ES1 Workgroup 5

Corporate Finance
Spring 2014

UST Case

1. What are the primary business risks associated with UST Inc.? Evaluate these risks from the
perspective of a bondholder. What other risks would a bondholder consider when evaluating UST Inc.?

The primary business risks associated with UST Inc. are the legislative environment, increasing price pressure
from competitors, and the lower profitability of the non-core businesses.

Legislative Environment
From the bondholders perspective, the unfriendly legislative environment surrounding tobacco products is
probably the biggest risk to consider. Although the Smokeless Tobacco Master Settlement Agreement had
resolved USTs potential state Medicaid liability, UST still had seven pending health related lawsuits at the end
of 1998. In addition to health related litigation, UST was also facing a pending dispute whereby Conwood CO.
alleged that UST had violate antitrust and advertising laws and participated in anti-competitive conduct.
Litigation is a particularly serious risk for bondholders, because payouts resulting from lawsuits or settlements
could potentially impair the companys ability to make interest and/or principal payments on debt outstanding.

Additionally, in the case we read that lawmakers were expected to continue to push for new laws to combat
youth tobacco use and to empower the FDA to regulate nicotine as a drug. These measures could more
indirectly affect cash flows of the firm by negatively impacting sales.

Threats to Profitability: Pricing Pressure/Competition & Non-Core Businesses
Another key business risk facing UST Inc. is the threat of erosion in its heretofore high profit margins.
Although UST had historically been the most profitable company in corporate America, this profitability
stemmed from several factors which were now at risk, including:
1. Commanding share of the moist smokeless tobacco market: Since 1991, USTs total market share
has suffered a gradual erosion, with negative 7-year CAGR for both total and premium market share
percentages (Exhibit 2).
2. Historical pricing flexibility: As more competitors come into the market, and as the value segment
continues to gain traction (Exhibit 2), UST risks losing this historical edge over its
cigarette-manufacturing counterparts in the tobacco industry.
3. Continued growth of moist smokeless tobacco: While smokeless tobacco remained the fastest
growing segment of the tobacco industry, in recent years the growth had slowed dramatically even in
that industry, to 1.2% by 1998. Combined with the erosion in market share and limitations on
advertising, this could lead UST to use price cuts to stimulate sales growth, leading ultimately to
diminished margins and a deterioration in profitability.

As well, USTs other business segments are significantly underperforming the core business. Bondholders
should carefully consider the risk that UST may choose to take some of the proceeds of the recapitalization and
squander them on these less profitable, riskier ventures which, on a standalone basis, would almost certainly
merit lower credit ratings than the company as a whole.

ES1 Workgroup 5

Corporate Finance
Spring 2014

2. Why is UST Inc. considering a leveraged recapitalization after such a long history of conservative
debt policy?

In 1997, UST had suspended its stock repurchase program, approved in 1996, because of legislative and legal
issues confronting the tobacco industry. In November 1998, the company signed the Smokeless Tobacco
Master Settlement Agreement resolving its potential state Medicaid liability and reinstated its repurchase
program. Management believed that this agreement represented significant progress with respect to the legal
and legislative matters confronting the company, permitting UST to proceed with its business strategy and
potential recapitalization.

At the time of the announcement, Vincent A. Gierer, Jr., cited the recapitalization and concurrent acceleration of
the stock repurchase program as "an opportunity for the Company to reward [its] long term stockholders and
maximize stockholder value in the future." Furthermore, from Exhibit 3 of the case, we observe that USTs P/E
ratio as of the 1998 year-end (13.8x) was significantly below the trailing 10-year average P/E ratio of 16.8x.
Therefore it seems reasonable to argue that the management of UST likely felt that their shares were
undervalued by the market, thus leading to the desire to accelerate the share buyback program.



ES1 Workgroup 5

Corporate Finance
Spring 2014

3. Should UST Inc. undertake the $1 billion recapitalization? Calculate the marginal effect on USTs
value, assuming the entire recapitalization is implemented immediately (J anuary 1, 1999).
Assume that the marginal corporate tax rate is 38% and the marginal personal tax rate is 21%.

In order to complete this calculation, we make the following additional assumptions:
USTs current bond rating is AAA (interest coverage ratio is N/A due to net interest income in 1998)
The combined direct and indirect costs of bankruptcy are 30%

We also rely upon the following data from Exhibit 3 & Exhibit 8 of the case:
USTs Market Value of Equity at year-end 1998 = $6470.8 million
USTs Market Value of Debt at year-end 1998 = $100 million (book value of total debt used as a proxy)
USTs EBIT for 1998 = $753.3 million
The current yield on 10-Year AAA bonds is 5.60%

Tax shields from debt financing at USTs current capital structure:
= (

)
= 100 (
0.380.21
10.21
)
= 21.5

Expected bankruptcy costs at current capital structure:
UST Value =

+ ()
=

+ )

In this case, since we assume USTs current capital structure is equivalent to a AAA rating, the probability of
bankruptcy is 0%, thus E(BC) = 0. Therefore:

= 6570.8 21.5

= 6549.3












ES1 Workgroup 5

Corporate Finance
Spring 2014

Now that we have obtained the unlevered firm value, we can continue our analysis under the proposed
recapitalization structure; that is, with an additional $1bn of long-term debt. As illustrated below, even under the
new capital structure, UST would retain an interest coverage ratio that should enable it to achieve a AAA credit
rating. As a result, the recapitalization would add no bankruptcy costs whilst creating a tax shield of $215
million. Therefore UST should undertake the recapitalization.



Note that for the estimated bond rating, the following implied ranges were calculated based on the data
provided for in Exhibit 8, Adjusted Key Industrial Financial Ratios Senior Debt Ratings:



As of year-end: 1998
Market value equity 6470.8
Market value debt 100.0
EBIT 753.3
Bankruptcy costs 30%
Tc 38%
Tp 21%
Interest
Interest
Coverage
Bond
Rating
Bond
Yield
Debt
Value
Tax
Shield
Prob of
Bankruptcy
Bankruptcy
Costs
Net
benefit
Debt/
Value
Total
Value
56 13.45 AAA 5.60% 1,000 215 0.00% 0 215 14.78% 6,764
UST, Inc.
APV Calculations
($ in millions)
Rating Low High
AAA 11.1
AA 8.2 11.1
A 5.7 8.2
BBB 3.3 5.7
BB 1.9 3.3
Bond Ratings Ranges
ES1 Workgroup 5

Corporate Finance
Spring 2014


Prepare a pro-forma income statement to analyze whether UST will be able to make interest
payments.

Yes; even using a very conservative forecast of 1.5% annual sales growth (approximately equal to YoY sales
growth from FY1997-FY1998, with margins, working capital and net capital expenditures held constant as a
percentage of sales, UST will generate more than enough free cash flows to make interest payments.





Year
1998 1999 2000 2001 2002 2003 2004 2005
Assumptions:
Sales growth 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5%
EBIT (percent of sales) 52.9% 52.9% 52.9% 52.9% 52.9% 52.9% 52.9% 52.9%
Working capital (percent of sales) 21.8% 21.8% 21.8% 21.8% 21.8% 21.8% 21.8% 21.8%
CapEx (percent of sales) 2.5% 2.5% 2.5% 2.5% 2.5% 2.5% 2.5% 2.5%
Depreciation (percent of sales) 2.2% 2.2% 2.2% 2.2% 2.2% 2.2% 2.2% 2.2%
Tax rate 38.0%
Cost of debt (k
d
) 5.6%
Calculations
Sales 1423.2 1445.0 1467.2 1489.7 1512.5 1535.7 1559.3 1583.2
EBIT 753.3 680.2 690.6 701.2 712.0 722.9 734.0 745.2
- Cash Taxes on EBIT @ 38.0% 286.3 258.5 262.4 266.5 270.5 274.7 278.9 283.2
= NOPLAT 467.0 421.7 428.2 434.7 441.4 448.2 455.1 462.0
+ Depreciation & Amortization 31.7 32.2 32.7 33.2 33.7 34.2 34.7 35.3
= Gross Cash Flow 498.7 453.9 460.9 467.9 475.1 482.4 489.8 497.3
Fixed assets and working capital
Net working capital 309.9 314.7 319.5 324.4 329.4 334.4 339.5 344.7
Investment in working capital 34.6 4.8 4.8 4.9 5.0 5.1 5.1 5.2
Investment in fixed assets 35.5 36.0 36.6 37.2 37.7 38.3 38.9 39.5
Free Cash Flow 428.6 413.1 419.4 425.9 432.4 439.0 445.8 452.6
Debt 100.0 1100.0 1100.0 1100.0 1100.0 1100.0 1100.0 1100.0
Interest 5.6 61.6 61.6 61.6 61.6 61.6 61.6
UST, Inc.
Income Statement & Free Cash Flow Projections ($ in millions)
ES1 Workgroup 5

Corporate Finance
Spring 2014

For the basic analysis, assume that the $1 billion in new debt moves UST to its long-run capital
structure. Is this new capital structure optimal for UST Inc.?

No. The new capital structure is not optimal for UST Inc. In examining a range of capital structure alternatives,
we see that the optimal capital structure (that is, the one with the highest net benefit to the companys overall
value, taking into consideration, both the tax shield and the probability of bankruptcy), is one in which the
company takes on the maximum allowable leverage while still retaining an investment-grade (BBB) rating.

As of year-end: 1998
Market value equity 6470.8
Market value debt 100.0
EBIT 753.3
Bankruptcy costs 30%
Tc 38%
Tp 21%
Interest
Interest
Coverage
Bond
Rating
Bond
Yield
Debt
Value
Tax
Shield
Prob of
Bankruptcy
Bankruptcy
Costs
Net
benefit
Debt/
Value
Total
Value
0 >20 AAA 5.60% 0 0 0.00% 0 0 0.00% 6,549
25 30.13 AAA 5.60% 446 96 0.00% 0 96 6.72% 6,645
50 15.07 AAA 5.60% 893 192 0.00% 0 192 13.24% 6,741
56 13.45 AAA 5.60% 1,000 215 0.00% 0 215 14.78% 6,764
75 10.04 AA 5.84% 1,284 276 0.28% 33 243 18.91% 6,793
100 7.53 A 6.12% 1,634 352 0.40% 47 304 23.84% 6,854
125 6.03 A 6.12% 2,042 440 0.40% 47 392 29.42% 6,941
150 5.02 BBB 6.84% 2,193 472 2.30% 273 199 32.50% 6,748
175 4.30 BBB 6.84% 2,558 551 2.30% 274 277 37.48% 6,826
200 3.77 BBB 6.84% 2,924 629 2.30% 274 355 42.35% 6,904
225 3.35 BBB 6.84% 3,289 708 2.30% 275 433 47.11% 6,982
250 3.01 BB 7.70% 3,247 699 12.20% 1,457 -758 56.06% 5,791
275 2.74 BB 7.70% 3,571 769 12.20% 1,459 -691 60.96% 5,859
($ in millions)
ES1 Workgroup 5

Corporate Finance
Spring 2014

4. UST Inc. has paid uninterrupted dividends since 1912. Will the recapitalization hamper future
dividend payments?

Assuming that dividends grow at the same rate as sales, and that all other income statement projections are
accurate, the recapitalization will not hamper future dividend payments. Even after payment of net interest,
sufficient cash flows will remain available to pay dividends at the historical level.



Year
1998 1999 2000 2001 2002 2003 2004 2005
Assumptions:
Dividend Growth Rate 1.0% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5%
Free Cash Flow 428.6 413.1 419.4 425.9 432.4 439.0 445.8 452.6
Debt 100.0 1100.0 1100.0 1100.0 1100.0 1100.0 1100.0 1100.0
Interest 5.6 61.6 61.6 61.6 61.6 61.6 61.6
Interest tax shield 1.96 21.56 21.56 21.56 21.56 21.56 21.56
Cash Flows Available for Dividends 428.6 409.5 379.4 385.8 392.4 399.0 405.7 412.6
Dividends 301.1 305.7 310.4 315.2 320.0 324.9 329.9 335.0
Free Cash Flow, Interest & Dividend Projections ($ in millions)
UST, Inc.