Debt Policy at UST Inc

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					Debt Policy at UST Inc.
    Should UST undertake debt
         recapitalization?



        Beidi Gu & Minhua Zhang
      Recap: What the pro-side said about the
                company value?
   Tax Shield
    UST wants to increase the firm value by enjoying the huge tax shield provided
    by more leverage.



Tax Shield: D = (0.38)($1billion) =$0.38billion
      Recap: What the pro-side said about the
                company value?
   The incremental effect on UST’s value of implementing the
    recapitalization, assuming that the plan is implemented immediately
    on January 1, 1999.

VU: The firm value before the debt recapitalization
VL: The firm value after the debt recapitalization
: Tax rate
D: Debt issued
: Probability of bankruptcy as a proportion of the firm value

VL = VU + Tax Shield – Expected Bankruptcy Cost
 VL = VU + D - PV (Financial Distress)
 VL = VU + D - (probability of bankruptcy * cost of bankruptcy)
 VL = VU + D - (probability of bankruptcy * ( * VU))
         Where  is some constant that is usually valued between 5% and 30%
   Recap: What the pro-side said about the
             company value?
Incremental chance=VL-VU=D - (probability of
  bankruptcy * ( * VU))
              =0.38*1 billion-0.0028*0.3*6.5billion
                    =$0.375 billion


So, the incremental change the added
 leverage causes is a increase of the firm
 value by $0.375 billion=375 million!
Really?
                   Real World
   There are Personal taxes!

      VL=Vu+{1-(1- C)(1- pe)/(1-y)}D

Rich investors faces marginal income tax ~ y =50%
Original tax on dividend pe=20%

                   = {1-(1- C)(1- pe)/(1-
    Now  effective 
    y)} = (1-.38)(1-.20)/(1-.50)=.008
   Tax Shield is only .008   billion = 8 million!
               Company Value
Incremental chance=VL-VU=D - (probability of
  bankruptcy * ( * VU))
              =0.008*1 billion-0.0028*0.3*6.5billion
                    =$0.003 billion


So, the incremental change the added
 leverage causes is a increase of the firm
 value by only $0.003 billion=3 million!
Oh!
      3 Million
         NOT
       375 Million
                    Risk, Risk

 Tough   market perspective
   Higher bankruptcy cost
               Tough market perspective

   Why UST did not lever the firm earlier?
     Low Tax Shield!
     High market occupancy and natural market
      expansion guarantees constant availability of positive
      NPV projects to enhance company value
     Customers shifted from smoking cigarette

   But the company realized that such momentum
    will not continue into the future!
                     Risk, Risk
                88.00%
                86.00%
                84.00%
                82.00%
                                           Total
                80.00%
                                           Market
                78.00%                     Share
                76.00%
                74.00%
                72.00%
                      1991   1994   1997


Let’s   use the debt shield as a last resort then 
              Tough market perspective

    What if the EBIT
                                                           Payout Ratio (EBIT CAGR 9%)

                             1.10

    doesn’t grow with 11%?   1.00



   9%  Unable to           0.90

                             0.80                                                                    Payout

    maintain the dividend    0.70
                                                                                                     Ratio



    stream in 2007           0.60




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   7%  Unable to                                         Payout Ratio (EBIT CAGR 7%)

    maintain the dividend    1.30


    stream in 2005           1.20
                             1.10
                             1.00
                             0.90                                                                     Payout
                             0.80                                                                     Ratio

                             0.70

                             0.60
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                   Risk, Risk

 Tough market perspective
 Higher bankruptcy cost
                 Higher Bankruptcy Cost

   Litigations and fines on health related issues
       Pending law suits at the end of 1998
   Litigations on anti-trust law suits
       UST vs. Conwood Co.
   1 Billion Case lost over last summer (2002)
You Decide Please

				
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