UST INC Recapitalization for Share Repurchase

UST Inc is a market leader in the moist smokeless tobacco segment in terms of revenue and
profit margins. The companys financial indicators demonstrate a positive trend in Net Operating
margin, ROI and ROA and strong interest coverage ratios over the previous ten years.
Historically the company has had a conservative capital structure with limited or no debt and has
consistently paid out dividends to shareholders. The demand for smokeless tobacco is
considered be relatively inelastic as demonstrated by the continuous revenues and cash flows;
and the company benefits from a strong brand presence in terms of its leading product brands i.e.
Copenhagen and Skoal.
As of 1993, UST considered the option of using additional leverage to repurchase shares and
benefit from the tax shield. The recapitalization proposal for share buyback would reduce the
number of total shares outstanding and increase managements ownership stake in the company.
The current operating environment for UST has several business challenges in the form of
significant competition from new entrants, potential litigation, regulation in the form of
consumer protection, and increases in the excise tax. Additionally the overall tobacco market is
considered a mature industry as shown by the limited growth; which could impact revenues and
profits negatively in the long-term. UST Inc also has limited product diversification and may be
challenged to replace revenue sources if regulations or consumer preferences erode current
product demand. Lastly by increasing leverage for share repurchase, UST may see a reduction in
their overall credit ratings and have to reduce dividends in the future.
The recapitalization scenario has been developed based on the following assumptions:
Debt is calculated as a percentage (%) of the market value of the firm
The debt is in the form of perpetual bonds and maintained at the same level. Hence PVTS
= Bond MV* tax rate
The strong interest coverage ratio qualifies UST debt to be considered as Investment
grade bonds (AAA-BBB)
The current Risk free T-Bond rate used in the analysis is 6.6%
In lieu of the above, the analysis for the optimal leverage for UST was performed with varying
debt levels from 0%-30%. Accordingly the debt was assigned the investment grade of AA for
10% debt, A for 20% and so on. The AA rating was based on the historical ability of the company
to generate positive cash flows and maintain profitability even with slowing growth; however the
risks in terms of changes in consumer opinion, market regulation and taxes also apply and hence
the rating is marginally lower than the highest grade rating of AAA. Further as the debt level
increases, the market value of the company increases due to the benefit of the tax shield arising
from interest payments.