# Debt Policy at UST Inc

Document Sample

```					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)