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Ust Case

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1.) Business risk: • Diversification into non-­‐core businesses such as video and television programming and pen and pencils may create difficulties to manage the group in a united and control manner. These diversification strategies may also signal the fact that managers are indeed exploiting their cash freedom in UST Inc with rent-­‐seeking intentions such as empire building or simply out of their own interest • UST Inc has not realized strong sales in the foreign markets while competitors are already doing so in the lights of a declining domestic market.

• Federal government would attempt to pay for the proposed health care reform by dramatically increasing the excise tax on smokeless Tabaco. Financial risks: • The unusually low amount of leverage (0%) might signal the fact that management does not want to have any debt constraints that could mitigate their rent-­‐seeking behavior. Thus, UST does not receive any incentive benefit from debt. Most projects are financed with cash, giving managers a large amount of freedom • Might consider setting provisions for litigation expenses as it affects operating income • A relatively high P/E ratio compared to peers 2.) Benefits of debt for UST: • Given UST’s large amount of diversification track record particularly funded with cash, the debt can act as a management and incentive control mechanism to restrict the rent-­‐seeking behaviors of their managers. • Debt can provide a debt tax shield for UST Inc that further enhances its cashflow • Debt issues a signal to investors that UST Inc is committed to improve its management through the monitoring effects of debt • Debt provides the funding for UST Inc to expand into foreign markets • Debt protects UST from being a takeover target, as the proceeds can be paid as dividends to shareholders 3.) To estimate the interest rate that UST Inc may need to incur on different debt/capital level, we could observe from the investment grade of UST Inc’s peers’ debt, and assign a corresponding interest rate level according to the yields shown in the appandix UST Inc various debt/equity level

FM431

Level of debt 0% 10% 20% 30% 50% 80% Debt to equity % 0% 11% 25% 43% 100% 400%

UST Inc. peers various debt/equity level and corresponding investment grade Peer Debt/Equity Investment Yield % grade Philip Morris 20.7% A 7.8% 7.8% American Brands 29.3% A 7.8% Universal 22.2% A-­‐ Corporation RJR Nabisco 143.3% BBB-­‐ 8.5% Dibrell Brothers 54.9% BB 9.1% Standard 57.6% BB-­‐ 9.1% Commercial Observing from this, we can see that although Debt/Equity % ratio is a huge factor that determines the debt’s grading of investment level, it is not the sole factor. For example, RJR Nabisco, even with huge amount of debt, has a higher investment grade debt that Dibrell Brothers and Standard Commercial. This might relate to RJR Nabisco’s exception as a firm after an LBO, or because RJR Nabisco has stronger net profit margin than its other two peers. Anyway given that UST Inc has a stronger financial performance than all of its peers in any selected ratios, the firm’s debt should receive a relatively positive investment grade. Here are my estimates. UST’s bond rating and interest rate in different debt/capital level Debt/Capital Debt/Equity Investment Yield % % grade 10% 11% A 7.8% 7.8% 20% 25% A 7.8% 30% 43% A 50% 100% BBB+ 8.5% 80% 400% B 10.6% 4.) According to the MM theorem, VL = VU + PV (Tax shield) -­‐ PV (Costs of distress). Thus, the main cost of debt is cultivating financial distress. Managers normally should care about financial distress costs when issuing debt, as they can incur direct costs and non-­‐direct costs of financial distress to the company. For example, classic share holder-­‐debt holder conflicts such as the underinvestment problem and adverse selection will arise. The financial distress also affects supplier, and employee relationships, as well as discounting assets as they have to be sold at fire-­‐sale prices. However, since UST Inc is a financially strong

company, the costs of financial distress is likely to be low especially if UST Inc will not issue over 100% of equity in its first debt issue in history.

5.) The benefit of debt is debt tax shield, which in UST’s case will be: Debt/Capital % Tax shield (Millions) 10 15.6 20% 31.2 30% 46.7 50% 77.9 80% 124.6 Level of debt

0% 10% 20% 30% 50% 80% Tax Shield (Cash flow) (Millions) -­‐

15.6

31.2

46.7

77.9

124.6 In terms of costs of financial distress, since: E(COFD) = [ P(default in a year) * (% of company lost if in distress)* (Pre-­‐ restructuring firm value)] / Rf Therefore, Debt/Capital Investment Default COFD Tax shield-­‐COFD % grade Probability (Millions) 10% A 0.10% 9.55 6.05 20% A 0.14% 26.72 4.48 30% A 0.14% 40.1 6.6 50% BBB+ 0.18% 85.9 -­‐8 80% B 2.42% 282.55 -­‐157.95 6.) The only factor that could hamper future dividend payment of UST Inc would be the financial distress, which puts the firm into bankruptcy and was forced to pay its debt holders first. In cases < than a debt/capital ratio of 30%, dividend yield instead increases as leverage reduces the number of outstanding shares to split the dividend. However, as leverage reaches 80%, the large amount of interest payment significantly reduces dividend payments.

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