UST: History of Conservative Debt Policy
UST Case Study
Steven Kinyon
Phillip LeCheminant
Ryan Makahilahila
1. UST has a long history of conservative debt policy. Briefly describe why UST is considering a recapitalization that involves issuing debt and repurchasing equity.
UST has a long history of a conservative debt policy. However, in 1998 they reinstituted their share buyback program. This means that they intended to issue up to $1 billion in debt in order to repurchase equity. Their intentions in repurchasing equity are to maximize earnings per share and receive a tax shield through their high amount of debt issuance.
2. Describe the pros and cons of the recapitalization from the perspective of the tradeoff theory of capital structure. What are the biggest concerns you have?
In a perfect M&M world, with no distress costs 100% leverage would give the firm the optimal debt level, because it would produce the highest tax shield. However, companies do not exist in a perfect M&M world, therefore, the tradeoff theory allows companies to estimate distress costs of leverage and find the optimal level of debt for their firm. The optimal level of debt is the level that yields the highest tax benefit and keeps distress costs low. The biggest concern we have is if UST borrows $1 billion dollars of long-term debt, they may not be able to fulfill their debt payments and as result may encounter a debt overhang issue in the future.
3. Should UST undertake the $1 billion recapitalization? Calculate the effect on UST’s stock price assuming that the entire recapitalization is done immediately (i.e., January 1, 1999). To simplify things, assume that the recapitalization will have no significant impact on the probability of financial distress.
Yes, they should undertake the $1 billion recapitalization, because it will increase EPS for investors and will create a tax shield for UST. (Refer to Exhibit A) Additionally, it will increase ROE for UST by 1% from 1998 to 1999. Their financials are strong
Steven Kinyon
Phillip LeCheminant
Ryan Makahilahila
1. UST has a long history of conservative debt policy. Briefly describe why UST is considering a recapitalization that involves issuing debt and repurchasing equity.
UST has a long history of a conservative debt policy. However, in 1998 they reinstituted their share buyback program. This means that they intended to issue up to $1 billion in debt in order to repurchase equity. Their intentions in repurchasing equity are to maximize earnings per share and receive a tax shield through their high amount of debt issuance.
2. Describe the pros and cons of the recapitalization from the perspective of the tradeoff theory of capital structure. What are the biggest concerns you have?
In a perfect M&M world, with no distress costs 100% leverage would give the firm the optimal debt level, because it would produce the highest tax shield. However, companies do not exist in a perfect M&M world, therefore, the tradeoff theory allows companies to estimate distress costs of leverage and find the optimal level of debt for their firm. The optimal level of debt is the level that yields the highest tax benefit and keeps distress costs low. The biggest concern we have is if UST borrows $1 billion dollars of long-term debt, they may not be able to fulfill their debt payments and as result may encounter a debt overhang issue in the future.
3. Should UST undertake the $1 billion recapitalization? Calculate the effect on UST’s stock price assuming that the entire recapitalization is done immediately (i.e., January 1, 1999). To simplify things, assume that the recapitalization will have no significant impact on the probability of financial distress.
Yes, they should undertake the $1 billion recapitalization, because it will increase EPS for investors and will create a tax shield for UST. (Refer to Exhibit A) Additionally, it will increase ROE for UST by 1% from 1998 to 1999. Their financials are strong