Debt Policy at Ust

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Debt Policy at UST The primary business risk facing UST in 1998 was that the U.S. tobacco industry itself was facing an uncertain future characterized by legal challenges, declining volumes, marketing restrictions, increased taxes, heavy discounting and consolidation. The U.S. smokeless tobacco industry also was transitioning away from the Premium Market and growing through the Price Value Market at a rate of 9%. Bondholders face very little investment risk given UST’s high interest coverage ratio and substantial cash flows, making UST less susceptible to the risk of bankruptcy. One would be concerned about the industry’s decline and the fact that growth is driven primarily by the Price Value Market. UST is positioned as the Premium…show more content…
By taking on debt, UST would benefit from a tax shield which would reduce their tax base and in effect allow them to generate more cash. Ultimately they want to use the debt to repurchase stock, thereby increasing the value of earnings per share. UST had been concerned with pending litigation but realized significant progress with respect to legal matters and wanted to reinstate the share repurchase program. The tobacco industry is known to be cash strong and UST generates substantive cash flows to service the interest payments. Excess cash will be better utilized servicing the debt as opposed to investing in questionable or underperforming non-core operations and projects. UST should undertake the $1 billion dollar recapitalization and should do so immediately (January 1, 1999). The $1 billion recapitalization will add approximately $231 million in company value. Recapitalizing will not hamper UST’s ability to make future dividend payments and stakeholders will continue to enjoy dividends payments equal to current payouts. (See Exhibits 1 and 2.) Assumptions: 1. A conservative 1% growth rate was used in calculating UST’s future sales growth potential. 2. The 5-year averages for Gross Profit, EBITDA and EBIT margins were used in constructing the pro-forma Income Statement. 3. Dividends were calculated using a 64% Dividend Payout Ratio for UST as provided in Exhibit 5 of the case (for 1998). 4. Bankruptcy costs were

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