Answer Questions
The CEO of UST would like you to prepare a three to four page case report discussing UST’s current financial situation and the implications of increasing leverage in UST’s capital structure. The firm is considering a $1 billion increase in long-term debt. Assume that the debt would be taken on immediately and held in perpetuity. The $1 billion would be used immediately to repurchase shares. Also assume that the top marginal tax rate is 38 percent. The following questions should be addressed when preparing the report for the CEO:
1) Provide an overview of UST’s business operations. In your presentation, feel free to provide visual detail of the type of products UST sells to its customers.
2) Compile a list of factors that a credit analyst or potential bondholder would take into account when evaluating UST’s proposed recapitalization. Discuss the important factors.
3) Why is UST considering a leveraged recapitalization after such a long history of conservative debt policy?
4) Comment on the past and future financial performance of UST. What is the stock market’s assessment of UST’s long-term growth rate?
a. Hint: use the growing perpetuity formula, 𝑃0 = 𝐷1⁄(𝐸𝑟𝐸 − 𝑔), and solve for 𝑔 to infer UST’s long-term growth rate. You will need to use the CAPM to find 𝐸𝑟𝐸. (You may want to do some online research of comparable tobacco companies to figure out the approximate beta you should use for the CAPM.) Assume that 𝐷1 = 𝐷0 × (1 + 𝑔).
5) Comment on the financial performance of UST relative to other tobacco companies.
6) Create three pro-forma income statements for fiscal year 1999 under each of the following assumptions: (1) the $1B in debt was not issued; (2) the $1B in debt was issued and is investment grade; (3) the $1B in debt was issued and is below investment grade. For the latter two cases, can UST afford to make the interest payments based on the respective pro-forma income statement?In answering this question, the CEO only wants a simplified pro-forma income statement that takes the following form:SALES
