Debt Policy at UST Inc.

1
Debt Policy at UST Inc.

• Should UST undertake debt recapitalization?

Beidi Gu Minhua Zhang
2
Recap What the pro-side said about the company
value?

• Tax Shield
• UST wants to increase the firm value by enjoying
  the huge tax shield provided by more leverage.
• Tax Shield ?D (0.38)(1billion) 0.38billion

3
Recap What the pro-side said about the company
value?

• The incremental effect on USTs value of
  implementing the recapitalization, assuming that
  the plan is implemented immediately on January 1,
  1999.
• VU The firm value before the debt
  recapitalization
• VL The firm value after the debt
  recapitalization
• ? Tax rate
• D Debt issued
• ? Probability of bankruptcy as a proportion of
  the firm value
• VL VU Tax Shield Expected Bankruptcy Cost
• ? VL VU ?D - PV (Financial Distress)
• ? VL VU ?D - (probability of bankruptcy
  cost of bankruptcy)
• ? VL VU ?D - (probability of bankruptcy (?
  VU))
• Where ? is some constant that is usually valued
  between 5 and 30

4
Recap What the pro-side said about the company
value?

• Incremental chanceVL-VU?D - (probability of
  bankruptcy (? VU))
• 0.381 billion-0.00280.36.5billion
• 0.375 billion
• So, the incremental change the added leverage
  causes is a increase of the firm value by 0.375
  billion375 million!

5
Really?
6
Real World

• There are Personal taxes!
• VLVu1-(1- ?C)(1- ?pe)/(1-?y)D
• Rich investors faces marginal income tax ?y
  50
• Original tax on dividend ?pe20
• Now ? effective ? 1-(1- ?C)(1- ?pe)/(1-?y)
  (1-.38)(1-.20)/(1-.50).008
• Tax Shield is only .008 billion 8 million!

7
Company Value

• Incremental chanceVL-VU?D - (probability of
  bankruptcy (? VU))
• 0.0081 billion-0.00280.36.5billion
• 0.003 billion
• So, the incremental change the added leverage
  causes is a increase of the firm value by only
  0.003 billion3 million!

8
Oh!
3 Million NOT 375 Million
9
Risk, Risk

• Tough market perspective
• Higher bankruptcy cost

10
Tough market perspective

• Why UST did not lever the firm earlier?
• Low Tax Shield!
• High market occupancy and natural market
  expansion guarantees constant availability of
  positive NPV projects to enhance company value
• Customers shifted from smoking cigarette
• But the company realized that such momentum will
  not continue into the future!

11
Risk, Risk

• Lets use the debt shield as a last resort then ?

12
Tough market perspective

• What if the EBIT doesnt grow with 11?
• 9 ? Unable to maintain the dividend stream in
  2007
• 7 ? Unable to maintain the dividend stream in
  2005

13
Risk, Risk

• Tough market perspective
• Higher bankruptcy cost

14
Higher Bankruptcy Cost

• Litigations and fines on health related issues
• Pending law suits at the end of 1998
• Litigations on anti-trust law suits
• UST vs. Conwood Co.
• 1 Billion Case lost over last summer (2002)

15
You Decide Please