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Hbs Case Ust Inc
Hbs Case Ust Inc
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.