The benefits of debt to UST are to create an interest tax shield. The interest tax shield directly increases the cash flows paid to equity investors. The present value of that interest tax shield increases the market value of UST as a leveraged firm vs. an unleveraged one, if they choose to recapitalize.
The value of these benefits is calculated as the present value of the future interest payments (if maintaining permanent debt then equal to the debt) multiplied by the 38% corporate tax rate (or D * tax rate). The table below shows the value of the tax shield with and without considering the probability of default based on debt ratings estimated in question 2. The formula for calculating with the probability of default is: PV(Tax Shield) = (D * r * tax rate) / (r + p)
I II III
PV (Tax Shield)$133 M$266 M$399 M
Debt Rating (Q2)AAAAAA
Probability of Default (p)0.97%1.15%1.45%
PV (Tax Shield) including default$118 M$232 M$338 M
2.What rating do you expect UST's debt to receive? You can use the handout "Estimating Default Probabilities from Promised Yields" (attached) and "Key Industrial Financial Ratios" (attached) to estimate the debt rating and the implied probability of default for the debt.
The debt rating that UST will receive depends on the amount of debt UST takes on. The table below shows the calculated key financial ratios possible for the given case data. It shows that the debt rating decreases from Scenario I to III.
In addition to the quantitative approach, the bond rating agencies will likely look at other aspects of UST’s business. They see that there are consistent cash flow, earnings, and dividends over a long period of time and are relatively recession resistant. This shows that UST’s financials are highly consistent and predictable, an...