Compute the interest coverage ratioAnswer:By using the 5% annual growth rate in sales, the sales of

1999 is:1,423,200,000 * (1+5%) = 1,494,360,000By using the EBIT/Sales ratio of 53%, the EBIT of 1999
is:1,494,360,000 * 53% = 792,010,000Interest expense of each year by using 20 years “A” Investment
Grade Corporate Bond:1,000,000,000 * 7.05% = 70,500,000Assume that all other interest expense is
zero:Interest coverage ratio = 792.01/70.5 = 11.2Does this ratio support an “A” rating?Answer:The
interest coverage ratio is 11.2, which exceed the requirement of “A” Investment Grade Corporate
Bond (7.2), and UST even meets the requirement for “AA” Investment Grade Corporate Bond (9.2),
thus the rating of the bond is well supported by the ratio.What if UST’s debt is rated ‘BBB’?Answer:If
the bond is rated to “BBB”, the interest rate for the bond will be 7.82%, with annual interest
payment of 78,200,000.The new interest coverage ratio is:792,010,000/78,200,000 = 10.1What is
you assessment of UST’s risk of experience financial distress?Answer:It is unlikely for UST to
experience financial distress due to strong cash flow that generated by the operation. From the
above calculation, we can see that even with lower the investment grade; it has little effect on UST’s
credit rating

What are the market value of equity and the share price at the end of 1998?Answer:The market
value of equity is $6,470.8 million and the share price at the end of the year is$34.88 (Exhibit
5)Further in this assignment we assume that the market price of the shares will remain at $34.88.
How much is the present value of the debt tax shield?Answer:PV (interest tax shield) = $1,000million
* 0.38 = $380millionHow will the market value of equity and the share price change when UST makes
the announcement?Answer:VL = $6,470.8 + $380= $6,850.8 (increase)E= $6,850.8 – $1,000 =
$5,850.8 (decrease)When the UST makes the announcement, the market value of equity will
decrease, but the total firm value increases (due to tax interest shield).How many shares will be
bought back?Answer:The UST Inc are able to buy back ($1,000 million / $34.88) =286,697 million
shares to a market price of $34.88 each. In total, stockholders has ($6,470.8 / $34.88) million =
185.5160 million shares before the repurchase of shares. After the repurchase, the stockholders have
(185.5160 – 28.6697) million= 156.8463 million shares outstanding. The new price of the share will
increase to (5,850.8 / 156.8463) = $37.3All over, the shareholders who kept their shares will benefit
from a capital gain of ($37.3 new price – $34.88 old price) = $2.42 per share. This adds up to a total
gain of ($2.42 * 156. 8463million) = $380 million which equals the interest tax shield.

What is the present value of the tax shield with personal taxations?Answer:To calculate the tax shield
with personal taxations we have to calculate the ‘Effective TaxAdvantage on Debt’. We can do this
by : Where tc = corporate tax, te = tax on dividens, ti = tax on interest income1- ( (1-0.38)(1-0.15)/(1-
0.4) ) = 0.1217 This means that from every 1 $ gain to the shareholders, effectively they only gain (1-
0.1217) = $0.87VL = $6,470.8 + (12.17 % * $1,000) = $6,592.5 million$6,592.5 / 185.5160 = $35.54
per share before repurchase $35.54 - $34.88 = $0.66 increase per share$0.66 * 156.8463 = $103.5
million in interest tax shield with personal taxation. Conclusion: We can conclude that this
transaction is a win-win situation as the interest tax shield amounts to 103.5 million and because the
share repurchases increases earnings per share and tends to elevate the market value of the
remaining shares. In addition, the fact that UST will benefit from this debt-to-equity recapitalization
is supported by UST’s high interest coverage ratio and the low risk of experiencing financial
distress.In addition, UST shouldn’t worry so much about the risks that would come in gaining more
debt for the reason that the company seems to face little risk of bankruptcy. While itwas noted that
the company is facing a lot of competition, and that people fear it is underperforming, UST should
still be able to take advantage and benefit greatly from thisnew debt structure. One must not forget
that UST is still a market leader, able to control the largest share and use brand recognition. What’s
more, despite the rise of competition, UST maintains its edge especially given therestrictions for
advertising tobacco. The conditions of the UST’s industry also prove that there will be economical
stability, at least in the foreseeable future. Given the increasing popularity of smokeless tobacco, as
well as the fewer cases that smokeless tobacco companies receive compared to regular ones, (as
mentioned) UST shows an optimistic future in its performance.

All of these instances prove that there shouldn’t be much worry about the riskiness of the firm. With
this, the firm, when using taxes, will only be able to improve its profits even more through tax
shields, and the investors themselves can also receive similar benefits.
Executive Summary As the leading manufacturer in the moist smokeless tobacco industry, UST Inc.
has long been recognized by its ability to generate high profit using low financial leverage. With a
dominant market share of 77%, the company maintains a pricing power that allows it to institute
annual price increases without losing costumers. However, UST’s market share was eroded
significantly in recent years by price-value competitors who enter the market with lower prices.
Although UST responded to these threat by introducing new products, market share still decreased
by 1. 6% over past 7 years.

In addition, UST is also exposed to an unfavorable legislative environment, in which the company is
under advertising and product promotion restrictions. The increasing business risks force
management of UST to consider a recapitalization plan in which UST borrows up to $1 billion to
repurchase its stocks. The marginal effect of the recapitalization will be a $380 million increase in
firm value, which is the present value of interest tax shield. Besides the recapitalization benefit,
management also needs to notice the costs of recapitalization, which include higher bankruptcy costs
and a potential of lower credit rating.

UST has a high and constant dividend payout history since 1912. The recapitalization will expose
more risks to shareholders since revenues will be used to pay interest before pay dividends. Thus,
the recapitalization may hamper future dividend payments. Background Having long been the
leading company in the moist smokeless tobacco industry, UST Inc. was famous for its product
innovation, dominate market share, and pricing adjusting power. However, as the competition of the
moist smokeless tobacco industry became more intense and the legislative environment became
more unfavorable, UST is facing several business risks: . Lose of market share. Relying on its superior
products and innovation ability, UST used to control most of the moist smokeless tobacco market
and was able to increase the price of its products year by year without losing its customers. The
historical pricing flexibility gave UST a robust earning performance and bumped up its stock prices.
However, as the speed of product innovation became slower, UST is facing the threat of price-value
competitors, who enter the market by charging a lower price. Although later UTS responded to the
threat by introducing new products, the company’s market share still dropped from 86. % in 1991 to
77. 2% in 1998. 2. Increase exposure to legislative environment. Moist smokeless tobacco
manufactures used to face fewer lawsuits than cigarette manufactures due to less scientific evidence
liking smokeless tobacco to cancer. However, the legislative environment has become more
unfavorable to smokeless tobacco manufactures since the industry has agreed on a ban on
advertising in order to settle state Medicaid lawsuit. Also, UST was the only main manufacturer that
signed an agreement on promotion restrictions that aim to reduce youth exposure.

Recapitalization UST has been widely known for its conservative debt policy, which allows
the company to generate high returns with very low financial leverage. However, as business
risks such as market share erosion and unfavorable legislation exposure increase, UST has an
incentive to change its capital structure in order to benefit from interest tax shield and
maximize the firm value. Recapitalization will also benefit shareholders in a way of higher
company stock price since the proceeds from debt will be used to repurchase outstanding
stocks.

Also, although UST has a very high gross profit margin and return on assets on its core
business compared to other smokeless tobacco manufactures, the poor performance of its non-
core operations such as market wine and premium cigars give UST a low to zero profit
contribution. UST’s management needs to diversify its product line and bump up earnings by
investing more in the non-core operations using debt funds. Marginal Effect of
Recapitalization To analysis if UST should undertake the $1 million recapitalization,
management needs to calculate the value of the firm before and after ecapitalization. In a
market with taxation, the value of the levered firm equals to the value of the unlevered firm
plus the present value of interest tax shield. Because management assumes that the new debt
is constant and perpetual, the present value of interest tax shield equals to the amount of debt
multiplied by the effective tax rate, which is 38%. Thus, the present value of UST’s future tax
saving should be 38% * $ 1 billion, which is $380 million. At the end of 1998, the market
equity of UST was $6,470. 8 million based on the average shares outstanding and year-end
stock price.

If UST borrows $1 billion debt immediately, the total value of the levered firm would be
$6,470. 8 million unlevered value plus $380 million tax shield, which is $6,850. 8 million.
Because firm value will rise to $6,850. 8 million immediately after the recapitalization
announcement, original shareholders will capture the full benefit of interest tax shield since
they are able to sell their stocks at a higher price. The new stock price is determined by
dividing the value of the levered firm by the number of shares outstanding at the end of 1998.

Since there were 185, 516,055 shares outstanding at year end 1998, the new stock price after
the announcement of recapitalization would be $6,850. 8 million divided by 185, 516,055,
which is $36. 93. Compared to the original stock price of $34. 88, each pre-existing
shareholder will benefit $2. 05 from the increase in leverage. If taxation is the only issue that
management should take into consideration, the marginal effect of raising debt will be
increase in company value by $380 million.

However, as financial leverage increases, default risk on debt also increases, thus leads to a
potential increase in bankruptcy costs. UST has been maintained an A-1 credit for its low debt
/ capital ratio of 28. 2%, which is a competitive advantage over its competitors who are highly
leveraged. If UST decides to increase its leverage ratio, it will cause rating agencies to revalue
its capital structure and cash flow generating ability in order to assign an appropriate rating.

The potential change in rating will significantly affect UST’s cost of capital. Thus,
management should balance the tax benefit with the expected cost of bankruptcy to maximize
form value. Besides its conservative debt policy, UST was also famous for its stable and
constant dividend payout since 1912. The recapitalization may hamper future dividend
payments since earnings should be used to pay off debt and interest expense before they are
delivered as dividends to stockholders.

Because debt is risk-free and debt holders have first claim on a company’s asset, levered
equity often carries a higher risk premium than unlevered equity to compensate stockholders.
The remaining balance of earnings after paying interest may also be retained for operating
purpose. Thus, the possibility of an interruption of cash dividends payout may occur.
Summary In summary, facing the increase business risks of losing market share and exposing
to unfavorable legislations, the management of UST Inc. s considering changing the
company’s capital structure by raising $1 billion debt and accelerating its stock buyback
program. The benefit of recapitalization will be an increase in firm value of $380 million and
increase in stock price by $2. 05 each share. However, management should also take into
consideration the potential increase in bankruptcy costs and changes in credit rating. Last, the
constant divided payout may be hampered by recapitalization since earnings need to be used
to pay interest to debt holders first.