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Assess the Business and Financial Risks of Ust. What Do You Think About Ust’s Capital Structure? What Are the Benefits of Debt in Ust’s Case?

Autor:   •  March 23, 2018  •  1,055 Words (5 Pages)  •  669 Views

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Capital Structure & Benefits of Debt

UST presents a capital structure with virtually no debt. In 1998 the Total Debt amounted to 100 million USD, all of it being Long Term. With a market value of equity of 6,470 billion USD, the firm’s capital structure is entirely composed by equity. To consider whether this type of arrangement is sensible, we must consider benefits and pitfalls of an (almost) 100% equity funding. From the perspective of the company’s management, a completely equity funded company can be positive because of the absence of covenants restricting the management’s decisions. It also means a greater flexibility from the operational standpoint, granting the possibility of investing in higher risk-reward projects. In this case however the presence of debt could be beneficial. In first instance an increase in the level of debt would grant the firm a Tax Shield. Furthermore, from a shareholder’s view, undertaking debt can positively align the management’s incentives. The covenants and the cash flow restriction imposed could discipline the management’s actions towards a more conservative and goal-driven approach.

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- Which credit rating do you expect for the new debt?

UST’s credit rating of its debt, before the share repurchase, is of AAA. EBIT ICR and EBITDA ICR are in fact 101,5% and 105,5%, well above the 12,9% and 18,7% thresholds. To understand what credit rating we should expect after the new debt issuance, we have to understand what effect the new debt will have on the two ratios aforementioned. To do so we can construct a Pro-Forma Balance Sheet for 1999, incrementing all the values by the CAGR of the previous 5 years. To calculate the credit rating for the new debt we can create a series of scenarios. In each we calculate the Interest Expenses based on the 20 year Interest Rate correspondent to the credit rating. It is important, when calculating the interest expenses, to multiply the value of the old debt (100 million) by the AAA rating. Once we have executed the operations, we can see that AAA and AA ratings do not hold. This comes from the lack of EBITDA ICR, which is in both cases lower than the required threshold. The final rating of the new company debt will be therefore A.

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