Beidi GU & Minhua ZHANG

Ec. 1745: Corporate Finance

March 18, 2003
Prof. La Porta

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 USTs 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 companys 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,
its 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 USTs 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 Expected Bankruptcy Cost
VL = VU + D - PV (Financial Distress)
VL = VU + D - (probability of bankruptcy * cost of bankruptcy)
VL = VU + D - (probability of bankruptcy * ( * VU))

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

Therefore, the marginal effect is:

? VL = D - (probability of bankruptcy * ( * VU))
= (0.38)($1billion) - (0.0028)(0.30)($6.5billion)
= $0.375 billion
Notes:
(1) The probability of bankruptcy is inferred using an AAA credit rating (from lecture
notes). See spreadsheet, row EBIT interest coverage ratio. The ratio after
recapitalization falls into the AAA rank which has a ratio of 12.9.
(2) , or the constant fraction of VU that we lose in event of bankruptcy, is given a
conservative estimate of 0.30 for conservative reasons.
(3) VU, or the value of the unlevered firm, is obtained by summing USTs market
capitalization ($6.4billion) and long-term debt ($0.1billion) in 1998. Although the
firm is technically levered (D/V = 1.5%) at this point, we can regard it as unlevered
(relative to post-recaptalization) for the purposes of simplicity.

Please see the attached spreadsheet for pro-forma income statement. Since the EBIT
stays much higher than the interest payment, the company should have no problem
to cover the interest. (In fact, the EBIT Interest Coverage Ratio is above 12.9x, thus
putting the firm rating at AAA)
4.

UST Inc. has paid uninterrupted dividends since 1912. Will the recapitalization hamper future
dividend payments? (Your answer should rely on quantitative analysis supported by an
explanation.)

Recapitalization will not hamper dividend payments in the near future. But the effect
is uncertain in the long run.
Refer to attached spreadsheet. The row titled Basic Earning per Share stays higher
than the projected Dividend per Share the company can always afford to pay the
dividend.
However, in order to maintain the dividend stream, the company in 10 years has to
face a 83% payout ratio even before the recapitalization. Assume the UST takes the
recapitalization, the payout ratio is going to rise to 90%, which will significantly
undercut the reinvestment in R&D since R&D is usually the first victim of budget cut
in a company. Given the increasingly competitive value sector of the market, a
weakened R&D will dramatically hamper USTs ability to maintain the market share,
hence the net sales.
Second, with the possible passage of the anti-trust law, the threshold of companies
entering the tobacco market gets lowered. Market prospect for UST is not positive
given the fierce competition evolved with guerrilla tactics from small companies.
Third, litigation cost on health issues as well as anti-trust law suite will inflict UST
heavier (near) bankruptcy cost and brings UST closer to the fringe of bankruptcy.
Finally, the grip of power by the managers due to the increase weigh in the voting
power from diminishing total market share number might lead to serious agency cost
as UST had traditionally be unsuccessful in non-core operation investments.
In conclusion, even though UST will be able to cover both the interest and dividend
in the near future, the long run effect of the 1 billion recapitalization is uncertain. A
cautious measure is recommended.