Ust Case Study

Topics: Debt, Free cash flow, Operating cash flow Pages: 7 (2122 words) Published: June 6, 2013
CAPITAL MARKETS AND FINANCING SPR 13|
Group Assignment 1|
UST Case Study|
2/19/2013
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Question 1:
In order to calculate the impact of the leverage recapitalization on UST’s value, we used the WACC and APV methods to calculate its value before and after the recapitalization. WACC Method
Using the WACC method, we first derived UST’s return on assets (rA). Since we are given the firm’s market capitalization, debt and cash, we calculated the current Enterprive Value of UST. We were then able to derive the return on asset as a function of UST’s market value. Specifically, we followed the below steps: 1. We estimated $467.8 million as the free cash flow of UST in 1999 based on the given assumption that its operating cash flows will grow at a rate of 3% in perpetuity. Free Cash Flow|  |  |  |

Sales| 1423.2|  | 1465.9|
EBITDA| 785.0|  | 808.6|
EBIT| 753.3|  | 775.9|
Tax| 287.6|  | 294.8|
Dep & Amort.| 31.7|  | 32.7|
CAPEX| 35.5|  | 36.6|
Working Capital| 309.9|  | 319.2|
Change in WC|  |  | 9.3|
 |  |  |  |
Free Operating Cash Flow| 429.5|  | 467.8|

2. We calculated $6,537.6 million as UST’s enterprise value as of the end of 1998 by adding together UST’s market equity of $6,470.8 million and total debt of $100 million and subtracting cash of $33.2 million from this value. 3. Given the assumed growth rate of 3% and UST’s free cash flow in 1999 and enterprise value, we derived 10.16% as the WACC from the growing perpetuity formula: EV=FCFWACC-g → WACC= FCFEV +g 4. We derived 10.22% as the rA from the WACC formula: WACC=Ra 1-tD V. In the presence of taxes, the WACC equals rA if the company is 100% equity-financed. Hence, instinctively, we can expect the WACC and rA to be closely equivalent in the case of UST due to its low leverage ratio of 1.52% prior to the recapitalization. Once we have derived the rA, we re-calculated the WACC before and after the recapitalization using the formula: WACC=Ra 1-tD V. Given these WACCs, we obtained UST’s value before and after the recapitalization using the growing perpetuity formula: EV=FCFWACC-g. Value - Before Additional Debt|  |  | Value - After New Debt Issuance|  | Return on Asset| 10.22%|  | Return on Asset| 10.22%|

Tax Rate| 38%|  | Tax Rate| 38%|
Debt| 100|  | Debt| 1100|
Debt / Value | 1.5%|  | Debt / Value| 15.5%|
WACC| 10.16%|  | WACC| 9.61%|
 |  |  |  |  |
Free Cash Flow| 467.8|  | Free Cash Flow| 467.8|
Growth Rate| 3%|  | Growth Rate| 3%|
Value| 6537.87|  | Value| 7075.87|

As expected, the WACC decreased from 10.16% to 9.61% after the recapitalization due to the higher leverage ratio resulting in increased tax savings. The decrease in WACC then resulted to the increase in UST’s value from $6,537.87 million to $7,075.87 million. APV Method

Using the APV method, we determined the value of UST by adding its enterprise value prior to the recapitalization (as computed above) and the present value of the tax shield caused by the increase in its leverage. To calculate the present value of the tax shield, we used the formula: PVTS=Additional Debt x Rd x tRts. We derived the cost of debt (rD) of 7.05% by estimating A as the new credit rating of UST after recapitalization. We took the 20-year interest rate given debt is perpetual. Since UST has a high coverage ratio, we assumed that the cost of the tax shield (rTS) is equal to rD. Given the debt is not growing, the cost of debt used to calculate interest rate cancelled out with the discount factor so in this particular case, credit rating did not affect tax shield calculations. Value - APV Method|  |

Initial Value| 6537.87|
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New Debt| 1,000|
Tax Rate| 38%|
Cost of Debt| 6.12%|
Value of Tax Shield| 23.256|
PV of Tax Shield| 380|
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New Value| 6,918|

Similar to the results in the WACC method, the...
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