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Debt Policy at UST

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1. How well is UST doing?

* UST has been doing extremely well. Revenues and earnings are growing at 9% and 11% respectively. * Named by Forbes as one of the top companies in terms of profitability. ROC, ROE and GPM one of the industry highest. * Paying back generous dividends of $2.2b and repurchasing $2b from 1988 to 1998. * However, they seem to be losing market share in the premium market to competitors and have not been able to make an impact in the Price Value tier.

2. Main sources of risk for UST cash flows?

* Pending health-related lawsuits
* Legislation (marketing restrictions) against the company could happen – New laws to stop tobacco use by young people * Changing consumer habits against tobacco
* Increased competition from both premium and price-value producers – USTs strategy is to launch similar products to fight competition may not always work as has been seen in the price-value segment * The demand for smokeless tobacco products was minimal in international markets and product expansion outside USA for greater market segment was not much of an option for UST. Consequently, a weak US economy could affect domestic consumption.

3. Comment on USTs capital structure. What might explain such a structure?

* Total Debt to Value is 17.6% which is low compared to the other Tobacco manufacturers. * It is a sign that UST is able to generate healthy cash flows and function well with low levels of debt. * On the other hand, it could also be an indication of not being able to identify or take advantage of new growth opportunities.

4. Factors important to credit and bondholders in analyzing UST? What credit rating would you assign to for a moderate addition of debt?

Factors that may be important to credit and bondholders are

* Brand name and market position – Superior
* Ability to generate cash flows – Superior
* Cyclicality of revenues – Superior
* Product diversification – Poor
* Geographic diversification – Poor
* Litigation risk – Poor
* Asset Tangibility – Good

Given USTs superior cash returns and low levels of debt, I would likely assign UST a A rating for their Long Term Debt issue as they are susceptible to litigation and changing consumer tastes.

5. Analyze Effects of $0.5b and $1b in new debt and share repurchase. What happens to EPS?

Value of Levered firm = Value of Unlevered Firm + PV(Tax Shield) – PV (Financial Distress)

| Current| $0.5 billion Plan| $1 billion Plan|
Stock Price| $36.88| | |
Shares Outstanding| 185.5| | |
UST Market Value| $6470.8| | |
Debt| $100m| 500| 1,000|
Shares Repurchased| | 13.55| 27.11|
Share Outstanding| | 171.94| 158.39|
PV of Tax Shield| 38%| $190| $380|
Levered Value of UST| | $6660.8| $6850.8|
Net Income (5% CAGR)| $467.9| $491.3| $491.3|
EPS| $2.52| $2.86| $3.10|

6. Summarize costs and benefits of leveraging UST. Articulate an “optimal” capital structure. Should UST undertake a major recapitalization?

* Increased risk of Financial distress
* Increased interest payments

* Tax Shield
* Increase ROE

With UST predicting little to no growth opportunities domestically and aboard with their tobacco products, restructuring its capital architecture with long term debt is the most assured method of maximizing the firm’s value. However, taking on debt does increase the amount of risk for bankruptcy, payment default, lower credit ratings, and reduction of dividends for UST and its shareholders.

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