Debt Policy at Ust Inc.

1263 Words Dec 8th, 2012 6 Pages
Executive Summary

As the leading manufacturer in the moist smokeless tobacco industry, UST Inc. has long been recognized by its ability to generate high profit using low financial leverage. With a dominant market share of 77%, the company maintains a pricing power that allows it to institute annual price increases without losing costumers. However, UST’s market share was eroded significantly in recent years by price-value competitors who enter the market with lower prices. Although UST responded to these threat by introducing new products, market share still decreased by 1.6% over past 7 years. In addition, UST is also exposed to an unfavorable legislative environment, in which the company is under advertising and product promotion
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In a market with taxation, the value of the levered firm equals to the value of the unlevered firm plus the present value of interest tax shield.

Because management assumes that the new debt is constant and perpetual, the present value of interest tax shield equals to the amount of debt multiplied by the effective tax rate, which is 38%. Thus, the present value of UST’s future tax saving should be 38% * $ 1 billion, which is $380 million.

At the end of 1998, the market equity of UST was $6,470.8 million based on the average shares outstanding and year-end stock price. If UST borrows $1 billion debt immediately, the total value of the levered firm would be $6,470.8 million unlevered value plus $380 million tax shield, which is $6,850.8 million.

Because firm value will rise to $6,850.8 million immediately after the recapitalization announcement, original shareholders will capture the full benefit of interest tax shield since they are able to sell their stocks at a higher price. The new stock price is determined by dividing the value of the levered firm by the number of shares outstanding at the end of 1998. Since there were 185, 516,055 shares outstanding at year end 1998, the new stock price after the announcement of recapitalization would be $6,850.8 million divided by 185, 516,055, which is $36.93. Compared to the

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