Fin 401

Ryan 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 business, as shown on the payoff/value graph
for debt holders and equity holders. UST used to be concerned about default risk and so they
maintained a constant conservative capital structure. The primary purpose of UST issuing debt
is to obtain a tax shield. They are a large company with a huge market share and high earnings,
and so this tax shield would be very large.
As UST is in the tobacco industry, which is highly volatile with restrictive legislation
currently being enacted. UST would like the tax shield to act as a buffer. They can do this
because they are not as of yet highly leveraged. They would be able to obtain the prime interest
rate on any debt they issue right now, so it is best that they issue debt before any potential
financial distress comes along in the volatile industry. Again, UST has very low leverage,
(17.6% debt-to-book capitalization, compared to a group median of 66%) so they can afford to
take on quite a bit more.
However, after running extensive analysis, USTs issue of $1 Billion in debt does seem a bit
excessive. To illustrate this, USTs debt-to-book capitalization changes after the repurchase
from 17.6% to 193.56%. In summary, we agree that taking on debt at this time is the correct
move to make, but we feel the amount of debt is excessive and could possibly hurt USTs credit
ratings.
2. Describe the pros and cons of the recapitalization from the perspective of the tradeoff
theory of capital structure. What are the biggest concerns you have?
Tradeoff Theory of Capital Structure: Assuming that taxes and financial distress are added into
the M&M world, the equation for the Tradeoff Theory of Capital Structure is:
Vu+(PV of tax benefits) (PV of Financial Distress)
There are several pros that we see with the recapitalization, and also several cons. First, the
tax shield that will be gained from the debt issue and stock repurchase will increase the value of

the firm (overall). There is a tax benefit to UST of $400 Million. Also, the value of USTs
stock price will increase with the repurchase, both due to positive investor speculation and the
fact that there will be less shares in the market, trading at a higher price due to the addition of
the tax shield. Lastly, the value of the firm, the whole pie will increase.
Moving on to the concerns which our financial analysis has revealed, the biggest potential
problem which we see with the debt recapitalization is that the amount of debt being issued is
enormous and may pose a potential increase to default risk, and subsequently to credit ratings
for UST. The debt-to-book capitalization (as stated above) goes from 17.6% to 193.6%
concurrent with the restructure. According to the key industrial financial ratios, a total debt-tocapital ratio above 79% is located within the CCC Non-investment Grade/Speculative rating.
This could drop USTs overall credit rating.
There are also additional concerns UST should take into consideration that may or may not
be directly related to the stock repurchase and debt issuance. First, foreign expansion for UST is
not an option. Second, UST cannot diversify into other sectors. Their main product is moist,
smokeless tobacco, and that is where they capture the main part of their market share. Lastly,
there is expected to be a continuous growth rate of possible litigation issues in the tobacco
industry and UST may soon be facing financial distress due to these problems.
3. Should UST undertake the $1 billion recapitalization? Calculate the effect on USTs stock
price assuming that the entire recapitalization is done immediately (i.e., January 1, 1999). To
simplify things, assume that the recapitalization will have no significant impact on the
probability of financial distress.
Yes. UST should undertake the $1 Billion recapitalization, assuming that the recapitalization
will have no significant impact on the probability of financial distress, or default risk/credit ratings.
The recapitalization will have a positive impact on UST stock prices. The gain-per-share from the
$400 Million tax shield will be $2.55. Thus, the old stock price of $34.88 will become $37.43. The
assumptions we are using are the following: There will be no financial distress from this decision to
recapitalize, we are using a 40% tax rate (as stated in the case), banks are willing to loan $1 Billion
to UST. Two additional assumptions that are important to mention that were used in our financial
analysis on the spreadsheets is that the 10-year bond rate was used as the interest rate and we kept
the dividend payout ratio the same.

4. Is the assumption that the recapitalization will not impact the probability of financial
distress a good one? Why or why not?
No, it is not a good assumption to use in this case. USTs total assets are only $913 Million,
and they are planning on issuing $1 Billion in debt that is going straight to shareholders. Under
normal circumstances, this would greatly affect the probability of financial distress for the firm, and
would probably shift their credit rating downward. Their debt-to-assets ratio went from 10.9% to
120%. This is not good for UST when comparing with other firms in the industry.
There are several major costs of debt restructuring. First, legal fees would potentially be a
problem for UST with an increase in leverage, with the possibility of default on the $1 Billion loan
principal later on down the road. Second, a decrease in sales is not a huge issue, as they have no
warranty or other customer-reliant services associated with their products. Third, suppliers should
not be affected by this probability of financial distress. Fourth, debt overhang could be a problem
as stockholders will be less likely in invest their money when they know that a major portion of any
profits would be going directly to debt-holders. If there is a large chance of principal default, the
stockholders may get nothing from that investment.
In summary, our main concern is not whether or not they will be able to pay their interest
expenses. Their EBIT interest coverage is 12.23 even with the debt restructuring. This implies that
they are still well within their means to make payments. The main concern we have with UST is
that they may be unable to repay the principal payments years down the road, due to their extreme
debt-to-assets ratio. A potential way to solve this problem is to decrease dividend payments (which
may not be feasible as it may upset stockholders) to help refund principal payments on the loan. By
decreasing the dividend payout ratio, retained earnings will increase dramatically, decreasing the
debt-to-asset ratio.
5. Evaluate the merits of the recapitalization in the framework of the pecking order theory of
capital structure. Evaluate its merits in the framework of the agency theory of capital
structure.
First, UST is following the framework of the pecking order theory as they go through a
recapitalization process. The pecking order states that when a company needs financing, it will look
to the most ready, easily attainable, and least costly forms of financing. Since UST only has $33
million dollars in cash on hand (which has most likely come from retained earnings), cash on hand
is not a sufficient source for USTs $1 Billion recapitalization. USTs dividend payout ratio is 64%,
only 36% of net income is being retained within the business. Because the objective of the

recapitalization is to reduce equity and increase debt for tax shield reasons, financing through the
means of debt is the most logical way of financing. Debt financing after internal financing is also
the next step on the pecking order theory. Thus, UST is following the pecking order theory as it
goes through its process of recapitalization.
The agency theory also is very applicable to the UST case. The agency theory answers the
question, Is the manager using the stockholders money better than the way the stockholders could
handle the money for themselves? By repurchasing more of the shares outstanding, UST will be
increasing shareholder value for the remaining shareholders due to the tax shield. Additionally the
shareholder value will increase due to an increase that typically occurs after a repurchase because
the manager is implying that the stock is undervalued. This shows that UST is confident that they
can be more efficient with the stockholders money than the shareholders could on their own.