Answer Questions

The CEO of UST would like you to prepare a three to four page case report discussing UST’s current financial situation and the implications of increasing leverage in UST’s capital structure. The firm is considering a $1 billion increase in long-term debt. Assume that the debt would be taken on immediately and held in perpetuity. The $1 billion would be used immediately to repurchase shares. Also assume that the top marginal tax rate is 38 percent. The following questions should be addressed when preparing the report for the CEO:

  1. 1) Provide an overview of UST’s business operations. In your presentation, feel free to provide visual detail of the type of products UST sells to its customers.
  2. 2) Compile a list of factors that a credit analyst or potential bondholder would take into account when evaluating UST’s proposed recapitalization. Discuss the important factors.
  3. 3) Why is UST considering a leveraged recapitalization after such a long history of conservative debt policy?
  4. 4) Comment on the past and future financial performance of UST. What is the stock market’s assessment of UST’s long-term growth rate?

a. Hint: use the growing perpetuity formula, 𝑃0 = 𝐷1⁄(𝐸𝑟𝐸 − 𝑔), and solve for 𝑔 to infer UST’s long-term growth rate. You will need to use the CAPM to find 𝐸𝑟𝐸. (You may want to do some online research of comparable tobacco companies to figure out the approximate beta you should use for the CAPM.) Assume that 𝐷1 = 𝐷0 × (1 + 𝑔).

  1. 5) Comment on the financial performance of UST relative to other tobacco companies.
  2. 6) Create three pro-forma income statements for fiscal year 1999 under each of the following assumptions: (1) the $1B in debt was not issued; (2) the $1B in debt was issued and is investment grade; (3) the $1B in debt was issued and is below investment grade. For the latter two cases, can UST afford to make the interest payments based on the respective pro-forma income statement?In answering this question, the CEO only wants a simplified pro-forma income statement that takes the following form:SALES
    EBIT
    INTEREST EXPENSE PRE-TAX NET INCOME TAX
    NET INCOME
  1. 7) Calculate the change in UST’s value due to the tax shield benefits of the additional debt. For this question, it would be useful to create a table containing the following information: value of the tax shield, value of the firm, value of the debt, value of the equity, number of shares repurchased, number of shares outstanding, and stock price. The table should cover the same three cases as Question 6. Assume that the $1B in debt is used to repurchase $1B in shares.
  2. 8) Comment on possible changes in value from the recapitalization due to other market frictions such as bankruptcy costs, information signaling, or other market frictions that you feel are applicable.
  3. 9) UST has paid uninterrupted dividends since 1912. Will the recapitalization hamper future dividend payments? Consider, in particular, the dividend paid per share in 1999, with the assumption that UST will try to maintain a constant dividend payout ratio.

The case report should be three to four pages in length (use the default spacing in Microsoft Word) with any useful tables or graphs attached. A one-paragraph executive summary should be included at the beginning of the report. The report should be presented in a professional manner and read as a cohesive document so that the CEO can easily understand your main points. If you need to make any assumptions, make them clear. Calculations should be relegated to an appendix. A report that consists of a mess of calculations and numbers or a series of random paragraphs pasted together would not be acceptable.

The case presentation should be about 20-30 minutes in length. Similar to the report, it should also be presented cohesively and in a professional manner so that the CEO can easily understand your main points. The presentation should be informative, concise, and should keep the listener engaged. The presenter should also be prepared to answer questions from the audience. A maximum of two people from your group should present your findings.