Debt Policy of Ust

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The leverage of UST has traditionally been very low (almost entirely financed through equity). Leverage ratio is consistently lower than the rest of industry, although it has increased in recent years. Additionally, liquidity has historically been very high, resulting primarily from the minimal debt UST has. However, this has shifted downwards over the past 5 years as a result of the company taking on more debt.

These trends were the result of a ramp up in share repurchases between 1992 and 1996, wherein additional debt was taken in order to finance the repurchase program as well as increasing dividend payments.

Exhibit 2: Sources and Uses of Funds

1995

1998

Uses

Sources

Total Assets

784

913.3

129.3

Total Liabilities

200

100

100

Total Equities

292.8

468.3

175.5

Based on a broad analysis of the sources and uses of funds, we identify that both assets and liabilities overall are uses of funds, whereas the key source of funds appears to be from shareholder's equity. This would suggest an overreliance on equity as a source of fund, as such prompting an assessment of the current finance policy.

In assessing the current capital structure, the sustainable growth rate was determined. Sustainable growth rate for UST in 1998 is calculated to be 37% (see below), whereas actual growth rate is 1.5%. Sustainable growth rate (g*) is much higher (35.5%) than the actual growth rate, in essence indicating that an actual growth rate of 37% would be required to support the current equity heavy capital structure. As such, the current capital structure is not suitable to sustain the business and in order to readjust to align g and g* UST has three options, 1) decrease leverage, 2) repurchase equity, and/or 3) raise dividends.

G* = (1-d) * ROE

= (1-64%) * 103.4% = 37%

Since UST's current capital structure is not suitable to meet its maximum growth rate without having to increase financial leverage or search outside financing, UST needs to take action in resolving this matter.

Option 1 is not applicable since UST's leverage ratio is already very low (17.6%) compared to the group average (65.9%), and option 3 is also not the best solution since dividend payout ratios is 64% - uninterrupted cash dividends since 1912, and dividends are sticky which leaves option 2 repurchase equity as the most suitable financial strategy. In the following section, we will explore the extent of the share repurchase required to match UST's current business.

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The recapitalization will not force UST to reduce its $1.62 dividend per share, assuming the dividend payout ratio is stabilized at 64% as per in 1998.

UST will be able to meet interest payments in all 4 cases, as we can see in the table above, the EBIT interest coverage ratio is above 5.6 times (which already the lowest amount ratio in Plan 4). Since there is no quantitative data for financial distress, we will perform a qualitative check. The market leverage(D/V) would increase to 21.14% with 2B leverage while industry average is around 65%. Thus, it can be safely assumed financial distress costs will not be enough to offset tax benefits at these levels.

Recommendation

UST should follow through with $1B recapitalization for 2 reasons:

- Maximizing leverage by $1B (and the number of shares repurchased) would lower sustainable growth rate g* to be more closely aligned to the actual growth rate g as per mentioned in the Financial Analysis.

- UST will not be forced to have its credit rating downgraded from AAA to BBB (which would increase the interest rates incurred on the debt).

UST should not follow through with a $2B recapitalization plan for two reasons:

- UST will have a very low EBIT interest coverage ratio of 5.6, a drastic drop from its 101.5 in the status quo.

- UST’s credit rating as a result to the heavily increased leverage will drop from AAA to BBB which will increase the debt yields from 5.60% to 6.84%.

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