Case 2

FIN500
Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi

Debt Policy at UST Inc.

Executive Summary

In the 1990’s, UST was a dominant producer of moist smokeless tobacco, controlling 77% of the

market. Smokeless tobacco products consist of snuff (dry and moist) and chewing tobacco (loose leaf,

plug and twist/roll) categories. UST was a market leader of the snuff product category, innovating with

new product forms and flavors over the years. UST has also been a profitable company, boosting its

shareholders’ earnings by undertaking measures such as increasing the cost of its products steadily with

time. UST also benefited from the steady increase in market demand for smokeless tobacco given the

rising restrictions on cigarette second hand smoke. UST was still criticized at the time for its tardiness

with new product introductions and losing its market share to new and smaller competitors. In 1997,

instead of cutting product prices to compete, UST introduced new line of lower priced products such as

Copenhagen Long Cut and Rooster. UST also renewed its focus on the marketing campaigns, launching

promotions and increasing couponing.

For years, tobacco industry had been embattled with health related lawsuits. Majority of these

litigations were for cigarette companies in comparison to smokeless tobacco industry. Still, UST had

seven pending health related lawsuits. UST has historically been one of the most profitable companies in

corporate America. Even though S&P rated the debt of many tobacco companies as investment grade, its

long term outlook of the tobacco industry was unclear given the rising restrictions on tobacco products

and health awareness among consumers. Despite the questionable outlook of tobacco industry, in

December 1998 UST’s board of directors decided for active capital structure change and approved the

decision to borrow up to $1 billion to accelerate the company’s stock repurchase program.

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Case 1 - Marriott Corporation: The Cost of Capital FIN500
Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi

What are the primary business risks associated with UST Inc.? Evaluate from the viewpoint of a

credit analyst or potential bond holder (1 point). Hint: you may compile a list of factors and

comment on them.?

UST has historically been one of the most profitable companies in corporate America and a

market leader in smokeless tobacco industry; however there are a few associated business risks with

UST as listed below:

 The demand for smokeless tobacco products was minimal in international markets and product

expansion outside USA for greater market segment was not much of an option for UST.

 UST had been slow to diversify its product line across various price points, consequently

allowing smaller competitors to gain traction for the lower priced smokeless tobacco product

categories. Companies like Swedish Match, Conwood and Swisher were reporting rising

revenues with snuff and chewing tobacco products.

 Tobacco industries (smoke or smokeless tobacco products) were involved in numerous health

related lawsuits and litigations. With FDA regulations, there were increasing restrictions on

tobacco use. Consumers were also getting health conscious and understanding the carcinogen

effects of tobacco with increasing anti-tobacco campaigns. UST had seven pending health related

lawsuits at the end of 1998. Lawmakers were expected to continue to push for new laws to

combat youth tobacco use, restrict tobacco advertising and empower FDA to regulate nicotine as

a drug. These developments made the distant future of tobacco industry and UST unclear.

2. According to Exhibit 3 of the case, the current P/E ratio is 13.8 (i.e., P0/E0 = 13.8). Using the 20-

year T-bond rate of 5.45% from Exhibit 8 of the case, assuming the stock market premium is 7%,

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Case 1 - Marriott Corporation: The Cost of Capital FIN500
Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi

and UST’s equity beta is 0.65, and UST will maintain a dividend payout ratio equal to the 5-year

average dividend payout ratio from 1994 until 1998, what is the implied earnings constant growth

rate, g (2 points)?

5-year average dividend payout ratio

1994 = 58%
1995 = 59%
1996 = 60%
1997 = 67%
1998 = 64%
Dividend payout ratio = 61.6%

CAPM
i = Rf + β(RM – Rf)
β = .65
Rf = 5.45% 20-year T-bond rate
RM – Rf = 7%
i = 5.45% + .65(7%)
i = 10%

Constant Dividend Growth Model

P0/E0 = (1+g)*d/(i-g)
P0/E0 = current price to earnings ratio = 13.8
d = dividend payout = 61.6%
i = required rate of return on the stock = 10%
g = constant growth rate
P0/E0 = (1+g)*d/(i-g)
13.8 = (1+g)*.616/(.1-g)
22.4026 = (1+g)/ (.1-g)
23.4026g = 1.24026
g = 5.3%

3. Assume a 38% tax rate, and net sales will grow at 5% from 1998 level, and the ratio of EBIT to

Net sales in 1999 will be equal to the 5-year average EBIT/Net sales ratio from 1994 to 1998

period, prepare a pro-forma income statement as the following table. Will UST will be able to

make interest payments (4 points)?

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Case 1 - Marriott Corporation: The Cost of Capital FIN500
Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi

Income Statement Projections (in millions, except per-share data and ratios)
Actual Pro-forma Pro-forma Pro-forma Pro-forma
1998 1999 1999 1999 1999

Net sales 1423.2 1494.36 1494.36 1494.36 1494.36

EBIT 753.3 796.05 796.05 796.05 796.05

Interest (2.2) 0 70.5 78.2 87.2

Pre-tax 755.5 796.05 725.55 717.85 708.85

earnings

Taxes 287.09 302.5 275.71 272.78 269.36

Net Income 467.9 493.55 449.84 445.07 439.49

Net debt 0.0 0.0 $1000.0 $1000.0 $1000.0

Interest rate NA NA 7.05% 7.82% 8.72%

Interest NA NA 11.29 10.18 9.13

coverage

Net Sales 1998 = 1423.2

1999 = 1423.2 * 1.05 = 1494.36

5-year average EBIT/Net sales ratio from 1994 to 1998:

(1994): 640.7/1204; (1995): 707.8/1305.8; (1996): 750.9/1371.7; (1997): 719.3/1401.7;
(1998): 753.3/1423.2;
Average EBIT/Net Sales Ratio = (.532 + .542 + .547 + .513 + .5293) / 5 = .5327
EBIT 1998 = 753.3
(Pro Forma) = 1494.36 * .5327 = 796.05

Interest: (Pro Forma) = $1000 x 7.05% = $70.5

(Pro Forma) = 1000 x 7.82% = $78.2
(Pro Forma) = 1000 x 8.72% = $87.2

Pre-Tax Earnings: (Pro Forma) = EBIT – Interest = 796.05 - 70.5 = 725.55

(Pro Forma) = 796.05 – 78.2 = 717.85

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Case 1 - Marriott Corporation: The Cost of Capital FIN500
Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi

(Pro Forma) = 796.05 – 87.2 = 708.85

Taxes: (Pro Forma) Pre-Tax Earnings x 38% Tax Rate = 796.05 x .38 = 302.5
(Pro Forma) = 725.55 x .38 = 275.71
(Pro Forma) = 717.85 x .38 = 272.78
(Pro Forma) = 708.85 x .38 = 269.36

Net Income: (Pro Forma) = Pre-Tax Earnings – Taxes = 493.55

(Pro Forma) = 725.55 – 275.71 = 449.84
(Pro Forma) = 717.85 – 272.78 = 445.07
(Pro Forma) = 708.85 – 269.36 = 439.49

Interest Coverage: Times Interest Rate Earned (TIE) = EBIT / Interest Expense
(Pro Forma) = 796.05 / 70.5 = 11.29
(Pro Forma) = 796.05 / 78.2 = 10.18
(Pro Forma) = 796.05 / 87.2 = 9.13

Given that for each set of interest rates, ranging from 7.05%, 7.82%, and 8.72%, each Times Interest
Rate Earned is of these ratios is greater than 1 (11.29, 10.18, and 9.13, respectively), UST will be more
than capable of making the interest payments.

4. Should UST Inc. undertake the $1 billion recapitalization? Assuming the entire recapitalization

is implemented immediately on 01/01/1999. Fill out the following form and show your solution

process and explain whenever necessary, assuming the $1 billion in new debt is constant and

perpetual (2 points). Hint: assumes that recapitalization plan was not anticipated by the capital

markets, so the stock price under recapitalization plan should be equal to the original market

price plus the PV tax shields per share, and assume shares are repurchased at the stock price

reflecting the recapitalization.

Valuation Impact of recapitalization (in millions, except per-share data and ratios)

Status Quo (12/31/1998) $1 billion Recap Plan

PV Tax Shields 0 38%

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Case 1 - Marriott Corporation: The Cost of Capital FIN500
Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi

Market Value of UST $6470.8 $6646.6

Net Debt 0 $1,000.0

Stock price $34.88 $42.38

Shares repurchased NA 4346330

Shares outstanding 185,516,055 156847330

Market value of Equity $6470.8 $6646.6

Debt/Equity ratio 0 0.15

Market value of UST(status quo)

It was given that UST has no debt and PV of tax shield is given as zero, so the market value of UST
is equal to its market value of equity before recapitalization, which was given as 185,516,055.

Assume 38% tax rate

Market value of UST = market value of debt + market value of equity

Therefore,

Value of status quo = $0 + 6470.8

= $6470.8millions

Market value of UST(after recap)= market value of UST equity before recap + interest tax shield of
debt.

= 6470.8(million) + 175,826,000

= 6646.6(million)

Market value of equity= dividends/ cost of equity (K(e)=5.2% in 1999, dividends = 301.0

Tax shield of debt= [ (income – ( debt x interest rate) } x tax rate

=( (467.9-(100.0 x 5.2) ) x 38%

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Case 1 - Marriott Corporation: The Cost of Capital FIN500
Team 4: Jesse Galindo, Sulabh Gupta, Maggie Jones, Wale Olukanmi

= 175,826,000

Stock price after cap= 6646.6/156,847,330

= 42.38

Shares repurchased (per exhibit 3) = 151.6/34.88 (stock price)

= 4,346,330

Shares outstanding after recap = original shares outstanding - $1billion / 34.88

= 156,847,330

Market value of equity before cap = stock price x outstanding shares

6470.8million = 34.88 x outstanding shares

Therefore

Outstanding shares = 6470.8million / 34.88

= 185,516,055

Debt/ equity ratio = total debt / total equity

After recap = 1000.0 / 6646.6

= 0.15

Recapitalization had a few positive effects

Market value of the firm increased by 176.6 million

Share price increased from 34.88 to 42.38

By using debt to repurchase, UST was able to create tax shield, which helped increase the value of the
firm and which will be a positive news for shareholders.

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