UST CASE STUDY

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1. Assess the business and financial risks of UST

Business risks are relatively low:
Main risk is that UST has undiversified business, it basically relies on one product
However its main product is noncyclical, it carries little systematic risk
Imminent increase in excise tax on smokeless tobacco (however, tobacco demand is considerably inelastic)
It is the (sub)industry leader (market share >85%), industry is an oligopoly which implies high barriers for potential competitors to enter the market

Financial risks are even lower:
Cash flows are constantly increasing
Profit margins are high
Outperforms comparable firms
No leverage
Forecasts are positive

2. What are the benefits of debt in UST’s case?

Debt tax shield: increase
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At each debt level, estimate the benefits of debt. Also, for each debt level, do a back-of-the-envelope calculation of how big the value lost in financial distress has to be for that debt level to be optimal for the firm. You can do this by estimating the costs of financial distress crudely as:

In order to find the benefits of debt, one needs to calculate the effective tax rate, given by:

Where: τc is the corporate tax rate τd is the tax rate for income from dividends τe is the tax rate on equity income: τe = (dividend payout ratio)(τdiv) + (1 – dividend payout ratio)(τcg) τcg is the tax rate on capital gains τdiv is the tax rate for income dividends

Bond default probabilities:
Bond Rating
P(default)
AAA
0.00%
AA
0.47%
A
0.14%
BBB
0.18%
BB
0.37%
B
2.42%
CCC
7.20%

6. UST Inc. has paid uninterrupted dividends since 1912. Will a recapitalization (issuing debt and buying back equity with the proceeds) hamper future dividend payments?

In order to check what happens to dividends per share, we need to examine the effect of leverage on the number of shares
The new number of shares outstanding will be equal to the older number of

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