertake the $1 billion recapitalization? (a)Prepare a pro-forma

(1999) income statements to evaluate USTs ability to make interest payments.
Exhibit TN-4: Income Statement Projections Actual 1998
Pro-forma 1999 (I) Pro-forma 1999 (II) Pro-forma 1999 (III) Pro- forma 1999 (IV)
Sales1423.21494.361494.361494.361494.365%
Annual Growth EBIT753.3792.01792.01792.01792.0153% of sales
Interest Expense-2.2070.578.287Pre-tax
Earnings 755.5790.52721.51713.81705.01
Taxes287.6300.40274.17271.25267.9038%
Tax rate Net
Income 467.9490.12447.34442.56437.11
Net debt00100010001000
Interest Rate--0.07050.07820.087
Interest Coverage--11.210.139.10
EBIT/Interest Expense Debt RatingABBBBB When examining USTs ability to make
interest payments, it is
Important to focus on the interest coverage ratio under each of the different pro-forma
scenarios. The interest coverage ratio illustrates the ability of the company (in this case,
UST) to make interest payments on the outstanding debt. As the interest coverage ratio
approaches 1, the ability of the company to make these interest payments becomes
problematic. From a bondholders perspective, the bondholder wants to be sure that the
company is always able to make the interest payments. For UST, in this case, as the debt
rating of UST decreases from a bond rating of A (Scenario II) to a debt rating of BB
(Scenario II), the interest coverage ratio is decreasing. However, from the bondholders
perspective, the decrease does not warrant a cause for alarm just yet. The 9.10 coverage
ratio is still a quality measure, and shows that UST is able to meet the Demand for the
interest payments as of the current projection.
5. Calculate the valuation impact of the recapitalization plan by estimating the value of
the interest tax shields, assuming a corporate tax rate of 38%. What other factors,
beyond the corporate interest tax shields, should UST consider in assessing.
The valuation impact of the plan?
Exhibit TN-5: Valuation Model Status Quo$1 Billion Recap Plan PV Tax Shields
(tD)0.00380.00 38%*$1000Value of UST (S = Vu)6,469.006,849.00 $380 + 6469Net
Debt0.001,000.00
Stock Price34.88 36.92 6849/185.5
Shares Re purchased n/a 27.08 Shares 185.50158.42Market Equity 6,469.00 6,849.00
Debt/Market
Equity0.000.15 1000/6849There are other factors, beyond the corporate tax shield, that UST
should consider when assessing the impact of the $1 billion dollar recapitalization plan. Some
of these factors include the signal that UST will be sending to investors with this
recapitalization plan. The effect that the recapitalization will have on the value of the firm;
Due to the change of the capital structure. Since the firm will be adding debt, and incurring
tax savings, this will have a positive effect on the stock price (Yes, it is true that the number
of shares will also be decreasing, leading to a higher E.P.S). Another factor that should be
considered is the fact that this recapitalization will have a negative effect on the firms
Liquidity. Since the debt/equity value of the firm will be increasing, the leverage of the firm
is increasing, and consequently the riskiness of the shares of common stock will also be
increasing. It is important for UST to consider these factors as the firm implements and
follows through with the recapitalization.

6.) UST Inc. has paid uninterrupted dividends since 1912. Assess the impact of the plan
on USTs $ dividend and dividend per share, assuming it continues to pay-out 64% of
its earnings as dividends.
Exhibit TN-6: Impact of Recapitalization on Dividends Debt = $1 Billion Actual 1998Proforma 1999 No debt Pro-forma 1999 Rd = 7.82Net Income467.9491442.56 Shares
185.5185.5158.42Earnings per Share2.522.652.79NI/Shares Dividend Pay-out
301.1314.2283.24NI*.64 Dividends per Share 1.621.691.79EPS*.64When assessing the
impact of the plan on the $ dividend and the dividend per share, it is clear that the
recapitalization plan reduces the total dividend pay-out from $314.2 to $283.24; however, the
dividend per share value increases from $1.69 to $1.79. This is caused in part by the reduced
number of shares outstanding as a result of the recapitalization. These assumption are based
on the fact that UST continues its policy of paying out 64% of earnings as dividends. It is
important for UST to continue to uphold this tradition of this dividend pay-out ratio in order
to keep the stockholders happy, and to not signal any negative ideas to the stockholders and
to Wall Street ------------------6. What are the primary business risks associated with UST Inc.? What are the attributes of UST
Inc.? Evaluate from the view point of the bondholder.
Over the years, UST has been a dominant producer in the tobacco industry, specifically the moist
tobacco industry. Event hough the past strategy with UST has entailed raising the prices of its
products on a regular basis, the company still shows signs of positive growth. Additionally, there
have been recent issues with smokeless tobacco products, such as lawsuits. However, there
remains a constant consumer demand for UST products. When evaluating the business risk of a
company, one of the primary drivers of its business risk stems from the price elasticity of its
products. Thus, these are a few reasons that illustrate that the smokeless tobacco industry
(USTs most dominant EBIT contributor) has a relatively steep demand curve and should be
considered as having an inelastic consumer demand. Also, it is important to note that UST
has products outside of its core operations in the wine and premium cigar market. Also, UST has
introduced products in the price value market as consumer demand has increased. Brand name
and market position superior Cash flow generating capacity- superior Cyclicality of revenues
superior Product diversification poor Geographic diversification good Asset tangibility good
Litigation Risk poor obviously, the two most troubling business risks associated with UST are its
litigation and product diversification risks. The smokeless tobacco industry will always face
potential lawsuits because of the ongoing health concerns. Also, even though UST has diversified
into other markets (wine and cigars), these products are very minimally attributing to USTs
EBIT. Nevertheless, UST products have a steady demand for their products, they produce
positive cash flows year-to-year, and the company has a dominant market position and brand
name with regard to their core business. For these reasons, it is determined that UST has a
relatively low business risk.

7. 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).

8. 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 payments.
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.

9. 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....
1. (b) Why is Wall Street concerned about USTs future prospects leading to a neutral rating on
the company?
Wall Street feltthat the companys management was content with its dominant market share
and was being too lax and slow in respondingto smaller competitors particularly in the value
segment of the market. Analysts were also concerned about the softeningsmokeless tobacco
market where unlike cigarette companies lack the option of fighting declining domestic
consumptionwith international growth; UST had no immediate opportunity for expanding
internationally. Finally, the public and politicalsentiment was negative regarding the tobacco
industry.4. Why is UST considering a leveraged recapitalization after such a long history of
conservative debt policy?UST isconsidering a leveraged recapitalization as a mean to enhance
the firms value. First, UST will benefit from the interest taxshield (roughly the increase in debt
multiplied by the corporate tax rate), in addition; this value plus the initial enterprisevalue will
be distributed across a small number of outstanding shares significantly increasing the value of
each share

------------------------------------------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 selfconfident 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 payments.
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....

---------------------------------------------

Fin 401Ryan Pratt

Questions for UST
1.UST has a long history of conservative debt policy. Briefly describe why UST is
considering a recapitalization that involves issuing debt and repurchasing equity.
UST is one of the most profitable companies in corporate America, and so they want to
recapitalize in order to maintain capital within the b siness, as shown on the payoff!"al e
#raph for debt holders and e$ ity holders% UST sed to be concerned abo t defa lt ris&
and so they maintained a constant conser"ati"e capital str ct re% The primary p rpose of
UST iss in# debt is to obtain a ta' shield% They are a lar#e company with a h #e mar&et
share and hi#h earnin#s, and so this ta' shield wo ld be "ery lar#e% As UST is in the tobacco
ind stry, which is hi#hly "olatile with restricti"e le#islation c rrently bein# enacted% UST
wo ld li&e the ta' shield to act as a b ffer% They can do this beca se they are not as of yet
hi#hly le"era#ed% They wo ld be able to obtain the prime interest rate on any debt they
iss e ri#ht now, so it is best that they iss e debt before any potential financial distress
comes alon# in the "olatile ind stry% A#ain, UST has "ery low le"era#e, (1)%*+
debt to boo& capitalization, compared to a #ro p median of **+- so they can afford to
ta&e on $ ite a bit more% .owe"er, after r nnin# e'tensi"e analysis, UST/s iss e of 1
illion in debt does seem a bit e'cessi"e% To ill strate this, UST/s debt to boo&
capitalization chan#es after the rep rchase from 1)%*+ to 123% *+% 5n s mmary, we
a#ree that ta&in# on debt at this time is the correct mo"e to ma&e, b t we feel the amo nt
of debt is e'cessi"e and co ld possibly h rt UST/s credit ratin#s%
2. escribe the pros and cons of the recapitalization fro! the perspective of the tradeoff
theory of capital structure. "hat are the biggest concerns you have#
Tradeoff Theory of 6apital Str ct re7 Ass min# that ta'es and financial distress are added
into the 898 world, the e$ ation for the Tradeoff Theory of 6apital Str ct re is7: ;(P: of ta'
benefits- < (P: of Financial =istress-There are se"eral pros that we see with the
recapitalization, and also se"eral cons% First, the ta' shield that will be #ained from the debt
iss e and stoc& rep rchase will increase the "al e of

----------------------------------------------------------------------

FIN 5204Managing Corporate Capital Investment and Capital StructureDebt 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 the bondholder.
Over the years, UST has been a dominant producer in the tobacco industry, specifically the
moist tobacco industry. Even
though the past strategy with UST has entailed raising the prices of its products on a regular
basis, the company still shows
signs of positive growth. Additionally, there have been recent issues with smokeless tobacco
products, such as lawsuits.
However, there remains a constant consumer demand for UST products. When evaluating the
business risk of a company,
one of the primary drivers of its business risk stems from the price elasticity of its products.
Thus, these are a few reasons

that illustrate that the smokeless tobacco industry (USTs most dominant EBIT contributor)
has a relatively steep demand
curve and should be considered as having an inelastic consumer demand. Also, it is important
to note that UST has
products outside of its core operations in the wine and premium cigar market. Also, UST has
introduced products in the
price value market as consumer demand has increased.
Brand name and market position - superiorCash flow generating capacity- superiorCyclicality
of revenues - superiorProduct
diversification - poorGeographic diversification - goodAsset tangibility - goodLitigation Risk
poorObviously, the two
most troubling business risks associated with UST are its litigation and product
diversification risks. The smokeless
tobacco industry will always face potential lawsuits because of the ongoing health concerns.
Also, even though UST has
diversified into other markets (wine and cigars), these products are very minimally attributing
to USTs EBIT.
Nevertheless, UST products have a steady demand for their products, they produce positive
cash flows year-to-year, and the
company has a dominant market position and brand name with regard to their core business.
For these reasons, it is
determined that UST has a relatively low business risk.
2. Discuss USTs past financial performance. Is the past performance expected to
continue in the future?UST Historical
Financial Performance5-year CAGR 10-year CAGRNet Sales 5% 9%EBIT
6% 11%EPS 9% 13%5-year Average 10year AverageGross Profit Margin 79.7% 77.3%Net Margin 32.7%
31.3%ROE 122.8% 89.1%Dividend Payout 61.6%
57.8%The historical financial data indicates that that compound annual growth per year has
been declining in the past five
year compared with the past ten years in Net Sales, EBIT, and EPS. Obviously, this is a sign
of UST slowing down its
financial performance due to factors such as an increase in competitors, less consumer
demand, etc... Nevertheless, it is
comforting that within the past five years, the operating data is generally not moving
backwards and is still growing (at a
much slower rate). When analyzing the 5-year and 10-year averages, the data indicates that
UST financials are still steady
and increasing.
Exhibit 2 suggests that the market share of UST has been slowly decreasing over the past 7years.
Due to the fact that there has been increased competition in the premium smokeless tobacco
market, UST is losing market
share with products in its core operations. Furthermore, the price value products in the
industry are showing a dramatic
increase in market share, yet UST only shows a 0.6% market share in 1998 (late mover). For
these reasons, UST needs to
focus their efforts on attracting the growing demand with the price value smokeless tobacco
products in order to strengthen

their long-term financial performance. Thus, because of the increased competition in the
smokeless tobacco industry, UST
has to constantly look for innovative ways in order for them to be a driving force in the
smokeless tobacco industry.
3. (a) Compare USTs financial performance and capital structure to other tobacco
firms.
Exhibit TN-3 Summary Financial Information for UST and other Tobacco
CompaniesUSTPhillip MorrisNorth AtlanticRJR
NabiscoDimonStandard CommercialUniversalMedian (exUST)Gross Profit Margin
(%)80.141.765.446.212.39.714.328Net
Margin (%)32.910.31.13.52.41.83.02.7ROE (%)103.449.3NM8.412.522.525.622.5ROA
(%)53.813.20.42.42.73.46.53.1Debt/Book Cap
(%)17.647.590.054.471.972.359.465.7Debt/Market Cap
(%)
1.510.1NA52.168.370.439.248.0EBITDA/Interest
coverage(x)105.612.71.63.73.35.44.44.1Corporate Credit
ratingAB+BBB-BB+BB-A-NMUSTs margins were far superior to all of its competitors; its
growth margin was 2.9x the
industry median and its net margin was12x the median. USTs ROE was an astonishing
103.4% and its ROA is equally
impressive at 53.8% compared to a 3.1% median. Its debt/book capitalization and
debt/market capitalization is 3.7x and 32x
lower than the median respectively. Its interest coverage of 105.6 xs is 25 xs more than the
industry median.
(b) Why is Wall Street concerned about USTs future prospects leading to a neutral
rating on the company?
Wall Street felt
that the companys management was content with its dominant market share and was being
too lax and slow in responding
to smaller competitors particularly in the value segment of the market. Analysts were also
concerned about the softening
smokeless tobacco market where unlike cigarette companies lack the option of fighting
declining domestic consumption
with international growth; UST had no immediate opportunity for expanding internationally.
Finally, the public and political
sentiment was negative regarding the tobacco industry.
4. Why is UST considering a leveraged recapitalization after such a long history of
conservative debt policy?
UST is
considering a leveraged recapitalization as a mean to enhance the firms value. First, UST
will benefit from the interest tax
shield (roughly the increase in debt multiplied by the corporate tax rate), in addition; this
value plus the initial enterprise
value will be distributed across a small number of outstanding shares significantly increasing
the value of each share.
Moreover, servicing this debt should not add any extra risk of financial distress due to the
highly cash generative nature of
USTs business plus the predictability of their future cash flows with a high level of
confidence.

Second, this debt will help discipline managers from investing in projects that earn returns
below the firms cost of capital
where UST have historically performed poorly. USTs investment in non-core operations of
its wine business and cigars
business generated operating profit margins of 14.9% and 5.9% respectively compared to its
tobacco operating profit
margin of 57.9%. By adding interest payment obligations into the framework excess cash will
be better utilized instead of
being invested into underperforming operations and projects.
5.) Should UST undertake the $1 billion recapitalization?(a)Prepare a pro-forma (1999)
income statements to evaluate USTs ability to make interest payments.
Exhibit TN-4: Income Statement ProjectionsActual 1998Pro-forma 1999 (I)Pro-forma 1999
(II)Pro-forma 1999 (III)Proforma 1999 (IV)Sales1423.21494.361494.361494.361494.365% Annual
GrowthEBIT753.3792.01792.01792.01792.0153%
of salesInterest Expense-2.2070.578.287Pre-tax
earnings755.5790.52721.51713.81705.01Taxes287.6300.40274.17271.25267.9038% tax
rateNet
Income467.9490.12447.34442.56437.11Net debt00100010001000Interest Rate-0.07050.07820.087Interest Coverage-11.210.139.10EBIT/Interest ExpenseDebt Rating--ABBBBBWhen examining USTs ability
to make interest payments, it is
important to focus on the interest coverage ratio under each of the different pro-forma
scenarios. The interest coverage ratio
illustrates the ability of the company (in this case, UST) to make interest payments on the
outstanding debt. As the interest
coverage ratio approaches 1, the ability of the company to make these interest payments
becomes problematic. From a
bondholders perspective, the bondholder wants to be sure that the company is always able to
make the interest payments.
For UST, in this case, as the debt rating of UST decreases from a bond rating of A (Scenario
II) to a debt rating of BB
(Scenario II), the interest coverage ratio is decreasing. However, from the bondholders
perspective, the decrease does not
warrant a cause for alarm just yet. The 9.10 coverage ratio is still a quality measure, and
shows that UST is able to meet the
demand for the interest payments as of the current projection.
(b) Calculate the valuation impact of the recapitalization plan by estimating the value of the
interest tax shields, assuming a corporate tax rate of 38%. What other factors, beyond the
corporate interest tax shields, should UST consider in assessing
the valuation impact of the plan?
Exhibit TN-5: Valuation ModelStatus Quo$1 Billion Recap PlanPV Tax Shields
(tD)0.00380.00 38%*$1000Value of UST (S = Vu)6,469.006,849.00 $380 + 6469Net
Debt0.001,000.00Stock
Price34.8836.92 6849/185.5Shares Repurchasedn/a27.08Shares 185.50158.42Market
Equity6,469.006,849.00Debt/Market
Equity0.000.15 1000/6849There are other factors, beyond the corporate tax shield, that UST
should consider when
assessing the impact of the $1 billion dollar recapitalization plan. Some of these factors
include the signal that UST will be

sending to investors with this recapitalization plan. The effect that the recapitalization will
have on the value of the firm;
due to the change of the capital structure. Since the firm will be adding debt, and incurring
tax savings, this will have a
positive effect on the stock price (Yes, it is true that the number of shares will also be
decreasing, leading to a higher E.P.S).
Another factor that should be considered is the fact that this recapitalization will have a
negative effect on the firms
liquidity. Since the debt/equity value of the firm will be increasing, the leverage of the firm is
increasing, and consequently
the riskiness of the shares of common stock will also be increasing. It is important for UST to
consider these factors as the firm implements and follows through with the recapitalization.
6.) UST Inc. has paid uninterrupted dividends since 1912. Assess the impact of the plan
on USTs $ dividend and dividend per share, assuming it continues to pay-out 64% of
its earnings as dividends.
Exhibit TN-6: Impact of Recapitalization on Dividends Debt = $1 Billion Actual 1998Proforma 1999 No debt Pro-forma 1999 Rd = 7.82Net Income467.9491442.56 Shares
185.5185.5158.42Earnings per Share2.522.652.79NI/Shares Dividend Pay-out
301.1314.2283.24NI*.64 Dividends per Share 1.621.691.79EPS*.64When assessing the
impact of the plan on the $ dividend and the dividend per share, it is clear that the
recapitalization plan reduces the total dividend pay-out from $314.2 to $283.24; however, the
dividend per share value increases from $1.69 to $1.79. This is caused in part by the reduced
number of shares outstanding as a result of the recapitalization. These assumption are based
on the fact that UST continues its policy of paying out 64% of earnings as dividends. It is
important for UST to continue to uphold this tradition of this dividend pay-out ratio in order
to keep the stockholders happy, and to not signal any negative ideas to the stockholders and
to Wall Street