Tax rate and a 10% discount rate when discounting future dividends.

Full Answer Section

• Regulatory Risk:
  • The tobacco industry faces increasing regulatory scrutiny, including potential restrictions on advertising, labeling, and product sales.
  • Increased taxes and litigation are also significant concerns.
  • For the bondholder this creates instability in revenue.
• Litigation Risk:
  • Tobacco companies are subject to numerous lawsuits related to the health effects of their products.
  • Large settlements or adverse court rulings could significantly impact UST's financial stability.
  • Large settlements could mean less money to pay back the debt holders.
• Health Concerns and Changing Consumer Preferences:
  • Growing awareness of the health risks associated with tobacco use could lead to a decline in demand for smokeless tobacco products.
  • Shifting consumer preferences toward alternative products or healthier lifestyles could also pose a threat.
  • A shift in preference would lead to lower income.
• Competition:
  • While UST has a strong market position, it still faces competition from other tobacco companies.
  • Increased competition could lead to price pressures and reduced profitability.
  • Reduced profitability reduces the ability to pay back debt.

2) Why is UST Considering a Leveraged Recapitalization?

After a long history of conservative debt policy, UST is likely considering a leveraged recapitalization for several reasons:

• Excess Cash and Limited Growth Opportunities:
  • UST may have accumulated significant cash reserves with limited opportunities for profitable reinvestment in its core business.
  • Returning excess cash to shareholders through a share buyback can increase shareholder value.
• Tax Advantages of Debt:
  • Interest payments on debt are tax-deductible, reducing UST's overall tax burden.
  • Increasing debt can therefore enhance the company's after-tax cash flow.
• Increase Shareholder Value:
  • By increasing the debt, the company is able to buy back shares of stock. This action will increase the earnings per share, and therefore increase the stock price.
• Defense Against Takeover:
  • Increasing debt can make UST less attractive to potential acquirers.
• Agency Costs:
  • By increasing debt, management is forced to produce higher cash flow, therefore reducing the amount of free cash flow that management could potentially waste.

3) Should UST Undertake the $1 Billion Recapitalization?

To analyze the feasibility of the recapitalization, we need to prepare a pro-forma income statement for 1999, considering the increased interest expense.

Assumptions:

• $1 billion in new debt.
• Interest rate based on the bond rating UST receives.
• We will need to find the interest rate based on the bond rating.
• We will assume that the 1998 income statement is a good base for the 1999 pro forma.
• We will assume that the operating income will remain constant.

Pro-Forma Income Statement (1999)

To do this properly, we need to consider several rating possibilities, and therefore interest rates.

• AAA Rating:
  • Interest rate: Assume 6% (hypothetical, needs to be researched)
  • Interest expense: $1 billion * 6% = $60 million
• BBB Rating:
  • Interest rate: Assume 8% (hypothetical, needs to be researched)
  • Interest expense: $1 billion * 8% = $80 million
• BB Rating:
  • Interest rate: Assume 10% (hypothetical, needs to be researched)
  • Interest expense: 1 billion * 10% = 100 million.

We will use the 1998 income statement as a base, and subtract the new interest expense.

• We will need the 1998 Income statement to provide accurate numbers.

Sensitivity to Bond Rating:

• The feasibility of the recapitalization is highly sensitive to the bond rating UST receives.
• A higher interest rate (lower bond rating) will increase interest expense, reducing net income and potentially straining UST's ability to make interest payments.
• A lower interest rate (higher bond rating) will result in lower interest expense, making the recapitalization more financially viable.
• The rating will also have an effect on the market perception of the debt, and therefore the stock price.

General Conclusion:

• UST should carefully assess the potential impact of the recapitalization on its financial ratios, particularly its interest coverage ratio.
• The company needs to ensure that it can generate sufficient cash flow to cover its increased debt obligations.
• The company should make sure that the increased risk, is offset by an increase in shareholder value.
• The company needs to make sure that the increased debt load, does not put the company into financial distress.

Important Note: To make a fully accurate pro-forma income statement, the 1998 income statement would be required. Also, the interest rates for the bond ratings would need to be researched, and not assumed.

Sample Answer

Context: We're analyzing UST, a company considering a $1 billion leveraged recapitalization. We need to evaluate its business risks, understand the motivation behind the recapitalization, and determine its financial feasibility.

1) Primary Business Risks of UST (Bondholder Perspective)

UST's primary business risks, from a bondholder's perspective, revolve around its long-term revenue stability and cash flow generation. These include:

• Product Concentration:
  • UST's revenue is heavily concentrated in smokeless tobacco products. A decline in demand for these products would significantly impact its financial health.
  • From the bondholders perspective, a decline in demand means a decline in ability to pay back the debt.