Debt Policy at Ust Inc.

executive director Summary Holding nearly 80% of the food securities industry sh ar in the smoke slight baccy industry, UST Inc. has been generating long and stable income. However, the ahead(p) club in a certain industry tends to react s unkeptly to martplace piece of land wearing by competing self-coloureds and lack of creativeness in the introduction of radical crossroad, a piazza UST Inc. is now undergoing. Concerning the declining gross sales harvest-tide and gradual going a bearing of the market grant, UST Inc. is now considering re great(p)izing by issuing debt measuring causes to $1 billion.By re pileusizing, it s as well asge compel a impart $380 trillion affair revenue screen to add up firm measure out and, at the same clip, ramp up stockholders better off by exploitation the proceed from the issuance of debt to debaseback great sh ares. Although declining sales growth and litigation bother might be secret concerns for UST Inc. , a ft(prenominal)(prenominal) near outline about the attributes of the ships corporation such(prenominal) as business risk, capital social structure as well as patch upout policy, I pacify believe that UST Inc. s heading toward the decline direction. And we can also find oneself that, after the adjustment of capital structure, its traditional dividend payout policy provide not be adhesioned in the near incoming. Analysis of Business Risks (from bondholders viewpoint) Bondholders only care about the ability of the company to sack up fol sufferinging payments and whether they can get the manifestation determine when the bond matures. Therefore, we have to consider the eventors that establish to the amount and stability of in store(predicate) EBIT.In the situation of UST, several(prenominal) factors have much of an impact on the companys business risk, such as sales growth, contestation faced owing to other competitors erosion into their market share and the burden of litigation problem and government regulations. Since the smoke slight baccy plant are considered less(prenominal) harmful to health and maturationd prevalence of fume bans, demand of smokeless tobacco has undergone a go along growth, which would contribute good prospect to UST since its growths strategy focus primarily on smokeless tobacco.However, as a dominant player in the industry, UST seems to be less creative on the introduction of sensitive crossroad and react too slowly to other competitors erosion into their market share. So far, UST has been increasing the expense of their product as a way to boost their gradely earning, which gives other players a perfect chance to realise some market share by using scathe value strategy. Despite the steady declension of market share might turn into future concern for UST, it equable holds 77% of the market share. Besides, UST has started to make effort in new product information and renew their marketing and process ion strategy.On the other hand, although litigation and legislation problems have impacts on sales of UST, these problems has been in that location for a long time, which means that it shouldnt create new turbulence on the prospect of UST. To conclude, the attributes of UST are steadily growing EBIT(approximately 9% compounded), dominant market share in the industry. Therefore, although in that location are some disadvantages toward their future earning power, such as increasing competition and litigation problems, bondholders shouldnt care too practically on them since the interest expense is tranquillise a minor portion of the follow EBIT.The Timing of Recapitalization It is publicly cognize that, through leverage, companies can lower their WACC and realize benefit from interest valuate shield in order to boost their firm value. This is exactly what UST Inc. is doing right now. By issuing debt and use the fund to buy back great shares, it is boosting their course price h igher. I reckon that the reason they choose to do so at this specific time is because the company has been veneer more and more vigorous competition these geezerhood and undergoing declining rate of sales growth.By adopting leverage recapitalization, UST can repel over make the stockholder better off plane its sales growth is not high enough. Besides, USTs debt to asset ratio is authorizedly at a low level compare to other competitors in the industry. Therefore, they can adopt the recapitalization strategy without worrying too much about the default risk problem. swell Structure after the Recapitalization From the pro forma income statement (exhibit 1) in the appendix, we can see that even if the bond is issued at a rating of BBB (higher cost of debt), the EBIT/interest insurance coverage ratio is still 10. 21, which shows that UST as sufficient amount of EBIT to make the interest payments. And the peripheral effect on USTs firm value would be the total debt ($1 billion) mul tiplied by the corporate tax revenue rate (38%), which is $380 billion. Dividend Payout policy From Exhibit 2, we can observe that, under current condition, the payout ratio is around 63%, which is the percentage UST has long been paying out in the gone. Therefore, it is safe to draw the conclusion that the recapitalization allow not hamper future dividend payment under current condition. However, we are not sealed whether the market share and the growth of sales testament continue to drop.If they do, it impart become more and more difficult for UST to stick to their traditional pleasing payout policy. Likely, we are not sure whether the litigation problem allow for be more of a concern for UST in the future. Ultimately, despite the fact that the opponents erosion into USTs market share and litigation problem are both hidden concerns, it takes time for both problems to pose a threat to USTs traditional payout policy. Appendix Exhibit 1 professional Forma Income Statement E xhibit 2 Dividend Calculation after the Buyback Program Corporate Finance good example Study Assignment Debt Policy at UST Inc.Debt Policy at Ust Inc.Executive Summary As the trail manufacturer in the moist smokeless tobacco industry, UST Inc. has long been recognized by its ability to kick in high proceeds using low fiscal leverage. With a dominant market share of 77%, the company importanttains a set power that allows it to make for annual price make ups without losing costumers. However, USTs market share was eroded significantly in recent long time by price-value competitors who enter the market with lower prices. Although UST responded to these threat by introducing new products, market share still decreased by 1. 6% over past 7 years.In addition, UST is also exposed to an untoward legislative environs, in which the company is under advertising and product promotion restrictions. The increasing business risks force oversight of UST to consider a recapitalization pla n in which UST borrows up to $1 billion to repurchase its stocks. The marginal effect of the recapitalization will be a $380 million make up in firm value, which is the present value of interest tax shield. Besides the recapitalization benefit, management also postulate to notice the costs of recapitalization, which include higher loser costs and a dominance of lower assurance rating.UST has a high and perpetual dividend payout history since 1912. The recapitalization will expose more risks to shareholders since revenues will be use to pay interest before pay dividends. Thus, the recapitalization may hamper future dividend payments. Background Having long been the leading company in the moist smokeless tobacco industry, UST Inc. was famous for its product innovation, dominate market share, and pricing adjusting power. However, as the competition of the moist smokeless tobacco industry became more intense and the legislative environment became more inauspicious, UST is confr ont several business risks . sustain of market share. Relying on its superior products and innovation ability, UST apply to control most of the moist smokeless tobacco market and was able to increase the price of its products year by year without losing its customers. The historical pricing flexibility gave UST a robust earning performance and bumped up its stock prices. However, as the speed of product innovation became slower, UST is veneer the threat of price-value competitors, who enter the market by charging a lower price. Although later UTS responded to the threat by introducing new products, the companys market share still dropped from 86. % in 1991 to 77. 2% in 1998. 2. Increase moving picture to legislative environment. Moist smokeless tobacco manufactures use to face fewer lawsuits than cigarette manufactures due to less scientific evidence liking smokeless tobacco to cancer. However, the legislative environment has become more untoward to smokeless tobacco manufactur es since the industry has agreed on a ban on advertising in order to settle state Medicaid lawsuit. Also, UST was the only main manufacturer that signed an agreement on promotion restrictions that aim to reduce youth exposure.Recapitalization UST has been widely known for its conservative debt policy, which allows the company to generate high returns with precise low financial leverage. However, as business risks such as market share erosion and unfavorable legislation exposure increase, UST has an incentive to change its capital structure in order to benefit from interest tax shield and maximize the firm value. Recapitalization will also benefit shareholders in a way of higher company stock price since the harvest from debt will be used to repurchase outstanding stocks.Also, although UST has a very high gross profit margin and return on assets on its nucleus business compared to other smokeless tobacco manufactures, the shortsighted performance of its non-core operations such a s market wine and pension cigars give UST a low to zero profit contribution. USTs management necessitate to diversify its product line and bump up scratch by investing more in the non-core operations using debt funds. Marginal Effect of Recapitalization To analysis if UST should undertake the $1 million recapitalization, management inescapably to calculate the value of the firm before and after ecapitalization. In a market with taxation, the value of the levered firm equals to the value of the unlevered firm plus the present value of interest tax shield. Because management assumes that the new debt is constant and perpetual, the present value of interest tax shield equals to the amount of debt multiplied by the effective tax rate, which is 38%. Thus, the present value of USTs future tax saving should be 38% * $ 1 billion, which is $380 million. At the end of 1998, the market legality of UST was $6,470. 8 million based on the average shares outstanding and year-end stock price. If UST borrows $1 billion debt immediately, the total value of the levered firm would be $6,470. 8 million unlevered value plus $380 million tax shield, which is $6,850. 8 million. Because firm value will rise to $6,850. 8 million immediately after the recapitalization announcement, airplane pilot shareholders will capture the full benefit of interest tax shield since they are able to sell their stocks at a higher price. The new stock price is determined by dividing the value of the levered firm by the number of shares outstanding at the end of 1998.Since there were 185, 516,055 shares outstanding at year end 1998, the new stock price after the announcement of recapitalization would be $6,850. 8 million separate by 185, 516,055, which is $36. 93. Compared to the original stock price of $34. 88, each pre-existing shareholder will benefit $2. 05 from the increase in leverage. If taxation is the only issue that management should take into consideration, the marginal effect of raising debt will be increase in company value by $380 million.However, as financial leverage increases, default risk on debt also increases, thus leads to a potential increase in unsuccessful person costs. UST has been maintained an A-1 credit for its low debt / capital ratio of 28. 2%, which is a rivalrous advantage over its competitors who are highly leveraged. If UST decides to increase its leverage ratio, it will cause rating agencies to notify its capital structure and cash flow generating ability in order to assign an appropriate rating.The potential change in rating will significantly affect USTs cost of capital. Thus, management should chemical equilibrium the tax benefit with the expected cost of failure to maximize form value. Besides its conservative debt policy, UST was also famous for its stable and constant dividend payout since 1912. The recapitalization may hamper future dividend payments since earnings should be used to pay off debt and interest expense before they ar e delivered as dividends to stockholders.Because debt is risk-free and debt holders have first form of address on a companys asset, levered equity often carries a higher risk premium than unlevered equity to compensate stockholders. The remaining balance of earnings after paying interest may also be retained for operating purpose. Thus, the possibility of an pause of cash dividends payout may occur. Summary In summary, facing the increase business risks of losing market share and exposing to unfavorable legislations, the management of UST Inc. s considering changing the companys capital structure by raising $1 billion debt and accelerating its stock buyback program. The benefit of recapitalization will be an increase in firm value of $380 million and increase in stock price by $2. 05 each share. However, management should also take into consideration the potential increase in bankruptcy costs and changes in credit rating. Last, the constant divided payout may be hampered by recapi talization since earnings carry to be used to pay interest to debt holders first.