1. Assess the business and financial risks of UST
Business risks are relatively low:
Main risk is that UST has undiversified business, it basically relies on one product However its main product is noncyclical, it carries little systematic risk Imminent increase in excise tax on smokeless tobacco (however, tobacco demand is considerably inelastic) It is the (sub)industry leader (market share >85%), industry is an oligopoly which implies high barriers for potential competitors to enter the market
Financial risks are even lower:
Cash flows are constantly increasing
Profit margins are high
Outperforms comparable firms
Forecasts are positive
2. What are the benefits of debt in UST’s case?
Debt tax shield: increase in debt results in lower taxable income and thus less taxes Reduction in agency costs: higher interest payments reduce the free cash flow available to firm’s management Consequently less money can be ‘overspent’ in investments with positive utility for management, but negative NPV for shareholders Tightening of free cash flow margin may induce management to increase financial efficiency
3. Exhibit 4 provides pro forma debt/total capital ratios. What interest rate do you expect UST to have to pay at these various debt levels? (Assume that if UST issues debt, it uses the proceeds to buy back equity). The highest debt level in the exhibit is 30%, you may want to look at 50 and 80% as well. At each debt level, try to estimate what bond rating the UST debt would have and what interest rate that would correspond to. Use the data on bond ratings and key financial ratios as a guide.
The interest rate that UST is expected to pay depends on the rating of its debt, this in turn depends on the level of debt since the higher the level of debt the higher the probability of UST defaulting Although it is not explicit how rating agencies assess the creditworthiness of companies, we can attempt to estimate the rating of...
Please join StudyMode to read the full document