Debt Policy at UST Case Questions
Group members: Wei-Ting Liao; Cong Ren; Gerald Nyiti; Beidan Wang
1- ) Give a brief summary of the company background
UST Inc. is a smokeless tobacco company which enjoyed a long tradition and a recognizable brand name. It is the leading producer of moist smokeless tobacco products and widely known for its conservative debt policy and uninterrupted cash dividend payout since 1912.
The company is the major player in U.S. smokeless tobacco market. For example, it holds the maximum market share (77%) as a whole, and dominates especially in the growing segment of moist smokeless tobacco. Additionally, it has widely recognized brand and competitive positon in the market by constant innovation and new product innovation. Finally, UST has historically been one of the most profitable companies not only in the smokeless tobacco market but also in the corporate America.
Although the above advantages, UST now faces with continuous threat from price-value competitors, a softening smokeless tobacco market, investors’ concern about over-investment on non-core operations and negative effect of public and political sentiment towards the tobacco industry.
2- ) Evaluate UST’s attributes/Risks from view point of bondholder
The following factors weave into the risks and attributes of the company from the creditors’ point of view (“” and “” represents advantage and disadvantage, respectively):
Widely recognizable brand Name
UST has widely recognized brand. We can see from the Table B of the case, the 1998 market share of the top moist smokeless tobacco brands, only one brand is not from UST. In addition to this, UST combat entrants by launching similar products, rather than cutting prices. New product introduction and success in the market demonstrate UST’s strong pricing ability result from the well-known brand.

 Threatened market Position
UST is a dominant player and market leader but the recent market erosion by small companies has raised concerns. And UST’s “counter attack” has not been effective in competing against price-value brands. The resignation of his CFO and President of tobacco unit further raise the uncertainty of the company’s efficiency of solving the market erosion problem.
 Historical strong cash generating ability
Tobacco industry is famous for its strong cash generating ability and UST has performed even better than the industry during the period of 1988 to 1998. We can see from the Exhibit 3 in the case, despite of the decrease in cash flows in 1997, UST posted continuous increase in cash flow with a compound annual growth rate of 12%. Also, in Exhibit 6 for tobacco companies’ S&P ratings, the financial ratio of UST are better than the A rating companies. And S&P only give favorable ratings to the highly cash generative nature of the tobacco industry.
 Cyclicality: moist smokeless tobacco industry is growing
The USDA reported moist smokeless tobacco has been the fastest growing segment of the tobacco industry with volume increasing at a 3.7% annual growth rate over the past 17 years compared with a 2% annual decline in cigarette volume over the same period. Also, A.C. Nielson reported that moist snuff volume grew 2.9% in 1997 and 1.2% in 1998.
The result shows the moist smokeless industry is stably growing, so the sales of UST products is likely to continuously grow correspondently.
 Product Diversification
UST is criticized for reduction in innovation and tardiness of new product introductions. Although it launched the Red Seal brand tobacco, Copenhagen Long Cut and Rooster, UST was too slow to react to the threat of value competitors and even let the huge loss of market share before entering market. So the new products need to compete with the already successful brand.
 Geographical Diversification
There is a chance of a cultural shift against tobacco, and UST is unlikely to expand to international market. Also, the performance of non-core operation was far less than expectation, investors would have concern for company’s overinvestment. So, UST does not have advantage in geographical diversification as most cigarettes companies do.
 Asset Tangibility
We can see from the following table, UST invested in non-core operation more and more. The total asset is increasing stably over the year from 1988 to 1998.

Litigation threat: probable liability obligations
UST had seven pending health related lawsuits at the end of 1998. The outcomes of these suits are uncertain. Despite the major Medicaid state settlements, lawmakers are expected to continue to push for new laws to combat youth tobacco use. Other litigation against tobacco companies is expected to continue, especially suits filed by individuals. This uncertain litigation and legislative environment makes the future cash outflows of UST risky.
The previous uncertainty is enhanced by a lawsuit that alleged that UST had violated antitrust and advertising laws and participated in anti-competitive conduct. Should UST lost the suite, it will be more vulnerable with competitors.
3-According to MM (if no taxes), does debt issuance matter? How about in the presence of taxes what are the pros and cons of debt?
The first preposition of Miler Modiglian principle states that; in an environment where there are no taxes exist, default risk or agency costs and capital structure are irrelevant. The value of a firm is independent of its debt ratio and the cost of capital will remain unchanged as the leverage changes.
Thus, Debt issuance will not matter if taxes are not present.
However, in reality, taxes do exist in a typical business environment. This brings about two important aspects; tax shield (or tax benefit/tax savings) and financial distress (or bankruptcy/default risk).
Pros
Debt Financing allows owners to keep ownership of the business since funds are obtained through bonds/loans which hold no rights to decisions of the firm other than promise of interest payments.
Tax Shield is another positive aspect that a company enjoys when using Debt financing. Debts attract interest expense which is an allowable expenditure under IRS. Hence, the more the level of debt, the more the amount of interest expense which then implies the higher the tax shield since taxable income is depleted further by the increasing interest expense.
Cons
Commitment to dedicate some of cash-flows to bond/loan holders. This implies that even at times of poor business performance, the company will still be required to pay lenders agreed amounts. Hence, Debts can leave the company vulnerable to working capital difficulties in the short run.
Financial Distress is another unfavorable aspect caused by an increase in the value of debt more into the long run. As the firm continues to borrow, its credit worthiness (credit rating) is gradually affected negatively since it now has a larger burden of loans to pay. Higher debt amounts make lenders doubt the ability of firms to settle. Therefore, newer lenders will finance the firm at higher interest rates (higher costs) to compensate for the increased risk of default buy the firm. Higher cost of borrowing (interest) faced by the firm adds back to the higher debt amount carried by the firm tarnishing its credit worthiness even further.
Ultimatum
It is key for the firm to monitor their cost of capital closely with respect to these two aspects.
The diagram below of Market Value of the Firm Vs Debt explains how the change in the value of the firm is affected by these two aspects. The Black straight horizontal line show an unlevered firm (zero debt) which shows a constant value of the firm through-out. The blue line shows the present value of tax shield which increases with the debt amount.
The red line represents the value of the firm. As seen in the figure below, the value of the firm rises until it reaches a maximum point and there after starts to fall. This is with respect to the two aspects discussed above.
The rising value relates to the tax shield enjoyed by the firm with increasing debt. Simultaneously, the financial distress rises. However, the benefit from the tax shield is greater than the cost of financial distress, hence, the value of the firm rises.
Nevertheless, the maximum value of the firm represents the point where tax benefit equates the cost of financial distress such that any further increase in debt results in higher financial distress.
According to the Trade-off Theory of Capital Structure, the manager should choose the debt ratio that maximizes firm value.

4- ) what is the expected growth rate (g in the formula below) of UST cash flows? Is it lower or higher compared to past?

Use the 1998 P/E ratio.
Assume CAPM, use 5.45% treasury bond rate for risk free rate, assume market premium is 7%(this value is relative to government bonds), and market beta of 0.65.
RE=5.45%+0.65*7%=10%
13.8=1/(10%-g)
G=2.75%
5- ) Should UST Inc. undertake the 1$billion recapitalization? Calculate the marginal or incremental effect on UST’s value, assuming the entire recapitalization is implemented immediately (January 1, 1999) * Assume a 38% tax rate * Prepare a pro-forma income statement to analyze whether UST will be able to make interest payments * For the basic analysis assume the 1$ billion in new debt is constant and perpetual. Should UST alter the new debt via a different level or change in the amount of debt through time?
Pro-forma income statement
Fill the gaps for 1999.
Use 20 year Bond yield
What is the present value of tax shield with respect to EACH BOND GRADE?
Use the 5 yr CAGR for sales growth
Use the current EBIT/SALES ratio to calculate the EBIT for 1999

| Actual | No Debt | AAA | AA | A | BBB | Bond Yield | | 0 | 0.0647 | 0.0676 | 0.0705 | 0.0782 | Sales | 1423.20 | 1494.36 | 1494.36 | 1494.36 | 1494.36 | 1494.36 | EBIT | 753.30 | 790.97 | 790.97 | 790.97 | 790.97 | 790.97 | Interest | -2.20 | 0.00 | 64.70 | 67.60 | 70.50 | 78.20 | Pretax Earnings | 755.50 | 790.97 | 726.27 | 723.37 | 720.47 | 712.77 | Taxes @ 38% | 287.09 | 300.57 | 275.98 | 274.88 | 273.78 | 270.85 | Net Income | 467.90 | 490.40 | 450.28 | 448.49 | 446.69 | 441.91 | Interest Coverage | N/A | N/A | 12.23 | 11.70 | 11.22 | 10.11 | Interest Coverage Needed | N/A | N/A | 12.9 | 9.2 | 7.2 | 4.1 | Total income for both stockholder and bondholder | 465.700 | 490.398 | 514.984 | 516.086 | 517.188 | 520.114 | interest tax shield | | | 24.586 | 25.688 | 26.790 | 29.716 | PV(tax shield) | | | 380 | 380 | 380 | 380 | Firm's value | | | 7339.5719 | 7014.413 | 6716.00426 | 6031.078 |

UST should undertake the 1 billion recapitalization if it is AAA rating. The interest coverage needed is higher than the coverage. If the rating of UST is worse than AAA, It could borrow more but it may not because such action may rises the risk of bankruptcy when the profit goes down.
The marginal effect on UST’s value of implementing the recapitalization (assumed the plan is implemented immediately on Jan. 1999) = the sum of the tax shield-PV (financial distress) VL-Vu= TD-(probability of bankruptcy-*cost of bankruptcy) =0.38*1 b-0.0028*0.1*6.5=0.378billion