This case is based on the HBS Debt Policy at UST Inc. Case
Instructions:
- The case should be done in your assigned groups.
- Hand in printouts of thespreadsheets and a brief write-up not exceeding two pages explaining what was done.
In December 1998, UST Inc.'s board of directors approved a plan to borrow up to $1 billion over five years to accelerate its stock buyback programs. UST is a very profitable smokeless tobacco producer with minimal debt vis-à-vis comparable firms. It is a dominant producer with 77% of market share, largely insulated from competition due to advertising restrictions. The company has managed to experience 36 consecutive years of earnings increases. UST does face some business risk. For example, virtually all of UST's cash flows come from the sale of a single-product: smokeless tobacco, and it has minimal sales outside of the US. There are also very few tangible assets. Finally, though litigation risk is lower for UST than it is for the cigarette manufacturers, there is still moderate lawsuit risk. All of these factors would be taken into account by S&P to determine ratings of UST's new debt. Historically, UST has maintained an A-1 credit rating for its commercial paper. As UST increases its debt level, it will likely issue long-term debt, thereby increasing the average maturity of debt outstanding.
Based on UST's income statement at the end of year 1998, it has $1,423.2 mil Net Sales and $753.3 mil Earnings before Interest and Taxes (EBIT). The past 5-year average growth rate for Net Sales is 5%. The current corporate debt yields on Dec 22, 1998 can be found in Ex. 1. Depending on the S&P ratings of UST's new debt, the cost of borrow will vary accordingly. Would UST be able to make interest payment with high probability if their debt were given A, BBB, or BB rating? Please present Pro-forma income statements for fiscal year 1999 and calculate interest coverage. (Assume 38% corporate tax rate; Interest Coverage=EBIT/Interest).
At the end of year 1998, UST's stocks are traded at $34.88 per share and there are 185.5 million shares outstanding. UST has 0 net debt. Assume that $1 billion new debt is constant and perpetual, that the recapitalization plan was not anticipated by the capital markets; calculate the marginal effect of the new debt issuance. What is the present value of the interest tax shield? What is the new stock price for UST? How many shares would be repurchased using the $1billion debt proceeds assuming these shares will be purchased at the new stock price? What would be the UST's Debt/Market Equity after the recapitalization?
Ex. 1. Dec 22, 1998 Corporate Bond Yields
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Debt Yield
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T-bills
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AAA
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AA
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A
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BBB
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BB
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20-year (%)
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5.45
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6.47
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6.76
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7.05
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7.82
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8.72
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