38% tax rate and a 10% discount rate when discounting future dividends.

Full Answer Section

• • For bondholders, this translates to increased uncertainty about future cash flows and potential for financial distress.
• Declining Consumption:
  • There is a general trend of declining tobacco consumption in developed countries due to health concerns and public awareness campaigns.
  • UST must adapt to changing consumer preferences and potentially diversify its product portfolio.
  • Bondholders face risks of shrinking revenue streams and increased difficulty in debt servicing.
• Consumer Preferences:
  • Consumer preference can shift quickly. With the rise of vaping, or other alternatives, UST could see a rapid decline in sales.
  • This poses a very large risk to bondholders.
• Litigation:
  • The tobacco industry is constantly facing litigation. A large settlement could severely harm UST's ability to pay back debt.

2) UST's Leveraged Recapitalization After a Conservative Debt Policy:

UST's shift towards a leveraged recapitalization after a history of conservative debt policy could be driven by several factors:

• Increased Shareholder Value:
  • A leveraged recapitalization can increase shareholder value by increasing earnings per share (EPS) and return on equity (ROE).
  • The debt-financed share buyback reduces the number of outstanding shares, leading to higher EPS.
• Defense Against Takeovers:
  • Increasing debt can make UST less attractive to potential acquirers.
  • The increased financial leverage makes a hostile takeover more difficult.
• Utilizing Excess Cash:
  • If UST has accumulated significant excess cash and sees limited opportunities for profitable reinvestment, a share buyback can be a way to return capital to shareholders.
• Low Interest Rates:
  • If interest rates are low, UST may find it attractive to take on debt at favorable terms.
  • The cost of debt, after the tax shield, could be lower than the cost of equity.

3) Should UST Undertake the $1 Billion Recapitalization?

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

Assumptions:

• Interest rate on the new debt: Let's assume an interest rate of 8% (this will be impacted by the bond rating).
• Increased interest expense: $1 billion * 8% = $80 million.
• We will assume that the 1998 income statement is a good base for the 1999 pro forma.

Pro-Forma Income Statement (1999):

(Note: You would need the actual 1998 income statement to create a precise pro-forma. For this example, I'll use placeholders.)

• Revenue: $X million (from 1998)
• Operating Expenses: $Y million (from 1998)
• EBIT: $Z million (X - Y)
• Interest Expense: $80 million (new debt) + old interest expense.
• Earnings Before Taxes (EBT): $(Z - 80 million - old interest expense)
• Taxes (38%): $(EBT * 0.38)
• Net Income: $(EBT - Taxes)

Analysis:

• If the pro-forma net income remains positive and sufficient to cover the increased interest expense, the recapitalization is financially viable.
• However, if the increased interest expense significantly reduces net income or leads to a loss, the recapitalization may be risky.
• We must analyse the interest coverage ratio, to determine if the interest payments can be made.

Sensitivity to Bond Rating:

• The bond rating UST receives will significantly impact the interest rate on the new debt.
• A higher rating (e.g., AAA) will result in a lower interest rate, reducing the interest expense and making the recapitalization more attractive.
• A lower rating (e.g., BB) will result in a higher interest rate, increasing the interest expense and making the recapitalization riskier.
• For example, if the interest rate was 12%, the interest expense would be 120 million, a 50% increase from the 80 million.
• Therefore, the lower the bond rating, the harder it will be for UST to make the interest payments.

Conclusion:

• UST should carefully evaluate its financial projections and consider the potential impact of different bond ratings on the feasibility of the recapitalization.
• A sensitivity analysis of the interest rate is crucial to assess the risks associated with the increased debt.
• If UST has a high EBIT, it is more likely that they can successfully complete the recapitalization.
• If UST has a low EBIT, the increased debt could be very dangerous.

Sample Answer

Scenario: UST is considering a $1 billion leveraged recapitalization through a debt-financed share buyback.

1) Primary Business Risks of UST (Bondholder Perspective):

• Industry Cyclicality:
  • UST operates in the tobacco industry, which, while historically stable, faces cyclical fluctuations in demand and regulatory pressures.
  • A downturn in the economy or increased anti-tobacco sentiment could significantly impact UST's revenue and cash flow.
  • From a bondholder's perspective, this means fluctuating ability to pay interest and principal.
• Regulatory and Legal Risks:
  • The tobacco industry is heavily regulated, and UST faces ongoing legal challenges related to health claims and product liability.
  • Increased regulations or adverse legal judgments could significantly impact UST's profitability.