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Group 2CAng Wee KiatKwek Louis
Lai Yuting
Mavis Tay
Yang Kangjie
DEBT POLICY AT
UST INC.
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INTRODUCTION TO
UST INC.
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Moist smokeless tobacco industryFastest growing segment of the tobacco industry
77%market share
Premium PositioningSteady price increases
Product introductions and innovations
BACKGROUND OF UST INC.
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STOCK REPURCHASE PROGRAM
1996Approval
1997Suspension
Nov, 1998Reinstated
Dec, 1998Approval of
$1bil loan plan
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BUSINESS RISKS OF
UST INC.
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7 pending health related lawsuits
Smokeless Tobacco Master Settlement Agreement
Antitrust lawsuit
Possibility of new laws and regulations
LEGAL CHALLENGES
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From 86.2% in 1991 to 77.2% in 1998
Inroads by competitors in price-value segment
Slow response to competition
Lesser new product introductions and innovations
ERODING MARKET SHARE
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Causes cancer
Regarded as a social menace
Restrictions on public advertising
Difficult to increase salesHigh barriers to entry
NEGATIVE SENTIMENTS
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Saturated domestic tobacco market
Growth 1-3% annually, mostly in price-value segment
No immediate opportunity for internationalexpansion
Poor performance in non-core operations
LIMITED OPPORTUNITIES
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ATTRIBUTES OF UST
INC.
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Strong brand name recognition
Market leader
Premium products Economies of scale
Management issues
Lack of initiative and foresight
BUSINESS ATTRIBUTES OF UST INC.
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Most profitable company in 1997 and 1998
Market leader
Strong financials Generous return of capital to investors
A-1 credit rating for commercial paper
Poor performance of non-core operations
FINANCIAL ATTRIBUTES OF UST INC.
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BONDHOLDERS
PERSPECTIVE
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Potential liabilities from lawsuitsPending health-related and anti-trust lawsuits
Higher likelihood of facing more health-related lawsuits
in the future as more research is done
This represents a likely increase in the liabilities
of UST in the futureBondholders, esp. long-term bondholders will view thisas less favourable
BONDHOLDERS PERSPECTIVE
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Weakness in management teamResignation of 2 top executives
Not profitable in its non-core operations
This could affect the long-term survival of thefirm
Long-term bondholders will view this as a risk for longterm bonds
BONDHOLDERS PERSPECTIVE
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Negative public and political sentiments Increased regulations and restrictions
High possibility of more of such regulations in future
Possibility of extreme regulations such as banning USTfrom selling tobacco products or nicotine beingregulated as a drug
This could also affect the long-term survival ofthe firmLong-term bondholders will also view this as anincreased risk of holding long-term bonds
BONDHOLDERS PERSPECTIVE
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Strong brand name recognition
Ability to reap economics of scale
Highly profitable in the short-term futureBondholders will have increased confidence of UST to
make its interest payments in the short-term
BONDHOLDERS PERSPECTIVE
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Healthy financialsMost profitable company in 1997 & 1998
Financial ratios that measure solvency and liquidity are
way above industry average.Very low debt-equity ratio
Implies a very high ability to meet its obligationsin the short-term
Bondholders, esp. the short-term bondholders will likethis aspect as it implies very little risk of default
BONDHOLDERS PERSPECTIVE
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RATIONALE FOR
LEVERAGEDRECAPITALIZATION
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Long history of conservative debt policyLong-term debt to capitalization ratio of 17.6% as ofend of 1998, as compared to industry average of 55.9%
Highly cash generative business
BEFORE RECAPITALIZATION
UST Inc. Industry
ROA 53.8% 4.8%
ROE 103.4% 23.7%
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What could have prompted the management tochange its debt policy and consider leveraged
recapitalization?
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Fear of negative effects on stock prices
Investors loss of confidence in UST Inc.
Competitive position affected by growth of valueplayers in moist tobacco industry
Eroding market share
Management issues
Legal and marketing restrictions might slow downfuture growth
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Increase stock prices and firm valuepre-emptively to signal confidence
Through stock repurchase
Through tax shield
Increase debt-to-equity ratio
Discipline management
WHY LEVERAGEDRECAPITALIZATION
1
23
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Through Stock Repurchase
Suggest confidence
Accelerate stock repurchase with additional leverage Intensity of stock buyback might reflect insiders information
and confidence, suggesting that USTs stocks are under-valued
Reflects an increasing EPS Hint to investors that stocks were being under-valued
Drives up stock prices
INCREASING STOCK PRICES1
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Through Tax Shield
Incremental tax shield:
Amount of incremental borrowing x corporate tax rate Eg. $ 1 billion x 0.38 = $ 380 million
Value of firm: Initial enterprise value + increased tax shield
Increase in firm value spreads across number ofoutstanding shares and increases stock price
Possibly higher corporate tax rates Higher tax shield
INCREASING STOCK PRICES1
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Combined effect
Stock repurchase will amplify the increase in stock
price that results from tax shield
Increase in firm value will spread over decreasedno.of outstanding shares
Further increase in stock price
INCREASING STOCK PRICES1
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Target an appropriate mix of debt and equity
History of conservative debt policy
Stable long-term incomes
Low debt-to-equity ratio indicates that UST Inc. might
not be taking advantage of increased profits thatfinancial leverage may bring
INCREASING DEBT-TO-EQUITY RATIO2
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Align the managers interests with USTs goals
Better investing decisions
Incremental debt introduces additional interestobligations
Decreases amount of capital managers access to invest
in new projects
Improves decision-making such that under-performingprojects are avoided
DISCIPLINE MANAGEMENT3
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Last but not least, it is imperative to note thatUST Inc. has a strong financial position in theindustry, which forms the underlying basis thatwhy UST could even consider leveraged
recapitalization.
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EFFECTS OF
RECAPITALIZATION
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Credit Rating
PV Tax Shield
PV Bankruptcy Costs
MARGINAL EFFECT
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Credit Rating
PV Tax Shield
PV Bankruptcy Costs
MARGINAL EFFECT
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Depends on bondholders concerns regarding USTBlah
Blah
Blah
Most probably get a credit rating of A
CREDIT RATING
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Credit Rating
PV Tax Shield
PV Bankruptcy Costs
MARGINAL EFFECT
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$1 billion debt
38% Tax Rate
PV Tax Shield = 38% * $1 billion
= $380 million
PV TAX SHIELD
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Credit Rating
PV Tax Shield
PV Bankruptcy Costs
MARGINAL EFFECT
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Probability of default * Cost of bankruptcy
PV BANKRUPTCY COSTS
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PV Tax Shield PV Bankruptcy Costs
Decision: Should undertake recapitalization
MARGINAL EFFECT
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AssumptionsAnnual growth = 1.20%
EBIT/Sales = 53.28%
10 year corporate bond yields
PRO-FORMA
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PRO-FORMA INCOME STATEMENT
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LUMP SUM V.S.
OVER TIME
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Cons of Lump Sum over Smaller issues:Higher risk of increased financial distress and thus,bankruptcy costs.
However, financial ratios are very healthy thus creditratings will not be affected
default rate (and thus bankruptcy costs) will not be
affected as much
LUMP SUM V.S. OVER TIME
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Three years (1996-1998) Philip Morris UST Inc.Corporate Credit Rating AOutlook Stable
EBIT interest coverage (x) 11.2 101.5EBITDA interest coverage
(x) 12.7 105.6Free operating cash flow/debt (%) 41.8 296.5Return on capital (%) 38.4 140.6Operating income/sales (%) 26 55.7Total debt/capital (including ST debt) (%) 49.3 28.2
Source: Debt Policy at UST Inc. (Case) Exhibit 6
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Pros of Lump sum over Smaller issues
Higher Tax shield
Larger increase in firms market value
(in millions, except stock)price)
Status-Quo S1 BillionRecap
(Lump Sum)
S1 BillionRecap
(Over time)
PV Tax Shields 380 339
PV of Bankruptcy cost 10 10
Market Value of UST 6470.24 6839.95 6798.87
Increase in Net Debt 0 1000 1000
Stock Price 34.88 36.873 36.652
Shares Repurchased 27.12 27.28
Shares 185.5 158.38 158.22
Market Equity 6470.24 5839.95 5798.87
Debt/Market Cap. 0 0.17 0.17
PV of tax shields
from each period
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Objective : To maximise the value per
share of the shareholder
Decision : To issue in one lump sum
LUMP SUM V.S. OVER TIME
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EFFECT OFRECAPITALIZATION
ON DIVIDENDS
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EFFECT ON DIVIDEND PAYMENTS
Actual 1999 1999
Debt = $1billion
1998Lump sum
debtNo debt
Net Income 467.9 437.8 475.8
Shares 185.5 158.38 185.5
EPS 2.52 2.76 2.56
DividendPayout
299.5 280.2 304.5
Dividendsper share
1.61 1.77 1.64
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EFFECT ON DIVIDEND PAYMENTS
Actual 1999 1999
Debt = $1billion
1998Lump sum
debtNo debt
Net Income 467.9 437.8 475.8
Shares 185.5 158.38 185.5
EPS 2.52 2.76 2.56
DividendPayout
299.5 280.2 304.5
Dividendsper share
1.61 1.77 1.64
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EFFECT ON DIVIDEND PAYMENTS
Actual 1999 1999
Debt = $1billion
1998Lump sum
debtNo debt
Net Income 467.9 437.8 475.8
Shares 185.5 158.38 185.5
EPS 2.52 2.76 2.56
DividendPayout
299.5 280.2 304.5
Dividendsper share
1.61 1.77 1.64
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Uncertainty in the long run
Unforeseen circumstances affecting USTsability to pay off debt
Decrease in credit ratings
Higher Cost of debt
EFFECT ON DIVIDEND PAYMENTS
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Decrease in income
Decrease in dividend payout
Decrease in retained earnings for investmentin R&D
EFFECT ON DIVIDEND PAYMENTS
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CONCLUSION
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Needs to overcome:Legal challenges
Limited opportunities for growth (internationalexpansion)
Strong financial position
Tax Shield
CONCLUSION
Recapitalization in
one lump sum offer