Zach Savidge [Ying Jiang]

Hugo Ou [Gabriel La Spada]

ECO 363
4/13/2014

Swedish Match Case

1. The company will save SEK 50,400,000 annually.

We assume the debt Swedish Match issues is a 10-year maturity coupon bond as the
average BBB corporate bond (the CFO believes Swedish Match will receive a BBB+
rating) with the yield closest to that of Swedish Matchs debt is the 10-year maturity.
Moreover, we do not assume that this debt will be refinanced into perpetuity because the
financing decisions of Swedish Match are clearly dynamic - the board will only decide on
the issuance of this one bond as the upcoming board meeting, not whether the fixed debt
level will be maintained through refinancing once the proposed bond reaches maturity.
Thus the value of the tax shield represents a 10-year annuity. Lastly, we assume the risk
of the tax shield is equivalent to that of the debt because we are estimating the value of
the tax shield of a fixed dollar value level of debt (as opposed to a level of debt that is a
fixed percentage of Swedish Matchs enterprise value). Hence the discount rate for the
annuity is the 4.5% yield to maturity of the debt.

Value of Tax Shield =
50, 400, 000
.045
(1
1
1.045
10
) = SEK 398,800,996.13

2. Post-Recap, Swedish Match will have an additional SEK 4 billion in debt and have
SEK 4.5 billion less in book value equity. The pre and post recap balance sheets as of
2004 are shown below.

Balance Sheet Pre-Recap Post-Recap

Cash & Short Term Investments $3,002 $3,002

Current Assets $4,884 $4,884

PP&E $2,712 $2,712

Other Assets $4,300 $4,300

Total Assets $14,898 $14,898


Current Liabilities $3,776 $3,776

Total Interest Bearing Debt $3,529 $7,529

Of Which: Long-Term Debt $2,559 $6,559

Other Liabilities $2,533 $2,533

Equity including Minority Interests $5,060 $1060

Total Liabilities & Equity $14,898 $14,898

3a. Immediately after announcing the leverage recap, Swedish Matchs market value of
equity will increase by the value of the tax shield (assuming there are no transaction costs
to issuing the debt and there are not distress costs associated with the additional debt
load). We assume that the book values of all tangible assets are equal to their market
values since we are provided with no information about their market values and, hence,
attribute the difference between the market and book values of equity solely to the
intangible assets of the company. The pre and post announcement market-value balance
sheets are provided below:

Balance Sheet Pre-Announcement Post-Announcement

Cash & Short Term Investments $3,002 $3,002

Current Assets $4,884 $4,884

PP&E $2,712 $2,712

Other Assets $4,300 $4,300

Intangible Assets $23,394 $23,793

Total Assets $38,292 $38,691


Current Liabilities $3,776 $3,776

Total Interest Bearing Debt $3,529 $3,529

Of Which: Long-Term Debt $2,559 $2,559

Other Liabilities $2,533 $2,533

Equity & Minority Interests $28,454 $28,853

Total Liabilities & Equity $38,292 $38,691

3b. After it completes the debt issuance, the total interest bearing debt figure will increase
by SEK 4 billion and the cash figure will increase by SEK 4 billion.

Balance Sheet Pre-Issuance Post-Issuance

Cash & Short Term Investments $3,002 $7,002

Current Assets $4,884 $4,884

PP&E $2,712 $2,712

Other Assets $4,300 $4,300

Intangible Assets $23,793 $23,793

Total Assets $38,691 $42,691


Current Liabilities $3,776 $3,776

Total Interest Bearing Debt $3,529 $7,529

Of Which: Long-Term Debt $2,559 $6,559

Other Liabilities $2,533 $2,533

Equity including Minority Interests $28,853 $28,853

Total Liabilities & Equity $38,691 $42,691


3c. After it completes the share repurchase, the cash figure will decrease by SEK 4 billion
and the market value of equity will decrease by SEK 4 billion.

Balance Sheet Pre-Repurchase Post-Repurchase

Cash & Short Term Investments $7,002 $3,002

Current Assets $4,884 $4,884

PP&E $2,712 $2,712

Other Assets $4,300 $4,300

Intangible Assets $23,793 $23,793

Total Assets $42,691 $38,691


Current Liabilities $3,776 $3,776

Total Interest Bearing Debt $7,529 $7,529

Of Which: Long-Term Debt $6,559 $6,559

Other Liabilities $2,533 $2,533

Equity including Minority Interests $28,853 $24,853

Total Liabilities & Equity $42,691 $38,691


4. Though the recapitalization will significantly increase Swedish Matchs leverage,
even in the worst-case scenario - EBITDA declining to SEK 1.5 billion - Swedish Match
should have sufficient cash flows to cover interest payments given the low level of
maintenance capital expenditures suggested by past capex spending (in 2004 it spent SEK
468 million on capex and will have annual interest payments totaling 446 million
assuming it pays the same interest it did in 2004 on existing debt. Assuming its declining
EBITDA is not couple with a large increase in net working capital in a downturn, an
EBITDA of 1.5 billion suggests it will have sufficient cash flow for a similar level of
capital expenditures while covering its increased interest obligations). Furthermore, the
additional debt would only increase debt to 24% of Swedish Matchs enterprise market
value. Thus the value of Swedish Matchs total assets would have to decline by
approximately 75% for its total liabilities to be greater than the value of total assets a
unlikely occurrence even in the worst case scenario described above. Together, these
facts imply that even under the worst-case operating scenario constructed by the CFO,
Swedish Match would not default. Since there is a very low chance of default even with
the additional debt, there is only a minimal increase in distress costs due to the issuance
and Swedish Match can afford to issue the debt.
Using 2004 pro-forma financials as if Swedish Match had preformed the recap in
the beginning of 2004, Swedish Match has a lower interest coverage ratios and a higher
Total Debt/EBITDA ratio than the average US industrial firm receiving a BBB rating.
These estimates are fairly conservative, however, as 2005 EBITDA will likely be flat to
slightly down given the stability in the tobacco industry and its historic trend but the level
of pre-existing debt and the interest on this pre-existing debt (i.e. debt not raised for the
recap), should be lower in 2005 than in 2004 given that the case states that Swedish
Matchs pre-existing debt comprised of banks loans which are being rapidly repaid. More
importantly, tobacco firms typically have more stable cash flows than the average
industrial firm, as, unlike many industrial firms, they are not very cyclical (even in
downturns, consumers do not cut back on their tobacco purchases due to their addiction).
Comparing Swedish Matchs ratios if it were to do the recap to the ratios of other tobacco
firms suggest its debt is similar in riskiness to that of BAT, Imperial Tobacco and
Gallaher, which are rated BBB+, BBB and BBB, respectively (see Figure 1). Moreover,
as discussed above, the risk of default is incredibly slim. Therefore, it seems Swedish
Match would be able to maintain either a BBB+ or BBB rating after the recapitalization.

Figure 1: Pro-Forma Swedish Match Credit Ratios Compared with Benchmarks

EBIT Interest
Coverage
EBITDA Interest
Coverage
Total
Debt/EBITDA
Leverage @
Market Values
Swedish Match 4.2 5.3 3.2 23.3%
Altadis (A- Rating) 5.4 6.4 2.9 24%
BAT (BBB+ rating) 6.8 7.7 2.5 28%
Imperial Tobacco
(BBB) 4.4 5.8 3.2 28%
Gallaher (BBB) 3.9 4.5 4.3 36%
Average BBB firm 4.7 6.5 2.2 24.5%
Average BB firm 2.5 3.5 3.5 35.5%

There are, of course, risks to the recapitalization. The increased debt load will
require a large percentage of the Swedish Matchs cash flows to be used for interest
payments, which will likely inhibit any further acquisitions. Moreover, though default is
unlikely, it is very likely that Swedish Match would have to cut back on its annual share
purchase program and dividend payments it returned just shy of SEK 1 billion through
share repurchases and dividends in 2004 in a downturn due to high interest payment
obligations. Cutting its dividend, in particular, would send its share price tumbling.
Taking on the debt will also greatly increase Swedish Matchs exposure to the bond
markets. Especially if Swedish Match is raising all SEK 4 billion through a single
maturity, bullet principal bond issuance, its ability to refinance and the cost at which it
will be able to do so will depend greatly on interest rates and the global economy at the
time its current debt matures. This poses a substantial risk. Lastly, it is worth revisiting
the CFOs worst-case scenario. Often management is overly optimistic about the future of
its own company. One particular scenario that could lead to an even further deterioration
in profitability is additional regulation on smokeless tobacco. If the CFOs estimate does
not represent a true worst-case scenario, Swedish Match may be at risk of default.
Overall, we recommend that Swedish Match moves forward with the
recapitalization. The tobacco industry produces huge cash flows but is in structural
decline due to increased regulation and consumer education about the health risks of
tobacco. The recapitalization utilizes the fact that Swedish Match will be able to produce
large and stable cash flows to add value through tax savings and returns capital to
shareholders so that they can reinvest it in growing areas of the economy. It also imposes
a necessary discipline on management ensuring that they do not chase growth through
value destroying acquisitions something management teams globally are apt to do,
especially when organic growth is implausible. These benefits seem to definitively
outweigh the given the minimal risks involved. As a cherry on top, institutional investors,
given that they have voiced support for the recap, may view the recap as a sign of
increased emphasis on shareholder value by management, causing the stock to surge.
That being said, we would not advise that Swedish Match does an even large
recap. Additional debt will undoubtedly lead to a lower credit rating, especially since the
companys cash flows are barely sufficient to maintain a BBB+ rating with the proposed
level of debt, increasing the firms borrowing costs substantially. It will also greatly
increase the risk of default, causing potential distress costs to most likely negate any
additional tax shield benefit. Lastly, it would give the company so little financial
flexibility that even moderate margin or revenue pressures due to increased competition
could result in the company having to cut back on dividend payments.