UST CASE Final - UST debt Policy PDF

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UST debt Policy...

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Fin 401/520 Carter Nelson Eva Li Wesley Settles Madeline McGrath

UST Case 1. UST has a long history of conservative debt policy. Briefly describe why UST is considering a recapitalization that involves issuing debt and repurchasing equity. In late 1998, UST’s management decided to borrow one billion dollars over five years in order to accelerate its stock buyback plan. Up until this point, UST was known for having a very conservative debt policy with a 17.6% leverage ratio compared to the industry median of 66%. Historically, UST has also had a significantly higher gross profit margin, return on assets, and return on equity than the industry median. This raises an important question--if it “ain’t broken,” why fix it? The most compelling reason for the expensive stock repurchase plan is the significant share erosion UST has experienced. In 1991 the company held 86.2% of the market share in the tobacco industry; by 1998, this percentage had decreased to 77.2% (see pie charts below) Investors have become increasingly skeptical about both UST’s future and the future of the tobacco industry as a whole. Litigation issues and a declining tobacco clientele have initiated these concerns among investors. Consequently, UST, who has been exceptionally profitable for years, believes that its shares are currently undervalued and therefore wants to repurchase them at the bargain price. UST can then make the needed adjustments to recapture some of the market share and resell the shares in the future for a profit once investors perceive the company as more valuable than they currently do.

2. Describe the pros and cons of the recapitalization from the perspective of the tradeoff theory of capital structure. What are the biggest concerns you have? The tax shield a company is afforded when they finance with debt is highly advantageous for a profitable company like UST. However, the more leveraged a firm is, the higher the probability of bankruptcy, a very costly consequence. This tradeoff that firms face with regards to debt and equity is reflected in the tradeoff theory of capital structure which posits that a firm will attempt a leverage ratio where the marginal gains from the tax shield are equal to the marginal costs of bankruptcy.

We have a few concerns with this recapitalization from the perspective of this theory. The firm’s long term debt currently has a book value of $100 million. The $1B addition would make the debt 10x greater than its current amount. As such, even for one of the most profitable firms in the United States, bankruptcy can become a legitimate concern if proper actions are not taken. Other considerations include the fact that the tobacco industry is somewhat volatile due to a decreasing clientele and increasing litigation issues which suggests that a company in this industry like UST should avoid a drastic increase to its leverage ratio. On the other hand, UST’s large amount of tangible assets and the positive signal debt sends argue for this recapitalization. According to the company’s 1998 balance sheet, UST has $913.3M worth of assets. Since this firm is a consumable goods company, it can be assumed that a large portion of these assets are tangible, meaning that they can be used to generate cash in case of an emergency. Another appealing outcome of this strategy is the positive signal that debt issuance sends to the market. Increasing the leverage of a company sends a message that management is optimistic about the future. UST’s financials corroborate this story: in 1998, UST’s EBIT interest coverage ratio is 101.5x, substantially higher than the industry median of 3.0x, meaning that UST can currently pay back its annual interest costs over 101 times with its EBIT alone. Therefore, although UST has not had much experience handling debt in the past, management has a healthy cash flow cushion in case something were to go awry. If a company like UST recapitalizes by issuing debt and repurchasing equity, then the decreasing costs made possible by a larger tax shield must be weighed against the increase in its probability of default. Management should weigh out the advantages and disadvantages of a debt issuance long before a decision is made in order to act in the best interest of the company.

3. Should UST undertake the $1 billion recapitalization? Calculate the effect on UST’s stock price assuming that the entire recapitalization is done immediately (i.e., January 1, 1999). To simplify things, assume that the recapitalization will have no significant impact on the probability of financial distress. After careful analysis, we believe that UST should move forward with this recapitalization. Both the company's sales and net profit margins have grown over the years which further indicate that it is capable of taking on more debt. The stock price will rise to $35.02 in 1999 due to the effects of a $25.74M tax shield which will immediately increase the value of the stocks that were repurchased as well. The tax rate we used is a simple 5-year average and the interest rate is the 10year, A-rated bond yield. The recap would also boost earnings per share and reduce the dividend payout ratio to 57.08% from 64% in 1998 due to the reduction in number of shares outstanding. This will have a significant positive effect on UST since its historical dividend payout ratio is much higher than the industry average of 49%. If we assume the debt is held in perpetuity, the tax shield would just be the $1.1B debt multiplied by the interest rate, which is $420.6M. As a result, the stock price will increase to $37.15.

Held Annually

Held In Perpetuity

1998 LTD

$100,000,000 1998 LTD

New LTD

$1,000,000,000 New LTD

Tax Shield

$25,742,030 Tax Shield

$100,000,000 $1,000,000,00 0 $420,621,407

# of shares outstanding

185,500,000 # of shares outstanding

185,500,000

Increase in Stock Price

$0.14 Increase in Stock Price

$2.27

1998 Stock Price

34.88 1998 Stock Price

34.88

1999 Stock Price*

$35.02 1999 Stock Price*

$37.15

Income Statement In millions $

% of 1999 Sales

1994

1995

1996

1997

1998

Net Sales

$ 1,204.0

Gross Profit

$ 952.0

$ 1,305.8 $ 1,043.6

$ 1,371.7 $ 1,098.9

$ 1,401.7 $ 1,109.8

$ 1,423.2 $ 1,139.7

$ 1,494.4 $ 1,190.6

79.67%

EBITDA EBIT

$ 668.9 $ 640.7

$ 736.9 $ 707.8

$ 779.2 $ 750.2

$ 749.8 $ 719.3

$ 785.0 $ 753.3

$ 829.2 $ 796.1

55.49% 53.27%

Interest Expense Pretax Earnings Net Income

$ 0.1 $ 640.6 $ 387.5

$ 3.2 $ 704.6 $ 429.8

$ 6.4 $ 744.5 $ 464.0

$ 7.5 $ 703.9 $ 443.9

$ (2.2) $ 755.5 $ 467.9

$ 67.3 $ 728.7 $ 450.1

Free Operating CF Special Charges Basic EPS

$ 399.2 $$ 1.92

$ 521.2 $$ 2.21

$ 456.4 $$ 2.48

$ 287.4 $ 8.0 $ 2.41

$ 429.5 $ 21.0 $ 2.52

$ 469.3 $$ 2.84

Diluted EPS Dividend Per Share Dividend Payout Ratio

$ 1.88 $ 1.12

$ 2.17 $ 1.30

$ 2.44 $ 1.48

$ 2.39 $ 1.62

$ 2.50 $ 1.62

$ 1.62

58%

59%

60%

67%

31.41%

64% 57.08%

4. Is the assumption that the recapitalization will not impact the probability of financial distress a good one? Why or why not? The assumption that multiplying the debt level of a company by 10x and not having any impact on the probability of financial distress whatsoever is ludicrous. After applying a 10-year Arated bond interest rate 6.12% to UST's $1.1B debt, its interest expense reaches $67.32M, which is nearly 8.4% of EBIT. And thus, UST’s ability to pay back debt is significantly impacted. Furthermore, UST’s net income growth rate has been shrinking over the past 5 years, and at times even negative (i.e. 1997), which demonstrates a consistent decrease in ability to pay back debt. As the price and legislation wars in the tobacco industry intensify, UST will be required to spend a lot of money introducing new products with uncertain NPVs or even be forced to cut prices, and in turn have less excess cash to allocate towards paying down debt. All things combined, their diminishing

margins, increased debt loads, and shrinking market share will influence probability of distress, but it wont increase it dramatically. The PV of distress cost = P(Default)*LGD and after reviewing multiple ratios, UST appears to have an overall rating of A in 1999 which places its P(default) between (1-3%) according to Moody's ratings. We derive our overall rating by analyzing the following ratios. Its EBIT Interest coverage ratio is high at 11.83x, which places them at an AA Investment grade rating. Its EBITDA interest coverage ratio is 12.32x, which places UST at an A rating in this category. The company’s fund flow/total debt stands at 75.38% giving it an AA rating in this respect. Impressively, the firm’s free operating cash flow/total debt (42.66%), return on capital (95.17%), and operating income/total Sales (53.27%) all fall under AAA ratings. Conversely, the billion dollar increase to long-term debt shifted long-term debt/capital and Total debt/capital ratios so that these ratios fall within the CCC rating threshold. Another reflective ratio of the significance of new debt can be seen in the contrast of 1998 and 1999 debt/equity ratios. In 1998, it was 21%, but in 1999, it was nearly 527%. Similarly, debt/asset levels increased astronomically from 1998 (10.9%) to 1999 (121.2%). 1995

1996

6,407.00

221.19

117.22

95.91 -342.41

11.83 AA

EBITDA interest coverage

6,689.00

230.28

121.75

99.97 -356.82

12.32 A

Fund flow/total debt

535.12% 368.45% 311.68% 681.64% 785.00% 75.38% AA

EBIT interest coverage

1997

1998

Ratin 1999 g

1994

Free operating cash flow/total debt 319.36% 260.60% 182.56% 261.27% 429.50% 42.66% AAA Return on capital

131.66% 144.28% 142.43% 132.92% 132.17% 95.17% AAA

Operating income/sales

53.21% 54.20% 54.69% 51.32% 52.93% 53.27% AAA

Long-term debt/capital

25.68% 25.46% 26.23% 18.63% 17.60% 123.89% CCC

Total debt/capital

25.68% 40.58% 47.06% 20.12% 17.60% 121.26% CCC

Ultimately, the majority of the ratios derived place UST in the A-AAA grade scale. However, it is important to note that if they were to fall from an A grade to BBB, then the distress costs would significantly increase from $28M to $72M. AAA

AA

A

BBB

Distress Costs from one grade decrease $0.00 $2,400,000 $2,800,000 $7,200,000

5.

BB+ $8,600,00 0

Evaluate the merits of the recapitalization in the framework of the pecking order theory of capital structure. Evaluate its merits in the framework of the agency theory of capital structure.

With regards to the pecking order theory of capital structure, the UST recapitalization does not hold as much merit as it could. The pecking order theory suggests that companies will make the financing decision that sends the least amount of signal to the market. As such, the theory suggests that profitable companies will first finance their projects with retained earnings. Secondary to

retained earnings, a company will elect to finance itself with debt which also sends relatively little signal to the market. Lastly, the pecking order theory states a company will typically avoid financing itself by issuing new equity due to the associated signal that it sends. Issuing new equity sends negative signals for a few different reasons. First, the company may not have enough confidence in its financial projects to sustain new debt issuance. Secondly, the company may feel that its stock is currently overvalued and thus wants to sell as many shares at the high price as possible. Lastly, the company may have a hard time finding a creditor to give them the debt because either their current structure is unstable or their financial future appears grim. Thus, even if these circumstances seem to be reality for the company, it will attempt to finance itself with either debt or retained earnings first to avoid negative signaling. In this case, UST has made the decision to finance itself with debt which avoids the pitfalls described above. Although they may have made the correct decision regarding the lesser two options of the pecking order theory, we will now analyze how their decision compares to the superior option. As mentioned above, the pecking order implies that a profitable company will finance its projects with retained earnings when possible to send the least amount of signal. Furthermore, Forbes ranked UST as the most profitable company in corporate America in 1997-98 according to its five-year return on capital of 92.1% which was about 20% higher than the second ranked firm. Needless to say, UST was perhaps in as good a financial position as any other company in America to finance its project with earnings. Information regarding the financial performance of UST is only given for the last decade. Nevertheless, this is sufficient for our analysis. As displayed in the exhibit below and holding all else constant, the 10-year aggregate increase in retained earnings account totals $1.45 billion dollars. If UST had decided to accelerate the stock-repurchase project even just a few years prior then the whole project could have been financed by internal sources. We will assume, however, that UST did not plan ahead and does not have this option and has thus decided to move forward with debt issuance which still sends an acceptable market signal.

A distant relative to the pecking order theory is the agency theory of capital structure. The agency theory suggests that owners may take on more debt in an attempt to force management to operate more efficiently. Agency theory aligns management’s interests with owner’s interests. The burden of regular interest and principal debt payments requires managers to run a tight ship. The improved efficiency that should come as a result of higher debt will increase firm value. In the case of UST, efficiency ratios such as ROA show that internal changes can be made in order to maintain high profit margins and firm valuation. UST’s ROA peaked in 1996 and has remained relatively constant since 1992. The 10-year high for debt ratio was 1996 as well at a ratio of 31%, nearly triple the current ratio of 10.9%. This lower debt suggests that UST has room for more liability. Consequently, UST’s decision to finance itself with debt holds significant merit according to the agency theory....