Ust Case Solution

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Key Issue 2: Is $1b appropriate to enhance UST’s firm value and ultimately shareholder value?

Higher leverage is very likely to create value for a firm considering capital structure change by exerting financial discipline and more efficient corporate strategy changes. Before evaluating whether $1b is value enhancing in quantitative measure, ability to cope with pre-requisite interest payment and potentially dividend payment (possibly dividend growth maintenance) should be considered.

Required debt rate and pro forma income statement

Risk determinants

Credit rating agencies take a wide range of factors – debt raising purpose, industry outlook, corporate profile and financial measures into account when performing corporate bond rating service. Debt is raised to repurchase shares rather than the normal case of capturing expansion opportunities to strengthen cash flow. This is not going to be regarded favorable to debt holders since the debt coverage ability in terms of cash or collateral is not strengthened. UST is characterized positively by commanding market share position in the moist smokeless tobacco market, strong brand name recognition, premium product offering, pricing flexibility; negatively by lack of geographical and product diversification, market share erosion, lackluster non-core investment performance, and recent key executive reshuffle and anti-trust dispute with Conwood Co.. Besides its cash generative nature, smokeless tobacco market still is faced with legal challenges (legislation, litigation, marketing ban), slowing down growth and possibility of future health research negatively influencing customer behavior. Financial measures will be conducted in the form of pro-form income statement, key data and ratios as follows.

Since credit rating determines debt cost and debt cost determines pro-forma income statement which ultimately may affect the initial credit rating assumption, AAA long-term issue rating was initially assumed but subsequently changed to AA rating and ultimately A rating based on comparison between key financial ratios to average industrial ratios in Case File EXHIBIT 8 and competitor ratios in Case File EXHIBIT 6 of relevant grades.

Pro-forma income statement and interest payment ability

Pro-forma income statement to illustrate interest and dividend payment ability is based on various assumptions as shown in Exhibit 1. Expected cases are the measures used in the following discussion. Conservatism is adopted throughout the assumptions especially sales growth rate, credit rating and Medicaid penalty assumptions.

Pro-forma income statement and key credit rating determinants are shown in Exhibit 2 and 3 respectively. Remaining share no. of 158.3m after repurchase is based on proportional value addition distribution between cash-out and remaining shareholders and this number is inserted to calculate earning per share and corresponding immediate share price change after announcement of repurchase program. According to Exhibit 3 and industrial average of relevant grades, only fund flow/ total debt and total debt/ capital measures are not comparable with A credit rating. Considering EBIT and EBITDA interest coverage are two most important criteria and equity market value is so substantially different from book value which leads to a healthy market leverage 15.86%, positively comparable with Philip Morris’s 10.14% and Universal Corp’s 39.25%. Sensitivity analysis is performed by changing sales growth rate to 2.98% in case 1. EBIT and EBITDA interest coverage ratios drop slightly to 10.1 and 10.5 respectively, which are still well above the industrial median.

Dividend payment ability, alternative policies and risk factors

If dividend growth rate is used as the medium to determine its payout policy, with a growth rate of 11%, net income will not be able to cover dividend payment by 2008. Other payout policy, say, lower growth rate, constant payout ratio, fixed amount...
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