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Fin 401Ryan Pratt

Questions for UST

1. UST has a long history of conservative debt policy. Briefly describe why UST is

considering a recapitalization that involves issuing debt and repurchasing equity.

UST is one of the most profitable companies in corporate America, and so they want to

recapitalize in order to maintain capital within the b siness, as shown on the payoff!"al e #raph

for debt holders and e$ ity holders% UST sed to be concerned abo t defa lt ris& and so they

maintained a constant conser"ati"e capital str ct re% The primary p rpose of UST iss in# debt

is to obtain a ta' shield% They are a lar#e company with a h #e mar&et share and hi#h earnin#s,

and so this ta' shield wo ld be "ery lar#e%

As UST is in the tobacco ind stry, which is hi#hly "olatile with restricti"e le#islationc rrently bein# enacted% UST wo ld li&e the ta' shield to act as a b ffer% They can do this

beca se they are not as of yet hi#hly le"era#ed% They wo ld be able to obtain the prime interest

rate on any debt they iss e ri#ht now, so it is best that they iss e debt before any potential

financial distress comes alon# in the "olatile ind stry% A#ain, UST has "ery low le"era#e,

(1)%*+ debt to boo& capitalization, compared to a #ro p median of **+- so they can afford to

ta&e on $ ite a bit more%

.owe"er, after r nnin# e'tensi"e analysis, UST/s iss e of 1 illion in debt does seem a bit

e'cessi"e% To ill strate this, UST/s debt to boo& capitalization chan#es after the rep rchase

from 1)%*+ to 123% *+% 5n s mmary, we a#ree that ta&in# on debt at this time is the correct

mo"e to ma&e, b t we feel the amo nt of debt is e'cessi"e and co ld possibly h rt UST/s credit

ratin#s%

2. escribe the pros and cons of the recapitalization fro! the perspective of the tradeofftheory of capital structure. "hat are the biggest concerns you have#

Tradeoff Theory of 6apital Str ct re7 Ass min# that ta'es and financial distress are added into

the 898 world, the e$ ation for the Tradeoff Theory of 6apital Str ct re is7

: ;(P: of ta' benefits- < (P: of Financial =istress-

There are se"eral pros that we see with the recapitalization, and also se"eral cons% First, the

ta' shield that will be #ained from the debt iss e and stoc& rep rchase will increase the "al e of

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the firm (o"erall-% There is a ta' benefit to UST of 400 8illion% Also, the "al e of UST/s

stoc& price will increase with the rep rchase, both d e to positi"e in"estor spec lation and the

fact that there will be less shares in the mar&et, tradin# at a hi#her price d e to the addition of

the ta' shield% >astly, the "al e of the firm, the ?whole pie/ will increase%

8o"in# on to the concerns which o r financial analysis has re"ealed, the bi##est potential

problem which we see with the debt recapitalization is that the amo nt of debt bein# iss ed is

enormo s and may pose a potential increase to defa lt ris&, and s bse$ ently to credit ratin#s

for UST% The debt to boo& capitalization (as stated abo"e- #oes from 1)%*+ to 123%*+

conc rrent with the restr ct re% Accordin# to the &ey ind strial financial ratios, a total debt to

capital ratio abo"e )2+ is located within the 666 @on in"estment rade!Spec lati"e ratin#%

This co ld drop UST/s o"erall credit ratin#%

There are also additional concerns UST sho ld ta&e into consideration that may or may not

be directly related to the stoc& rep rchase and debt iss ance% First, forei#n e'pansion for UST isnot an option% Second, UST cannot di"ersify into other sectors% Their main prod ct is moist,

smo&eless tobacco, and that is where they capt re the main part of their mar&et share% >astly,

there is e'pected to be a contin o s #rowth rate of possible liti#ation iss es in the tobacco

ind stry and UST may soon be facin# financial distress d e to these problems%

$. Should UST underta%e the &1 billion recapitalization# 'alculate the effect on UST(s stoc%price assu!ing that the entire recapitalization is done i!!ediately )i.e.* +anuary 1* 1,,,-. To

si!plify things* assu!e that the recapitalization will have no significant i!pact on theprobability of financial distress.

Bes% UST sho ld nderta&e the 1 illion recapitalization, ass min# that the recapitalization

will ha"e no si#nificant impact on the probability of financial distress, or defa lt ris&!credit ratin#s%

The recapitalization will ha"e a positi"e impact on UST stoc& prices% The #ain per share from the

400 8illion ta' shield will be C% % Th s, the old stoc& price of 34%DD will become 3)%43% The

ass mptions we are sin# are the followin#7 There will be no financial distress from this decision to

recapitalize, we are sin# a 40+ ta' rate (as stated in the case-, ban&s are willin# to loan 1 illionto UST% Two additional ass mptions that are important to mention that were sed in o r financial

analysis on the spreadsheets is that the 10 year bond rate was sed as the interest rate and we &ept

the di"idend payo t ratio the same%

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. /s the assu!ption that the recapitalization will not i!pact the probability of financialdistress a good one# "hy or why not#

@o, it is not a #ood ass mption to se in this case% UST/s total assets are only 213 8illion,

and they are plannin# on iss in# 1 illion in debt that is #oin# strai#ht to shareholders% Under

normal circ mstances, this wo ld #reatly affect the probability of financial distress for the firm, and

wo ld probably shift their credit ratin# downward% Their debt to assets ratio went from 10%2+ to

1C0+% This is not #ood for UST when comparin# with other firms in the ind stry%

There are se"eral maEor costs of debt restr ct rin#% First, le#al fees wo ld potentially be a

problem for UST with an increase in le"era#e, with the possibility of defa lt on the 1 illion loan

principal later on down the road% Second, a decrease in sales is not a h #e iss e, as they ha"e no

warranty or other c stomer reliant ser"ices associated with their prod cts% Third, s ppliers sho ld

not be affected by this probability of financial distress% Fo rth, debt o"erhan# co ld be a problem

as stoc&holders will be less li&ely in in"est their money when they &now that a maEor portion of any profits wo ld be #oin# directly to debt holders% 5f there is a lar#e chance of principal defa lt, the

stoc&holders may #et nothin# from that in"estment%

5n s mmary, o r main concern is not whether or not they will be able to pay their interest

e'penses% Their 5T interest co"era#e is 1C%C3 e"en with the debt restr ct rin#% This implies that

they are still well within their means to ma&e payments% The main concern we ha"e with UST is

that they may be nable to repay the principal payments years down the road, d e to their e'treme

debt to assets ratio% A potential way to sol"e this problem is to decrease di"idend payments (which

may not be feasible as it may pset stoc&holders- to help ref nd principal payments on the loan% y

decreasin# the di"idend payo t ratio, retained earnin#s will increase dramatically, decreasin# the

debt to asset ratio%

0. valuate the !erits of the recapitalization in the fra!ewor% of the pec%ing order theory ofcapital structure. valuate its !erits in the fra!ewor% of the agency theory of capitalstructure.

First, UST is followin# the framewor& of the pec&in# order theory as they #o thro #h a

recapitalization process% The pec&in# order states that when a company needs financin#, it will loo&

to the most ready, easily attainable, and least costly forms of financin#% Since UST only has 33

million dollars in cash on hand (which has most li&ely come from retained earnin#s-, cash on hand

is not a s fficient so rce for UST/s 1 illion recapitalization% UST/s di"idend payo t ratio is *4+,

only 3*+ of net income is bein# retained within the b siness% eca se the obEecti"e of the

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recapitalization is to red ce e$ ity and increase debt for ta' shield reasons, financin# thro #h the

means of debt is the most lo#ical way of financin#% =ebt financin# after internal financin# is also

the ne't step on the pec&in# order theory% Th s, UST is followin# the pec&in# order theory as it

#oes thro #h its process of recapitalization%

The a#ency theory also is "ery applicable to the UST case% The a#ency theory answers the

$ estion, G5s the mana#er sin# the stoc&holders/ money better than the way the stoc&holders co ld

handle the money for themsel"esHI y rep rchasin# more of the shares o tstandin#, UST will be

increasin# shareholder "al e for the remainin# shareholders d e to the ta' shield% Additionally the

shareholder "al e will increase d e to an increase that typically occ rs after a rep rchase beca se

the mana#er is implyin# that the stoc& is nder"al ed% This shows that UST is confident that they

can be more efficient with the stoc&holders/ money than the shareholders co ld on their own%