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Debt Policy at UST Inc Case Solution & Answer

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Debt Policy at UST Inc Case Study Solution

Introduction

UST Inc. produces smokeless tobacco products, and it isconsidered as the leading producer in the tobacco industry. It is widely identified for its high dividend payout andtraditional debt policy, since it enteredin the marketin 1912. In December 1998; UST Inc.’s board of directorsdecided to acquire a$1 billion loan, for the period of five years in order to start its stock repurchase program. The stock repurchase program was approved in 1996, but in 1997 the program got suspended because of some unfavorable legislation issues that were being faced by the tobacco industry.

Problem Statement

Vincent Gierer, the CEO andthe Chairman of UST Inc., was considering the execution of the debt policy’s implementation plan, for which he had had discussions with his management team for having an analysis of the debt policy’s impact as well as therecapitalization’s effect.(Mitchell, 2001).

Situational Analysis

The Smokeless Tobacco Master Settlement Agreement was signed by the company in November 1998, in order to restart its stock repurchase program and resolve its liability issues. In December, 1998; UST Inc.’s board of directors made the decision of acquiring a $1 billion loan for five years’ time period, in order to initiatethe company’s stock repurchase program.

Potential Business Risks

UST Inc. produces smokeless tobacco products, and is considered as the leading producer in the tobacco industry. Although, as a leading producer; UST Inc. has faced a number of business risk, which are discussed below in detail:

• The aggressive price increase strategyimposed a high risk for the business,because thecompetitors adopted a price cutting strategy as compared toUST Inc., which enabled them togenerate more revenues and boost their sales.
• Over the past years, UST Inc. had enforced the growing trend of innovation process related to flavors and forms, successfully. Despite which, the company was widely criticized for not expanding or reducingits product’s lines, with the introduction of new as well as an innovative process.
• The president and CFO of the company resigned in 1997 because to the differencesin the views ofsetting the company’sstrategic direction. This exposed the company to a massive threat of mismanagement.
• The value players were also apotentialrisk for the company, and the company hadfailed to encounter these players on time, because of their already established brands.
• The promotional and marketing strategies for the product’s advertisement were widely affected by the legal restrictions imposed on public advertising.
• At the end of 1998, seven lawsuits were filed against UST Inc., because of litigation concerns.

The Smokeless Tobacco Master Settlement Agreement was signed by the company, in November 1998, in order to restart its stock repurchase program and resolve it liability issues- Medicaid lawsuit. For this, UST Inc., decided to pay $200 or $100 million for 10 subsequent years,with an inclusion of reducing the youth exposure and accepting the advertisement restrictions……………………………

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Case analysis - Ust Inc. Debt Policy

Ust Inc. Debt Policy, case study , case analysis, smokeless tobacco company, tobacco products, price-value market share, price-value competitor, tobacco industry, leveraged recapitalization

UST Inc. is the dominating smokeless tobacco company in the market with over 75% of market share and 90% of sales coming from their tobacco products. Their declining market share poses a problem for the company. As a premium and leading brand, the company ignored lower priced competitors. After losing 9% of their market share to price-value brands/competitors, they launched their own price-value brand named "Red Seal". This move was too late as they addressed the problem as insignificant early on. With declining market share, and pending litigations, health movements/reforms against tobacco, these aspects may negatively impact future cash flows and estimates. Even though smokeless tobacco is a much healthier alternative to cigarettes and has fewer litigation cases, UST Inc. has put most of its eggs in one basket by having over 90% of their sales come from their smokeless tobacco line.

• Case summary
• The company
• Issues and risks
• Recapitalization
• Recommendations

[...] in 1998 by and slowdown the percentage decrease in total market share by as down in figure 10 below. Figure 10 This slowdown in market share loss is the company's attempt at regaining market share by their price-value marketing strategy. The downfall to this was the lower profit margins as the COGS is higher due to the marketing expenses shown in figure 11 below. Figure 11 Another recommendation is to acquire their largest price-value competitor which would be the Swisher Company. Swisher has the highest 7 Yr. [...]

[...] UST Inc. was so successful that the company beat Coca-Cola and Microsoft for most profitable company. Issues and Risks (Ranking from largest impact to smallest impact on the future growth of the company) Declining market share Internal differences in goals and direction of the company Pending health litigations Despite having a strong brand with dominating market share, there are many risks associated with UST Inc. As a credit analyst or potential bond holder, having 7 pending health related lawsuits and litigation cases can have an impact on future cash flows. [...]

[...] We can see net sales and profit increasing year over year. Figure 1 The company generates over 85% of sales from tobacco which can show an undiversifiable risk in their market. The weight of the company lies in the hands of the tobacco industry. In figure 2 below, we can see profits of over 95% in the tobacco section of their company. Figure 2 According to the Standard & Poor's corporate ratings in figure 3 on the next page, UST Inc. [...]

[...] Case Summary UST Inc. is the dominating smokeless tobacco company in the market with over 75% of market share and 90% of sales coming from their tobacco products. Their declining market share poses a problem for the company. As a premium and leading brand, the company ignored lower priced competitors. After losing of their market share to price-value brands/competitors, they launched their own price-value brand named “Red Seal”. This move was too late as they addressed the problem as insignificant early on. [...]

[...] while all other competitors gaining market share in figure 5 below. Figure 5 The company is not in good position to expand internationally due to smokeless tobacco and tobacco (in general) not being of popular use overseas. Recapitalization UST Inc. considering leveraged recapitalization after a long history of conservative debt policy can be attributed to using debt to increase interest tax shield, fund discounts and rebates to retain or gain market share, reduce capital costs, buy back shares, increase share value, and fight or defend against hostile takeovers. [...]

• Number of pages 10 pages
• Language English
• Format .doc
• Publication date 09/01/2017
• Read 1 times
• Updated on 09/01/2017

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UST INC. Harvard Case Solution & Analysis

Home >> Finance Case Studies Analysis >> UST INC.

QUESTION # 01: What is the effect of adding $ 1 billion of debt (with 10 years maturity) to the ratios as in Exhibit 8?

ANSWER # 01:

Debt Financing:

When the company issues debt instruments that is treasury bond (T-Bills), notes payable, bill payable and any other kinds of bond to raise its fund is considered as debt financing. Returns on debt instrument is paid as interest as compared to dividend which is paid on the stock of the company. The interest payment is a liability of the company, regardless whether the company has earned loss in any of the year. Interest payment reduces the tax payment of the company as the interest is tax deductible. Additional debts of $1 billion in the capital structure of the UST Inc. reduces the tax liability of the company by the $0.38 billion every year, assuming the average tax at a constant rate of 38 percent.  Increase of the debt in the capital structure of the UST Inc. also reduces the weighted average cost of capital of UST Inc., as the reduction in the weighted average cost of capital increase the market value of the UST Inc.

EFFECTS ON FINANCIAL RATIOS:

Interest coverage ratio of UST Inc would decrease with the increase in debt of $1 billion, as the earning before interest and tax would be assumed to remain the same but the interest cost would increase as the level of debt increases. This results in the decrease in the interest coverage ratio which will decline to 10 times. UST Inc might suffer financial risk on the interest payment. As shown in Exhibit 1.

Earnings before interest, tax, depreciation and amortization (EBITDA) ratio would also reduce as the increase in debt of $1 billion in the UST Inc. earnings before interest, tax, depreciation and amortization (EBITDA) ratio decreased to 10.45 times, which is 105.6 times before the injection of $1 billion in the capital structure of UST Inc. As shown in Exhibit 1.

Fund flow to total ratio declines due to increase in the interest payment on the additional debts of $1 billion and decrease in the total fund flow of the company UST Inc. increase in interest payment and decrease in fund flow cause this ratio declines to 28.88 percent which is before the incorporation of $ 1 billion debts is 364 percent. As shown in Exhibit 1.

Free cash flow to total debt would also dramatically change with the increase in debts of $1 billion in the capital structure of the UST Inc. as the ratio declines from 296.5 percent to 28.26 percent. This decrease in the ratio is due to the increase in total debts of the company. As shown in Exhibit 1.

Return on capital ratio reduces as the increase of $1 billion debt in UST Inc, as the return is calculated by adding earnings before tax and interest expense. Return on capital would reduce to 53.60 percent, which is before the new debt of $ 1 billion is 140.6 percent. As shown in Exhibit 1.

Operating income to sales ratio will be affected by the injection of $ 1 billion debt in the capital structure of the UST Inc. as the operating income to sales ratio will not consider the interest payment as well the debt amount. Therefore the operating income to sales ratio will remain same as it is before that is 55.7 percent. As shown in Exhibit 1.

Total debt to total capital ratio would also reduce by the increase in the debts of $1 billion. The leverage position high in UST Inc. as the total equity would reduce to approx 25 percent of the total capital structure. The financial problem can also be faced by the UST Inc. with the increase in the debts. The total debt to total capital ratio would be 74.62 percent after the incorporation of $ 1 billion debts. As shown in Exhibit 1.

QUESTION # 02: What would be the implied rating of UST after having this amount (or other amounts) on the balance sheet?

ANSWER # 02:

An additional $1 billion debt in the capital structure of the UST Inc. reduces the credit rating of the company from the AAA rating to AA rating company. Rating on the basis of earnings before interest, tax, depreciation and amortization (EBITDA) of $1 billion debt decrease the credit rating of UST Inc. to AA rating. The UST Inc. rating on the basis of fund flow to total debt would be BB rating, which is before the projection of $1 billion debt in the capital structure of the company is AAA rating. The credit ratings of UST Inc. on the basis of free cash flow to total debt ratio would fall to AA................

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Debt Policy At UST Inc Case Study Solution Analysis

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