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HBS Case Study: Debt Policy at UST Inc.

FNCE 201 Corporate Finance Prof. Fu Fangjian

Due: the class in 4th week (10-14 Sep)

UST Inc. is considering a debt-for-equity recapitalization. In the deal, UST will issue $1 billion debt to buy back stocks. In class we argue that an important determinant of a firms debt policy is the tradeoff between the tax benefits of debt and the costs of financial distress and bankruptcy. Mature firms generating positive and stable operating income are more likely to take advantage of the debt tax shields and less likely to verge on bankruptcy, and thus may consider using more debt in their capital structure. Do you think UST Inc. would benefit from this transaction? Between 1988 to 1998, UST has enjoyed excellent financial performance. The firm has posted continuous increase in sales, earnings and cash over the entire period with a 10 year compound growth rates of 9%, 11% and 12% respectively. Most noticeably, the firm has also maintained margins with average gross profit, EBITDA, EBIT and nets margins of 77%, 53%, 50% and 31% respectively. Judging from the financial performance of UST (stable positive earnings), we can firmly conclude that the UST is an assets-in-place firm. The purpose of the debt-for-equity recapitalization is for UST to enhance their overall firm value. 1. First, UST will benefit from the interest tax shield. a. Tax Shield = Corporate Tax Rate * Debt = 0.38 * 1 billion = $0.38 billion In addition, the recapitalization will decrease the number of outstanding shares and as such generate higher returns for shareholders. Moreover, servicing this debt should not add any extra risk of financial distress due to the high positive cash flow generative nature of USTs business. 2. Second, this debt will help prevent 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%. With concern that the management might use the excess funds to over-invest in these under-performing businesses again, adding interest payment obligations into will ensure that the excess cash will be utilized.

HBS Case Study: Debt Policy at UST Inc.


Assume that UST implements the deal on 1 January 1999 and thus has an increased debt of $1 billion in 1999. Assume UST plans to maintain the debt level in the future. Assume a corporate tax rate of 38%, a 5% annual growth in sales from 1998, and an EBIT/sales ratio of 53%. Assume that USTs debt is rated A, and use the 20-year interest for this rating. Compute the interest coverage ratio. Does this ratio support an A rating? What if USTs debt is rated BBB? Whats your assessment of USTs risk of experiencing financial distress? Taking into consideration the debt amount of $100 million from 1998, the total debt in 1999 will be $1100 million ($1.1 billion). We will also assume that the debt of $100 million back in 1998 is rated A as well. Sales in 1999 = 1.05 * 1423.2 = $1494.36 million EBIT in 1999 = 1494.36 * 0.53 = $792.01 million Assuming USTs debt is rated A Interest Expense in 1999 = 1100 * 0.0705 = $77.55 million Interest Coverage Ratio = 792.01/70.5 = 10.21 Since interest coverage ratio is 10.21>7.2, it supports that UST debt is an A rating and even an AA rating as well Assuming USTs debt is rated BBB Interest Expense in 1999 = 1100 * 0.0782 = $86.02 million Interest Coverage Ratio = 792.01/86.02 = 9.21 Even if USTs debt is rate BBB, interest coverage ratio is 9.21>7.2, which still supports that USTs debt can still be rated A or AA Even though the interest coverage ratio is decreasing when the debt rating of UST decreases from A to BBB, it is still not a worrying sign as the high interest coverage ratio of 9.21 indicates that UST is able to meet their interest payments without much problem. As such, UST risk of experiencing financial distress is low. Next we evaluate the tax benefits quantitatively. For simplicity we ignore taxation at investors level. Assume the leverage recapitalization on 1 January 1999 is unexpected by investors in the market.

HBS Case Study: Debt Policy at UST Inc.


What are the market value of equity and the share price at the end of 1998? How much is the present value of the debt tax shield? How will the market value of equity and the share price change when UST makes the announcement? How many shares will be bought back? Assumptions: We will be assuming that the average shares outstanding is equal to the end of year shares outstanding for year 1998 Market value of equity (end of 1998) = $6470.8 million Share Price (end of 1998) = $34.88 PV of debt tax shield = 0.38 * 1000 = $380 million After announcement: V(levered firm) = V(unlevered firm) + PV (tax shield) = 6470.8 + 380 = $6850.8 million Share price = 6850.8/185.5 = $36.93 No. of shares repurchased = 1 billion/36.93 = 27.08 million shares No. of outstanding shares = 185.5 27.08 = 158.42 million shares Market value of equity = 36.93 * 158.42 shares million = $5850.0 million If we also account for the taxation at investors level, assume UST investors are in the tax bracket of 40% for the salary and interest income but pay a tax rate of 15% on dividends and capital gains, what is the present value of the tax shield due to the debt offering? Tc is the corporate tax rate, Te is the dividends and capital gains and Tp is the personal income tax rate Effective tax advantage of debt = 1- [(1- Tc)(1-Te)/(1-Tp)] = 1 [(1-0.38)(1-0.15)/(1-0.4)] = 0.122 PV (tax shield) = 0.122 * 1000 = $122 million

HBS Case Study: Debt Policy at UST Inc.


Note: If you run into some difficulty in your analysis (e.g., you think some important info missing), you might proceeds with some reasonable assumptions.

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