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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 (UST’s 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 UST’s 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 UST’s 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 10-
year 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 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. (a) Compare UST’s 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. (%)103.449.3NM8.412.522.525.622.5ROA
(%)53.813. 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. 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 company’s 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 firm’s 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
UST’s ability to make interest payments.
Exhibit TN-4: Income Statement ProjectionsActual 1998Pro-forma 1999 (I)Pro-forma 1999 (II)Pro-forma 1999 (III)Pro-
forma 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-- ExpenseDebt Rating--ABBBBBWhen examining UST’s 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
bondholder’s 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 bondholder’s 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 firm’s
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 UST’s $ dividend and dividend
per share, assuming it continues to payout 64% of its earnings as dividends.
Exhibit TN-6: Impact of Recapitalization on DividendsDebt = $1 BillionActual 1998Pro-forma 1999 No debtPro-forma
1999 Rd = 7.82Net Income467.9491442.56Shares185.5185.5158.42Earnings per Share2.522.652.79NI/SharesDividend
Payout301.1314.2283.24NI*.64Dividends per Share1.621.691.79EPS*.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 payout 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 payout ratio in order to keep the stockholder’s happy, and to not signal any negative ideas to the stockholders and
to Wall Street.