Debt Policy at UST Inc.

Summary Financial Information for UST ($ Million)

1988 Summary Operarting Data Net Sales Gross Profit EBITDA EBIT Interest Expense (Income) Pretax Earnings Net Income Free Operating Cash Flow Special Charges/Non-Recuring Items (Gains)b Basic Earnings per Share Diluted Earnings per Share Dividend per Share Dividend Payout Ratio
a

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

5-Yr CAGR 5% 6% 6%

$611.90 $673.90 $756.40 $898.40 $1,032.20 $1,097.50 $1,204.00 $1,305.80 $1,371.70 $1,401.70 $1,423.20 437.3 488.4 564.6 670.9 775.4 851.1 952 1043.6 1098.9 1109.8 1139.7 277.9 315 368.6 446.4 525.2 591.4 668.9 736.9 779.2 749.8 785 260.2 298.4 349 423.8 500.8 564.8 640.7 707.8 750.9 719.3 753.3 -1.1 -3.2 -3.2 -2.3 -1.9 -2 0.1 3.2 6.4 7.5 -2.2 261.3 301.6 352.2 426.1 502.6 566.8 640.6 704.6 744.5 703.9 755.5 162.2 190.5 223.3 265.9 312.6 347.9 387.5 429.8 464 443.9 467.9 $135.20 $195.10 $217.80 $247.30 $267.90 $340.70 $399.20 $521.20 $456.40 $287.40 $429.50 ($35.00) $1.49 $1.67 $1.43 $1.63 $0.80 $0.96 54% 58% $8.00 $2.52 $2.50 $1.62 64%

6% 5% $21.00 9% 9% 11%

$0.74 $0.71 $0.37 50%

$0.87 $0.83 $0.46 53%

$1.04 $0.99 $0.55 53%

$1.26 $1.20 $0.66 52%

$1.92 $1.88 $1.12 58%

$2.21 $2.17 $1.30 59%

$2.48 $2.44 $1.48 60%

$2.41 $2.39 $1.62 67%

Summary Financial Information for UST ($ Million)

1988 Balance Sheet and Cash Flow Data Cash and Cash Equivalents Total Assets Long-Term Debt Total Debt Shareholders' Equity Average Basic Shares Outstanding Working Capital Capital Expendituresc Dividends paid Share Repurchases $72.70 $598.00 $21.80 $30.80 $453.30 220.6 $221.10 $20.80 $81.70 $67.40 1989 $54.60 $630.20 $6.80 $14.50 $482.30 219.8 $209.30 $23.70 $101.20 $97.50 1990 $46.60 $622.60 $3.10 $4.80 $473.90 215.2 $197.20 $37.20 $118.30 $151.30 1991 1992 1993 1994 $50.70 $741.20 $125.00 $125.00 $361.70 202 $221.20 $23.70 $225.70 $298.80 1995 $69.40 $784.00 $100.00 $200.00 $292.80 194.4 $144.80 $14.00 $252.40 $274.80 1996 $54.50 $806.60 $100.00 $250.00 $281.20 187.4 $144.00 $36.70 $277.30 $237.80 1997 $6.90 $826.40 $100.00 $110.00 $436.80 183.9 $275.30 $55.80 $298.10 $45.70 1998 $33.20 $913.30 $100.00 $100.00 $468.30 185.5 $309.90 $35.50 $301.10 $151.60

$41.50 $36.40 $25.30 $656.50 $674.00 $706.20 $40.00 $1.30 $40.00 $482.90 $516.60 $463.00 211.6 209.8 208.5 $210.00 $249.00 $228.40 $28.40 $30.10 $54.50 $139.70 $168.00 $199.70 $184.40 $212.60 $236.70

Summary Financial Information for UST ($ Million)

1988 Stock Price Data High Low Year End Price/Earnings Ratiod Market Equitye Selected Growth Rates and Ratios Sales Grow th Net income Grow th Dividend Grow th Gross Profit Margin EBITDA Margin EBIT Margin Net Margin Return on Average Equity Return on Average Assets Long-Term Debt/Capitalization Total Debt/Capitalization 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 5-Yr CAGR

$10.50 $15.38 $18.25 $33.88 $35.38 $32.75 $31.50 $36.00 $35.88 $36.94 $36.88 $6.00 $9.63 $12.38 $16.38 $25.38 $24.38 $23.63 $26.63 $28.25 $25.50 $24.56 $10.25 $15.31 $18.25 $32.75 $32.00 $27.75 $27.88 $33.38 $32.38 $36.94 $34.88 13.9x 17.6x 17.5x 26.0x 21.5x 16.6x 14.5x 15.1x 13.1x 15.3x 13.8x $2,260.60 $3,366.00 $3,926.60 $6,930.00 $6,713.70 $5,785.00 $5,630.60 $6,487.20 $6,066.60 $6,794.00 $6,470.80 7.20% 23.90% 23.30% 71.50% 45.40% 42.50% 26.50% 38.00% 28.30% 4.60% 6.40% 10.10% 17.50% 24.30% 72.50% 46.70% 44.30% 28.30% 40.70% 31.00% 1.40% 2.90% 12.30% 17.20% 19.60% 74.60% 48.70% 46.10% 29.50% 46.70% 35.60% 0.60% 1.00% 18.80% 19.10% 20.00% 74.70% 49.70% 47.20% 29.60% 55.60% 41.60% 0.00% 0.30% 14.90% 17.50% 21.20% 75.10% 50.90% 48.50% 30.30% 62.50% 47.00% 0.00% 0.00% 6.30% 11.30% 20.00% 77.50% 53.90% 51.50% 31.70% 71.00% 50.40% 8.00% 8.00% 9.70% 8.50% 5.00% 2.20% 1.50% 11.40% 10.90% 8.00% -4.30% 5.40% 16.70% 16.10% 13.80% 9.50% 0.00% 79.10% 79.90% 80.10% 79.20% 80.10% 55.60% 56.40% 56.80% 53.50% 55.20% 53.20% 54.20% 54.70% 51.30% 52.90% 32.20% 32.90% 33.80% 31.70% 32.90% 94.00% 131.30% 161.70% 123.70% 103.40% 53.50% 56.40% 58.30% 54.40% 53.80% 25.70% 25.50% 26.20% 18.60% 17.60% 25.70% 40.60% 47.10% 20.10% 17.60%

5%

79.70% 55.50% 53.30% 32.70% 122.80% 55.30% 22.70% 30.20%

Summary Information for UST and Peer Companies

Tobacco Product Manufactures UST Inc. Summary Operating Data a Fiscal Year End 31-Dec-98 Net Sales $1,423.20 Gross Profit 1139.7 b EBITDA 785 EBITb 753.3 Interest Expense (Income) -2.2 Pretax Earnings 755.5 Net Income 467.9 Free Operating Cash Flow $429.50 Special Charges/Non-Recurring Items (Gains)c $21.00 Basic Earnings per Share $2.52 Diluted Earnings per Share $2.50 Dividend per Share (Common) $1.62 Dividend payout Ratio 64% Philip Morris Tobacco Leaf Merchants Universal Corp

North RJR Nabisco Standard Atlantic DiMon Inc. Holdings Commercial Trading Co.

31-Dec-98 $74,391.00 30993 15501 13811 890 12921 7672.4 $6,076.40 $3,834.00 $3.16 $3.14 $1.68 53%

31-Dec-98 $93.10 60.9 36.3 29.1 24.9 4.2 1 $14.50 ($7.09) ($7.09) 0%

31-Dec-98 $20,563.00 9493 3602 2467 880 1455 718 $2,016.00 $2,069.00 $2.22 $2.22 $2.05 92%

30-Jun-98 $2,171.80 266.9 200.2 156.7 83.8 72.9 52 $52.50 $16.90 $1.17 $1.16 $0.66 56%

31-Mar-98 $1,492.80 145 85.8 65.3 37.8 37.1 26.9 ($61.30) $2.18 $2.05 0%

30-Jun-98 $4,287.20 613.6 329.5 278.4 64 231.3 130.4 $110.20 ($16.70) $3.71 $3.68 $1.11 30%

Summary Information for UST and Peer Companies

Tobacco Product Manufactures UST Inc. Balance Sheet and Cash Flow Data Cash and Cash Equivalents Total Assets long-Term Debt Total Debt Preferred Stock & Minority Interest Shareholders' Equity Average Basic Shares Outstanding Workding Capital Capital Expenditures d Stock Price Data Fiscal year End Price/Earnings Ratioe Market Equity f Philip Morris Tobacco Leaf Merchants North RJR Nabisco Standard Universal Atlantic DiMon Inc. Holdings Commercial Corp Trading Co. $2.80 $260.00 $202.60 $215.60 $39.30 ($15.40) 528.20 $42.00 $0.50 Nah Nah Nah $300.00 $28,892.00 $9,982.00 $10,467.00 $957.00 $7,809.00 323.90 ($259.00) $576.00 $29.69 13.4x $9,614.40 $18.70 $1,797.50 $797.00 $1,079.50 $0.50 $421.90 44.50 $706.40 $36.60 $11.25 9.6x $500.30 $34.10 $79.80 $839.50 $2,056.70 $197.10 $263.10 $469.90 $849.60 $30.30 $31.70 $149.60 $547.90 12.40 35.20 $219.10 $328.80 $9.70 $90.00 $15.94 $37.38 7.3x 10.1x $197.30 $1,315.20

$33.20 $913.30 $100.00 $100.00

$4,081.00 $59,920.00 $12,615.00 $14,662.00

$468.30 $16,197.00 185.50 2,429.00 $309.90 $3,851.00 $35.50 $18.4.0 $34.88 $53.50 13.8x 16.9x $6,470.80 $129,951.50

10

Buyback and Earnings

Earnings Shares outstanding Months 0-6 Months-6-12 Average shares outstanding EPS Change in EPS

Year 1 100 100 100 100 1.00

Year 2 100 100 50 75 1.33 33.33%

Year 3 100 50 50 50 2.00 50.00%

Year 4 100 50 50 50 2.00 0.00%

12

Buyback and Earnings

Year 1 100 100 100 100 1.00 1 Year 2 120 100 50 75 1.60 60.00% 1.2 20.00% Year 3 144 50 50 50 2.88 80.00% 1.44 20.00% Year 4 172.8 50 50 50 3.46 20.00% 1.728 20.00%

Earnings @ 20% growth rate Shares outstanding Months 0-6 Months-6-12 Average shares outstanding EPS Change in EPS EPS if no buyback Change in EPS

14

Buyback Need not to Increase EPS Always

Year 1 No. of Shares 1000 @ 1 Operating profit Interest Income on Excess Cash@10% interest Earnings EPS After Buyback of 100 shares for 3 per share Operating profit Interest Income on Excess Cash@10% interest Earnings EPS After Buyback of 300 shares for 1 per share Operating profit Interest Income on Excess Cash@10% interest Earnings EPS 100 30 130 0.13 100 0 100 0.11 100 0 100 0.14 Year 2 100 30 130 0.13 100 0 100 0.11 100 0 100 0.14 Year 3 100 30 130 0.13 100 0 100 0.11 100 0 100 0.14 Year 4 100 30 130 0.13 100 0 100 0.11 100 0 100 0.14

15

Buyback and Debt Capacity Impairment

DE ratio increases leading to running off with debt capacity may be only at book value May be the change in DE ratio overstates the change in companys level of financial risk and reduction of borrowing capacity

18

Other Issues of Buyback

Management trying to squeeze out a few more EPS in deteriorating situation to meet the markets forecast May not be a meaning restructuring of the company May not be a genuine change in management attitude towards maximizing stockholders value Simply a cyclical attempt to retain control over the stockholders investment

19

Summary Information for UST and Peer Companies

Tobacco Product Manufactures UST Inc. Selected Growth Rates and Ratios Sales Growth Gross profit Margin EBITDA Margin EBIT Margin Net Margin Return on Average Equity Return on Average Assets Long-Term Debt/Capitalization Total Debt/Capitalization Philip Morris Tobacco Leaf Merchants

North Median RJR Nabisco Standard Universal Atlantic DiMon Inc. (excl.UST) Holdings Commercial Corp Trading Co. 10.20% 65.40% 39.00% 31.30% 1.10% NM 0.40% 89.40% 90.00% -0.50% 46.20% 17.50% 12.00% 3.50% 8.40% 2.40% 53.20% 54.40% 2.20% 12.30% 9.20% 7.20% 2.40% 12.50% 2.70% 65.40% 71.90% 10.20% 9.70% 5.70% 4.40% 1.80% 22.50% 3.40% 52.30% 72.30% 4.20% 14.30% 7.70% 6.50% 3.00% 25.60% 6.50% 31.20% 59.40%

1.50% 80.10% 55.20% 52.90% 32.90% 103.40% 53.80% 17.60% 17.60%

3.20% 41.70% 20.80% 18.60% 10.30% 49.30% 13.20% 43.80% 47.50%

28.00% 13.40% 9.60% 2.70% 22.50% 3.10% 52.80% 65.70%

20

Key Financial Ratios for Tobacco Companies

Tobacco Product Manufacturers Philip Morris Three-Years (1996-1998) Corporate Credit Rating Outlook EBIT interest coverage (x) EBITDA interest coverage (x) Fund flow/total debt (%) Free operating cash flow/total debt (%) Return on capital (%) Operating income/sales (%) Total debt/capital (including ST debt) (%) A Stable 11.2 12.7 56.3 41.8 38.4 26 49.3

Tobacco Leaf merchants

North Tobacco RJR Nabisco Standard Atlantic DiMon Inc. Universal Corp Companies UST Inc. Holdings Commercial Trading Co.a Medianb B+ Stable 1.3 1.6 6.8 5.6 11.8 38.1 90.6 BBBStable 2.5 3.7 14.5 6.8 10.3 15.6 55.1 BB+ Negative 2.6 3.3 12.3 10.1 13.4 16.4 67.8 BBPositive 3.3 5.4 6.7 -2.6 6.6 3.6 77.5 AStable 3.5 4.4 18.5 2.9 16.9 7.6 65.8

3 4.1 13.4 6.2 12.6 16 66.8

101.5 105.6 364 296.5 140.6 55.7 28.2

21

Factors to be Considered by Lender

Brand name and market positions Cash flow generations Cyclically Product diversification Geographical diversification Asset tangibility Litigations

23

Capability to service Debt of $1 Billion

Even at interest rate of 8.7% (Ex. 7) interest will be only 11% of forecasted EBIT Lower rating factors..

Litigation risk Less tangible assets Single-product risks

25

Industrial Senior Debt Rating Distributions (1999)

26

Discussion Question

Is debt for replacing equity a good idea?

28

Income Statement Projections

Actual Pro-forma Prof-forma Prof-forma Pro-forma 1998 1999 1999 1999 1999 1,423 1,494 1,494 1,494 1,494 5% anuual Growth 754 792 792 792 792 53% of sales -2.2 0 70.5 78.2 87 756 792 721 714 705 287 301 274 271 268 38% tax rate 469 491 447 443 437 0 0 1000 1000 1000 7.05% 7.82% 8.70% 11.23 10.13 9.10 A BBB BB

Sales EBIT Interest Pre-tax earnings Taxes Net Income Net Debt Interest Rate Interest Coverage Debt Rating

31

Valuation Model
Status Quo PV Tax Shields Value of UST 6469 Net Debt 0 Stock Price 34.875 Shares Repurchased Shares 185.5 Market Equity 6469 Debt/Market Equity 0 $1 Billion Recap Plan 380 6849 1000 36.924 27.08 158.4 5849 0.17

32

Impact of Capital Structure on Firm Value

Beta is unle vered beta Cost of eq uity is cost of capital
As debt ra tio increases, beta increases: Levered Beta = Un leve red Beta (1+ (1 -t) (Debt/Equity))

As debt ra tio increases, interest expenses increase. Interest coverage ratio drops and rating declines. This increa ses the cost of debt

Cost of Capital = Cost of Equity (Equ ity/(Debt + Equity)) + After-tax Cost of Debt (Debt/(Debt + Equity))
If interest expen ses exceed the EBIT, th e tax benefit will decline: Tax rate = EBIT/Interest Exp *Tax rate As cost of capital changes, Change in firm value = (Old Cost of cap ital - New Cost of Capital)(Current firm value)(1+g) / (New Cost of Capital-g) If investors are rational, increase in stock price = Change in firm value/ Tota l number of shares outstanding If sto ck can b e bough t at tod ays price, Increase in stock price = Change in firm value/ Remain ing shares outsta nding . Debt Ratio Thre e key assumptions: 1. Operating inco me remains unchange d as the debt ratio change s 2. All existin g debt is refinanced at th e new cost o f debt 3. Debt is used to buy back stock rather tha n invest in projects 99%

0%

34

Debt and Value of Firm

Increase with more debt if the following factors not considered..,

Financial distress Signaling effects Incentive effects Event clientele effects

35

Effect of Leverage on Firm Value

VLevered = Vunlevered + tD CBankruptcy and Distress

tD: PV of debt tax shields tD: value effect of firms financing VUnlevered : PV of operating cash cash flows

As borrowing increases default risk will offset the value created by borrowing When borrowing is more default risk will more than offset the value created by borrowing Value of CBankruptcy and Distress can be computed by..,

Debt market indications

Differential value between two debt instruments

Put option valuation [may also use credit derivatives]

36

Firm with Mismatched Debt

41

Firm with Matched Debt

42

Credit Rating and Key Financial Ratios

Key Industrial Financial Ratios by Credit Rating Investment Grade Non-Investment Grade AAA AA A BBB BB B EBIT interest coverage (x) 23.4 13.3 6.3 3.9 2.2 1 Funds from operations/total debt (%) 214.2 65.7 42.2 30.6 19.7 10.4 Free operating cash flow/total debt (%) 156.6 33.6 22.3 12.8 7.3 1.5 Return on capital (%) 35 26.6 18.1 13.1 11.5 8 Operating income/sales (%) 23.4 24 18.1 15.5 15.4 14.7 LT debt/capital (%) -1.1 21.1 33.8 40.3 53.6 72.6 Total-debt/capital, incl. Short-term debt (%) 5 35.9 42.6 47 57.7 75.1

43

Credit Rating and Firm Value Illustration

Debt Ratio 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Beta 1.27 1.36 1.46 1.66 1.94 2.40 3.00 4.00 6.00 12.00 Cost of Equity Bond Rating Interest rate on debt 9.57% AAA 5.15% 9.92% AAA 5.15% 10.36% A6.15% 11.16% C 15.00% 12.27% C 15.00% 14.10% D 16.50% 16.50% D 16.50% 20.50% D 16.50% 28.51% D 16.50% 52.51% D 16.50% Tax Rate Cost of Debt (after-tax) 38.00% 3.19% 38.00% 3.19% 38.00% 3.81% 27.08% 10.94% 20.31% 11.95% 10.66% 14.74% 8.88% 15.03% 7.61% 15.24% 6.66% 15.40% 5.92% 15.52% WACC Firm Value (G) 9.57% $5,590 9.25% $6,111 9.05% $6,272 11.09% $1,388 12.14% $1,159 14.42% $453 15.62% $398 16.82% $355 18.02% $320 19.22% $291

44

Effect of Leverage on Beta Illustration

T he se inputs are absolute ly e sse ntial to the calculation. Ente r the curre nt be ta of the company = Ente r the marginal tax rate for the company = Ente r the ave rage de bt/e quity ratio ove r the pe riod of the re gre ssion = Ente r the curre nt marke t value of e quity in the company = Ente r the curre nt book value of de bt in the company = Ente r the ave rage maturity of the de bt in the company = Ente r the inte re st e xpe nse s from the most re ce nt 12 months = Ente r the curre nt marke t inte re st rate on this company's de bt = Marke t Value of De bt = Ente r the e stimate d de bt value of the firm's ope rating le ase s Output fro m the Analy s is Unle ve re d Be ta for the firm (base d upon ave rage de bt/e quity ratio) = Curre nt Be ta for the firm (base d upon curre nt de bt/e quity ratio) = De bt to Capital 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% 90.00% Customiz e d Inputs De bt/Equity R atio 0.00% 11.11% 25.00% 42.86% 66.67% 100.00% 150.00% 233.33% 400.00% 900.00% B e ta 1.28 1.38 1.49 1.64 1.83 2.11 2.52 3.20 4.57 8.69 Effe ct of Le v e rage 0.00 0.09 0.21 0.35 0.55 0.82 1.23 1.92 3.29 7.40 35% 1.57 1.28 1.48 $ $ $ $ 1.40 36% 14% 50,889 12,342 5 876 7.50% 12,142 T he following inputs are use ful for the re -e stimation of the be ta, if the curre nt D/E ratio is diffe re nt from the av e rage .

Ente r the de bt/e quity ratio that you think the firm will have =

45

Le ve re d Be ta base d upon this de bt/e quity ratio =

Effect of Leverage on Beta Illustration

46

Estimating Probability of Distress

Coupon Rate = Maturity of bond= Ris kfree rate = Market price of bond= Year 1 2 3 4 5 6 7 8 Value of bond = Probability of dis tres s (Annual) = Probability of dis tres s over 5 years = Probability of dis tres s over 10 years = Cas h Flow $120.00 $120.00 $120.00 $120.00 $120.00 $120.00 $120.00 $1,120.00 12.00% 8 5.00% $653.00 CF (1- ) $103.76 $89.72 $77.58 $67.08 $58.01 $50.16 $43.37 $350.00 Pres ent Value $98.82 $81.38 $67.02 $55.19 $45.45 $37.43 $30.82 $236.90 $0.00 $653.00 13.53% 51.66% 76.63%

To estim ate the prob ab ility of distress 1. Open s olver (from tools ) 2. Set the value equal to the m arket price of bond 3. Solve for the probability of dis tres s

47

Cost of Financial Distress

Elephant in the room No straight forward model exists to adjust beta estimates for costs of financial distress Could estimate the present value of expected costs of financial distress by assuming,

Financial markets will price them equivalently to an insurance policy or a put option

48

Cost of Financial Distress

Valuing Put Option

Price

Must be the value of firms assets

Exercise price
Volatility

Face value of debt

Volatility of operating income Since its not levered right now share price volatility can be used Term of debt Should be contemporaneous with the life of option Valuing a put option on debt

Life of option Risk free rate Dividend

49

Cost of Financial Distress

Direct costs of Bankruptcy

Lawyers and accountings

Cost of dividing up the pie - enforcement costs.

Loss of PV of Tax Credits On Sales and customers: Future Service and reliability. Large costs of switching suppliers Lost up-front relationship specific costs. On Firm Opportunities: Higher Supplier Charges / trade credit Cutback in R&D, advertising On Operating Costs: Higher Labor Costs / Higher costs of investing in long term relationship On Flexibility: Debt restrictions and covenants Expected(Costs) = Prob. of bankruptcy * Cost of Bankruptcy

Indirect costs of Bankruptcy

Indirect costs are related to economic distress not bankruptcy. This is true for firms that enter bankruptcy. Many avoid bankruptcy restructure their debt quickly

51

Causes of High Bankruptcy Costs

Higher bankruptcy cost causes..,

Key

employees jump ship Suppliers refuse to grant credit Customer seek more stable suppliers Lenders demand higher interest rates Impose more restrictive loan covenants if potential bankruptcies looms

52

Deciding Financing Mix

Life Cycle

Start- up firms: more equity Mature firms: more debt. Debt ratio similar to comparable firms in the same business Retained earnings being the most preferred choice Work down the preference list, rather than picking a financing mix directly

Comparable firms

Financing Hierarchy

56

Optimal Financing Mix

The Operating Income Approach: In this approach, the optimal debt for a firm is chosen to ensure that the probability that the firm will default does not exceed a management-specified limit. The Cost of Capital Approach: In this approach, the optimal debt ratio is chosen to minimize cost of capital, if operating cash flows are unaffected by financing mix, or to maximize firm value. The Adjusted Present Value Approach: In this approach, the effect of adding debt to firm value is evaluated by measuring both the tax benefits and the bankruptcy costs. The Return Differential Approach: In this approach, the debt ratio is chosen to maximize the difference between ROE and cost of equity Comparables Approach: The debt ratio is chosen by looking at how comparable firms are funded

57

Effect of New Debt

Share price will quickly and fully reflect the changes in investors perceptions because of

Present value of new debt tax shields created by the recapitalization - Marginal tax rate times the value of debt outstanding Present value of the costs of financial distress Signaling effect

Stock holders opinion on expectation of insiders Bind management to deliver predictable operating results in order to service the debt Investors may bail out of stock; allowing others to buy in

Incentive effects

Clientele effects

58

Debt Financing Disciplines Managers

Control on investing in risk projects Higher debt requirements forces manager to earn more to service debt High debt payments in LBO force managers to conserve cash by eliminating unnecessary expenditures More careful with shareholders money

59

Signal of Leveraged Recapitalization

Run out of profitable and internal investment opportunities Firms debt capacity would not be more profitably employed in financing new investments,

Plant Equipment Acquisitions

Shares are undervalued (if debt used for buying back shares) Signal optimism on the part of managers and directors regarding future cash flows, which suggest they will be sufficiently sizeable in the future to meet the burden of interest and principal payments Commitment on the part of insiders not to divert the resources of the firm to other uses

60

Implementing Capital Structure Change

Need to increase the debt incrementally

May increase dividend payout Continuously engage in repurchases or acquisitions

Leveraging can be a good kick-off tactics for the management

Could be a vehicle for signaling the new managements concern with the financial side of the business as well as producing visible gains in EPS and ROE

62

Implementing Capital Structure Change

Adding debt by buying back stock selling at premium is less attractive

Benefits of added debt will be wiped out by the premium paid for buying back

Other alternatives

Debt-for-securities swap Special dividend using add debt Adding debt through acquisitions if the acquisition premium is low

63

Life Cycle and Financing Choices

Reven ues
$ Reven ues/ Earnings Earnings

Time

Extern al fund in g needs

High, but co nstrained by infrast ruct ure

High, relative t o firm value.

Moderat e, relat ive t o firm value.

Declin in g, as a percent of firm value

Lo w, as pr oject s dry up .

Intern al finan cing

Negat ive or low Own ers E quit y Bank Debt

S age 1 t S art-up t Accessing private equit y

Negat ive or low Venture Capit al Co mmo n S ock t

S age 2 t Rapid Exp ansio n

Lo w, relat iv e to fundin g needs Co mmo n st ock Warrant s Co nvert ibles

S age 3 t High Growt h

High, relative t o fundin g needs Debt

More th an fundin g needs

Extern al Finan cing

Growt h st age

Retire debt Repurch ase st ock

S age 5 t Declin e

64

S age 4 t Mat ure Growt h Bo nd issues

Finan cing Transition s

Inital Public o fferin g

S easoned equity issue

Design the Perfect Financing Instrument

The perfect financing instrument will

Have all of the tax advantages of debt While preserving the flexibility offered by equity
Duration Currency Effect of Inflation Uncertainty about Future
Grow th Patterns Cyclicality & Other Effects

Start with the Cash Flows on Assets/ Projects

Def ine Debt Characteristics

Duration/ Maturity

Currency Mix

Fixed vs. Floating Rate * More floating rate - if CF move w ith inflation - w ith greater uncertainty on future

Straight v ersus Conv ertible - Convertible if cash flow s low now but high exp. growth

Special Features on Debt - Options to make cash flow s on debt match cash flow s on as sets

Commodity Bonds Catastrophe Notes

Design debt to have cash f lows that match up to cash flows on the assets f inanced

65

Start with the

Designing Debt
Duration Currency Effect of Inflation Uncertainty about Future Growth Patterns Fixed vs. Floating Rate * More floating rate - if CF move with inflation - with greater uncertainty on future Straight versus Convertible - Convertible if cash flows low now but high exp. growth

Cash Flows on Assets/ Projects

Cyclicality & Other Effects

Define Debt Characteristics

Duration/ Maturity

Currency Mix

Special Features on Debt - Options to make cash flows on debt match cash flows on assets

Commodity Bonds Catastrophe Notes

Design debt to have cash flows that match up to cash flows on the assets financed

Overlay tax preferences Consider ratings agency & analyst concerns

Deductibility of cash flows for tax purposes

Differences in tax rates across different locales

Zero Coupons

If tax advantages are large enough, you might override results of previous step Analyst Concerns - Effect on EPS - Value relative to comparables Ratings Agency - Effect on Ratios - Ratios relative to comparables Regulatory Concerns - Measures used Operating Leases MIPs Surplus Notes

Can securities be designed that can make these different entities happy?

Factor in agency conflicts between stock and bond holders Consider Information Asymmetries

Observability of Cash Flows by Lenders - Less observable cash flows lead to more conflicts

Type of Assets financed - Tangible and liquid assets create less agency problems

Existing Debt covenants - Restrictions on Financing

If agency problems are substantial, consider issuing convertible bonds Uncertainty about Future Cashflows - When there is more uncertainty, it may be better to use short term debt Credibility & Quality of the Firm - Firms with credibility problems will issue more short term debt

Convertibiles Puttable Bonds Rating Sensitive Notes LYONs

66

Factors Affecting Capital Structure Decision

Company life stage Use of funds Capital markets favor of the company Base assumptions Industry average norms Industry dynamics Shareholders objectives and preferences Agency cost Signaling cost Financial distress cost

69

Financial Slack

Financial Slack can be defined as the amount of funds a firm has available to invest without visiting the external financial markets after paying interest and before paying dividends + Depreciation The following factors influence whether firms should have more equity (financial slack) or more Debt in their capital structures..,

Firms Track Record of Picking Good Investments The likelihood of good investments and opportunities arising (growth industry?)

74

Framework to Getting to the Optimal

75

Capital Structure Theory

MM theory

Zero taxes Corporate taxes Corporate and personal taxes

Trade-off theory Signaling theory Debt financing as a managerial constraint Pecking order theory

Retained Earnings Straight Debt Convertible Debt External Common Equity Straight Preferred Stock Convertible Preferred

76