Topics in Corporate Finance Group 14

Table of Contents Business Analysis .................................................................................................................................... 2 1) A brief description of UST Inc.’s business as of 1993. .................................................................... 2 UST Inc. sources of risk and evaluation thereof. ................................................................................ 2 How well is it doing. Is it on sustainable path? .................................................................................. 3 In terms of Cashflows and sales volatility; ..................................................................................... 3 In terms of costs and other factors; ............................................................................................... 4 Financial Analysis ................................................................................................................................... 6 2) The rationale for the current market value of UST Inc.’s Equity. ................................................... 6 1) Dividend Discounted Model Approach. ................................................................................. 6 2) Gordon Growth Model Approach. .......................................................................................... 6 3) Free Cash Flow Discounted Model Approach. ........................................................................ 6 4) Residual Income Model Approach. ........................................................................................ 7 5) Relative Multiples Model Approach. ...................................................................................... 7 3) Evaluation of the capital structure ................................................................................................. 8 4) Share Repurchase Program Analysis ............................................................................................ 10 5) No Arbitrage ................................................................................................................................. 12 6) Assignment of Bond Ratings and Interest Rate ............................................................................ 13 7) EPS analysis .................................................................................................................................. 14 8) Value creation and costs .............................................................................................................. 15 Appendix 1 (DDM) ................................................................................................................................ 17 Appendix 2 (FCF Method) ..................................................................................................................... 17 References ............................................................................................................................................ 18

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Business Analysis 1) A brief description of UST Inc.’s business as of 1993. UST Inc. is a producer of moist, smokeless tobacco. The corporation dominates the smokeless tobacco market with 86% of industry sales. Since UST Inc.’s inception in 1911, the corporation has held uninterrupted success, withstanding the great depression as well as successive recessions given its capable management team and the nature of the product. It has distributed increasing dividends to its shareholders for the past 22 years as well as undergone significant share repurchase programs. The financial performance of UST Inc. is unparalleled in its industry and is one of the most profitable corporations in the USA. According to a 1993 Fortune survey, UST Inc. is the second most admired corporation based on financial performance. However, its overall reputation based on the same survey is ranked 94 due to the nature of its business products. UST Inc. is primarily focused on the end result of performance and not with matters of promotion of its corporate image. Finally, UST Inc. has had a very conservative debt policy and mostly relied on own financing with respect to new projects.

UST Inc. sources of risk and evaluation thereof. 1. Restriction on public advertisement; strategic risks. Nonetheless the firm has been extremely successful in developing a strong brand name and advertisement is well focused and properly channelled at adult males. However, there are additional risks that could lead to the requirement of moist, smokeless tobacco products to display the health risks of consuming tobacco, similar to cigarette packets. However, those restrictions are also a blessing in disguise given that UST Inc.’s competitors will not be able to use conventional advertisement routs to erode UST Inc.‘s market share. Additionally, the restriction on advertisement could be an issue if the firm found new growth opportunities; for example, through the sale of a new tobacco product since advertisements would not be a real option for the benefit of product promotion. 2. Changing public opinions on tobacco products; reputational risk. Moist, smokeless tobacco products are not as dangerous as cigarettes but not completely safe either. According to the American Cancer Society website (see references), there are no forms of smokeless tobacco safe for consumption even if advertised as an adequate substitute by such companies. 3. Ban of tobacco products; strategic risks.

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Unlikely possibility and mainly dependent on lobbying powers of the tobacco industry on congressmen in general. This is much more a political issue and dependent on how for example the industry and its respective firms contribute for political donations and general elections. 4. Litigation risks; reputational and compliance risks. An important factor in the tobacco industry given the nature of their products and its health risks. Based on the case study, the risks have declined since the American Supreme Court recently determined that warning labels disallowed lawsuits based on an insufficient lack of warning. Moreover, the industry has successfully defended its products over the years. However, there are possibilities that governments could become more stringent with regards to tobacco sales to young adults and teenagers. But risks to UST Inc. are far lower than cigarette producers. To date, UST Inc. has no major outstanding major lawsuits which is striking given that it is the dominant player in its market. Major lawsuits would greatly increase the volatility of future cashflows. 5. Burdensome excise taxes; operational and strategic risks. According to the case study, the federal government would increase taxes on smokeless tobacco products for proposed health care reforms. Excessive taxes on tobacco products, more importantly moist, smokeless tobacco products for UST Inc. could shift the demand for their products south. However, since the product contains high levels of nicotine, UST Inc.’s products are therefore addictive. And it is well known that in economic theory, the price elasticity of demand of such products are very inelastic and as such any increase in prices due to taxes will burden the consumer, and less so the producer. Thus the effect of increased prices is not as dangerous as suggested for the firm but because it will adversely impact the disposable income of consumers more. 6. Replacement of key personnel; strategic risks. The departure of Louis Bantle after twenty years of service, being replaced by Vincent Gierer could mean unforeseen issues for the firm if Mr. Gierer is found to be counterproductive. The firm does not suffer from financial risks given the next section.

How well is it doing. Is it on sustainable path? As mentioned in the beginning, UST Inc. is doing very well as of 1993. Not only is the firm properly managed and focused on its core, but also external factors are contributing to the firm’s success.

In terms of Cashflows and sales volatility; 1. There have been recent bans on smoking in public places leading to the fall in unit volume of cigarettes, whereas moist, smokeless tobacco unit volume increased by over 70% since 1979. Moist, smokeless tobacco is the fastest growing segment of the North American market as

3


mentioned in the case study. The convenience factor of UST Inc.’s products is the key marketing argument especially after the recent ban on public smoking. The market for UST Inc.’s product is growing and there are possibilities of entering new untouched markets. 2. The strong brand name of UST Inc. in terms of Skoal and Copenhagen along with the ever increasing demand of their products allowed UST Inc. to increase prices and therefore allowing for a significant premium on their products and thus high margins for the firm. 3. Given the nature of the addictive product, sales have been relatively stable, with low volatility in cashflows, meaning that the firm can face recessions head on and this should also be helpful if the firm is ever considering increasing its debt level for various reasons. 4. Moreover, with nearly 90% of the market sales due to product brands such as Skoal, Copenhagen and other variations of Skoal; UST Inc. commands eight of the top ten selling moist, smokeless tobacco products. Demand for UST Inc.’s products have been such that they were able to increase selling prices without a reduction in sales.

In terms of costs and other factors; 5. Due to the advertisement restrictions, it is unlikely that competitors will erode market share using promotional tactics, however they could opt for other measures such as price wars. 6. The company is doing very well financially in terms of key fundamentals and ratios. In 1992, UST Inc. had its thirty-second consecutive year of net earnings growth, shareholders have realised a near 600% increase in dividends over the last ten years. Over the same time frame, sales increased by 12%, net income by 19%, stock price increased from $2.93 to $32.00 (adjusted for stock splits) and cash flows by 37%. Such high increases in cashflows and sales could be beneficial for capital expenditure or new growth opportunities either directly or via taking on debt. 7. On a relative basis, UST Inc. again does not fail to impress given its financial performance vis-àvis its peers. UST Inc. has had exceptionally high profit margins and high return on assets and equity as well as an absence of significant debt levels. Other firms have had far worse debt ratios. As such, UST Inc. could easily enter into a price war with competitors if necessary but also, UST Inc. could easily heavily invest in new markets, frontiers, products for growth without being fearful of competitors retaliating to drive UST Inc. out of business. 8. Moreover, UST Inc. has an investment grade debt rating from Standard & Poor’s which should be very helpful if UST Inc. is considering any new debt issue. 9. Given UST Inc.’s strong financial position, suppliers and customers are not fearful of the firm’s ability to sale on credit to consumers or purchase inventory, materials on credit from suppliers and as such, UST Inc. should continue with smooth business operations. 4


10. UST Inc. implemented a diversification strategy during the 1970s and 1980s by acquiring several companies in vastly different sectors. So far, of the six business acquisitions UST Inc. engaged into, the firm has divested from four of them but is still engaged in a wine business as well as a camera car lease firm. Diversification is a strongly debatable case especially since shareholders can achieve similar or even better diversification compared to a firm and as such own firm diversification is seen as unnecessary and even burdensome even as in the UST Inc.; whereby they are extremely cautious and mindful of new venture risks. It is therefore is relatively good news that UST Inc. has divested from the majority of its acquisitions and will likely allow the firm to use its ever increasing cashflows for better tobacco related positive Net Present Value (NPV) projects for the benefit of its shareholders. 11. Instead of diversifying as it did, UST Inc. should consider entering foreign markets especially since it is likely that new regulation of public smoking will affect several countries and this would be a good opportunity to eat at the market share of cigarette producers even though moist, smokeless tobacco may not be well known outside north America given that it is related to the history of American Indians. Overall, UST Inc. is apparently heading towards an even greater trajectory with forecasts of earnings to be in an uptrend. The calculated sustainable growth rate is based on; ! = #$%×(1 − *+,+-./- 123456 726+4). Please note that ROE was obtained via decomposition method and the results are exactly the same that of the case study’s exhibit 1. Over the period from 1983 to 1992, the geometric average sustainable growth rate was 18%, and 19% using simple average. Year

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

28.02

26.16

22.15

18.52

17.75

15.99

13.23

14.11 15.36

14.66

Sustainable Growth Rate (g*); (%)

There is clearly an increasing trend in the growth rate. The company could grow ever more without taking on leverage at impressive rates of growth especially since g* is greater than the growth rate of sales with an arithmetic mean of 12% (11% geometric mean). Clearly the firm is growing sustainably given that it has increasing g* greater than growth of sales and there was no need to take on leverage or issue equity. The high growth rate itself can be explained by all the previous fundamental points raised and thus by the firms increasing profitability and asset turnover offsetting the decreasing leverage, thus mainly due to its increasing ROE.

5


Financial Analysis 2) The rationale for the current market value of UST Inc.’s Equity. The current market value of UST is $ 6,753,300,000.00, which means a per share price of approximately $32.00. The first step was to calculate an appropriate discount rate given the appropriate model. Luckily enough, since in 1992, the firm did not have any debt, we could use the following identity; 9:;; = 7< = 7= = 7. To calculate the required return on equity, two approaches can be used. We solved for r in the Gordon Growth formula; V=

>? (@AB)

and we also solved for r in the

justified leading P/E formula1. Our respective answers for r were 21.62% and 20.96%, taking an average, we get 21.29%.

1) Dividend Discounted Model Approach. IJ

*G 1+7

C64DE F7+D. =

G

+

*IJ (1 + !) 1 × (7 − !) 1+7

IJ

GKI

Where *G = *J 1 + ! G and *J = $0.80. This is very similar to the next approach. Please see appendix 1 for our results table.

2) Gordon Growth Model Approach. We use the following formula: C64DE F7+D. =

PQ IRB @AB

3) Free Cash Flow Discounted Model Approach. CFO is used in the calculation, the case study’s appendix mention that Cash flow provided in exhibit 1 already subtracts investing activities. There is therefore no need to adjust the CFO by Capex to arrive at Free Cash Flow to the Firm (FCFF). Moreover, since there is no debt, therefore FCFF equals Free Cash Flow to Equity (FCFE) and no adjustments for interest rate and net borrowing are needed. Please find our results in Appendix 2. IJ

S;SSG 1 + 9:;;

C64DE F7+D. =

G

+

S;SSIJ (1 + !) 1 × (9:;; − !) 1+7

IJ

÷ /5UV.7 4W Xℎ27.X

GKI

Where WACC is same as required return on equity.

1

CFA level 2;

ZQ [?

>?

=

\?

@AB

1−V

= 7−! where b is the retention rate. Therefore, 7 = (1 − V)×%1 /F0 + ! 6


4) Residual Income Model Approach. C64DE F7+D. = ^_ +

#$% − 7 ^J (7 − !)

÷ /5UV.7 4W Xℎ27.X

Below are the overall results: Approach

Result

Dividend Discount Model

$ 28.99

Gordon Growth Model

$ 33.04

Free Cash Flow Model

$ 47.44

Residual Income Model

$ 35.93

The results are relatively impressive, but less so for the FCF model. The other three are showing results quite close to the end of year market price of £32.00 with the best result being the GGM approach. FCF performed poorly given the strict assumptions we undertook especially since we did not have access to the complete financial statement of the firms and certain values were missing, for example depreciation expense and capital expenditure.

5) Relative Multiples Model Approach. The valuation of UST Inc. was based on a relative basis whereby several ratios were computed and compared and evaluated with respect to three firms that could be characterised as in the peer group of UST Inc. namely Philip Morris, RJR Nabisco and American Brands since they are tobacco product manufacturers. Below are the overall results: Stock Price from Relative Valuation Based on: Dividend yield

$ 32.61

Price/Cashflows

$ 19.98

Price/Earnings

$ 19.41

EV/EBIT

$ 18.77

Price/EBIT

$ 11.98

Price/Book

$ 7.00

Price/Sales

$ 4.66

The only remarkable outcome is that of Dividend yield’s accuracy. All the other ratios are not as good at estimating the market price of UST Inc. In general, it can be stated that relative valuation is not appropriate in the case of UST Inc. since the firm does not have peers which are very much comparable to it especially given its capital structure and impressive financial performance but more fundamentally since it is the undisputed leader in the moist, smokeless tobacco industry and the other firms are oriented towards another tobacco industry. 7


3) Evaluation of the capital structure UST has a low level of leverage through the 10-year period. During the first 5-year period (19831987), the company’s leverage ratios (book value) was 15% on average and continued to payback its debts in the following years, driving the leverage to go down. The company operated at zero leverage in 1992. In the meantime, UST had implemented stock repurchase program since 1984; however, the equity did not decline but gradually increased during the period. The lack of decreases in the equity resulted from the fact that the company initiated an aggressive stock option plan which encouraged its employees to buy stocks. Also, the total assets demonstrated gradual increases, with 8% annual compounded growth rate in the first 5-year period and 2% in the latter period. We consider UST’s capital structure sound and safe, and its capital structure is examined from the following dimensions: 1. The sustainable growth rate far exceeds its actual sales growth rate, shown in the figure below. The sustainable growth rate was 19% during the 10-year period while the sales and the assets have grown at the annually compounded rate of 12% and 6%, respectively. To further examine the drivers of the sustainable growth, the growth is attributed to the high profitability and high asset turnover. The net profit margin was averaged 25%, an extremely high figure compared to the industry average of 10%. The asset turnover was averaged 1.12 far above the industry average of 0.7, due to its relatively light scale of assets and outstanding sales. Although the company has the highest payout ratio (51%) and low leverage ratio (9%) which may have offset the growth, UST’s sustainable growth was very strong in the industry.

Capital Structure & Sustainable Growth Rate debt ($ million) total asset growth

0.30

equity ($ million) sustainable growth

sale growth

800.00

0.20

600.00

0.10

400.00

0.00

200.00 1992

-0.10

1991

1990

1989

1988

1987

1986

1985

1984

1983 0.00

8


2. The retained earnings (49%) from the high profitability injected the resource more than the need of its actual growth and investments, and this explained why UST achieved to continually decrease its debt level and did not need external funding. In addition, the cash flow had grown at an annual rate 37%, and the company maintained a huge cash position averaged at 6% far above the industry average of 2%. The domestic moist tobacco was approaching a mature stage in 1990s. The R&D and investment expenses accounted a fraction of its operating expenses. The advertisements which acted as a driver for the company’s sales also accounted a small percentage of its sales. Overall, both the increases in the cash flows and the decreases in operation expenses enabled the company to cut its debts and achieve the low leverage. 3. In terms the high competition of the tobacco industry in 1980s, it explained why the management chose to continually decease its debt level, enabling the company to stay away from any competition threat. Also, the management was conservative toward investment plans and did not attempt to voluntarily increase its leverage. 4. The customer had little concern about whether the company may have fallen into distress. It is worth noting that since UST dominated the moist tobacco industry and owned 90% market share, the company should maintain a strong financial position to avoid any chance of distress that may damage its reputation and public relations. 5. There is little difficult of redeploying its assets if the company fell into distress because the manufacturing facility may be adopted by other companies. 6. There may exist some agency problems with a large position of excess cash although there is little evidence in the case. But the conservatism in the management may help to prevent from taking reckless investments. As seen from the above analysis, UST’s capital structure is very solid and bears little risk of financial distress. In the 1980s, the tobacco industry grew rapidly in a fierce competitive environment, and there existed litigation risks and tax proposals that may give shocks to the market. These factors explained why UST management took a conservative policy toward investments and financial leverage that helped the company to stand at a vantage point in combat for the bad state in the economy. The financial performance proved that the management did contribute to generate considerable dividends and capital gains to shareholders. In this context, we consider UST’s capital structure a good strategy. In 1990s, the company faced a relatively mature stage in the moist tobacco industry. The growth may slow down and there still existed litigation risks and tax reforms. The management should 9


consider new approaches to its capital structure to maximize the company’s value. Uses of debts to take advantage of tax shields will be examined in the following contexts.

4) Share Repurchase Program Analysis Table 1 Preliminary 1993

Pro Forma 1994 - Debt as a Percent of Pre-Restructuring Firm Value 0%

Operating Income

10%

20%

30%

570.00

570.00

570.00

570.00

570.00

Interest Expense

0.80

0.00

45.99

98.28

160.65

Pretax earnings

576.00

570.00

524.01

471.72

409.35

Taxes

218.00

216.60

199.12

179.25

155.55

Net Earnings

348.00

353.40

324.89

292.47

253.80

Total Dividends

200.00

201.44

185.19

166.71

144.66

Shares outstanding (millions)

210.00

210.00

189.00

168.00

147.00

Earnings per share

1.69

1.68

1.72

1.74

1.73

Dividends per share

0.96

0.96

0.98

0.99

0.98

Common equity

495.00

495.00

495.00

495.00

495.00

Market equity

6300.00

6300.00

5909.00

5519.00

5128.00

Stock Price

30.00

30.00

31.27

32.85

34.89

Debt

-

0.00

630.00

1260.00

1890.00

Interest Rate

-

6.70%

7.30%

7.80%

8.50%

Interest Coverage

-

-

12.39x

5.80x

3.55x

Bond Rating

-

AAA

AA

A

BBB

6300.00

6300.00

6300.00

6300.00

-

239.00

479.00

718.00

6300.00

6539.00

6779.00

7018.00

Value of Unlevered Firm PV(Tax Shield) Value of Levered Firm

Exhibit 4 of the case was completed based on the following assumptions: 1. Operating Income remains unchanged at $570 million 2. The firm would be able to repurchase its shares at $30 To complete the table, we proceeded as follows: Calculation of New Stock Price 1. Calculate the level of debt in the new capital structure which is equal to the total value of the firm multiplied by the proposed level of debt. Divide the value of debt by $30 to find the number of stocks repurchased and the new number of outstanding shares.

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2. Consequently, the value of the firm increases by the value of the tax shield because of the tax deductibility of interest payments. Assuming that debt is a perpetuity, the present value (PV) of the tax shield can be computed as F` a2b Cℎ+.c- = ;4714726. 62b 726. ∗ e.,.c 4W *.V6 = fg * 3. Compute the new value of the firm by adding the PV of the tax shield. Generally ` e.,.7.- W+7U = ` h/c.,.7.- W+7U + fg * 4. The new stock price is now the new value of equity divided by the number of outstanding shares where the new value of equity is simply the value of the levered firm less the value of debt. Calculation of net earnings and dividends 1. A bond rating and an interest rate is assigned to the different capital structures. A detailed explanation is available in Question 6. Then calculate the interest expense by multiplying the interest rate by the level of debt. Pre-tax earnings are simply the operating income less interest expenses. 2. Assuming that the tax rate stays constant at 38% from the preliminary figures in 1993, net earnings are obtained by subtracting tax expenses from pre-tax earnings. 3. Next compute earnings per share (EPS) as the net earnings divided by the number of outstanding. From Exhibit 1 in the case, it can be seen that UST has always maintained a consistent dividend payout policy where the dividend per share (DPS) is always a constant proportion (57%) of EPS. It is reasonable to assume this continues and hence we can compute the new DPS figures. 4. The total dividend payout for the firm will be the DPS multiplied by the number of outstanding shares. 11


5) No Arbitrage Realistically, the scenario in question 4 will not happen. This is because following the announcement of a leveraged recapitalization, shareholders will realise that the value of the firm and consequently the value of their stocks have increased because of the tax shield. Table 1 displays the resultant share price following a leveraged recapitalization, assuming that UST would be able to repurchase the shares at $30. However, this situation is an arbitrage opportunity as investors could buy shares at $30 and profit from the share’s higher price immediately after the leverage recap. Hence, if we assume the condition of no arbitrage, the scenario in question 4 will never happen. This is because following the announcement of a leveraged recapitalization, shareholders will realise that the value of the firm and consequently the value of their stocks have increased because of the tax shield. Table 2

No Arbitrage Condition Debt PV(Tax Shield) Value of Firm after announcement Number Of Outstanding Shares before Leveraged Recapitalization Value of Shares after announcement

10% 630 239.4 6539.4 210 31.14

20% 1260 478.8 6778.8 210 32.28

30% 1890 718.2 7018.2 210 33.42

In all cases, the equity value increases and the stock prices all increase beyond the initial $30. Hence shareholders will be unwilling to tender their shares at $30 as they would be better off waiting for the higher price. Therefore, UST has to offer at least as much the value of shares after announcement in the table above to convince investors to part with their stocks. It is also worth noting that the value of shares after the announcement of the leveraged recapitalization will not change even after the actual leveraged recapitalization as the firm can only buy a smaller number of shares. Hence the price will not rise as much as predicted in the table. 12


6) Assignment of Bond Ratings and Interest Rate As the debt level increases, bond rating is expected to decline while interest rate is expected to increase. This is expected since a higher amount of leverage results in an increase in the amount of the interest payments. Correspondingly, for a given operating income, it becomes harder for the firm to meet these debt obligations, as highlighted in the falling interest coverage ratio. Therefore, as leverage increases, the risk of default rises and creditors will demand a higher level of interest to compensate for the increase in risk and the firm becomes less credit worthy. Naturally, with a 100% equity structure, the risk of default is virtually zero hence that should be assigned the highest credit rating AAA. Being conservative, we match the interest coverage ratios of the different capital structure, which are similar but higher, to the interest coverage averages of the different credit ratings from 1990 to 1992. Hence a firm with a 10% debt which has an interest coverage ratio of 12.39 is assigned an AA credit rating as it is higher and closest to 9.3 and so forth. While it was tempting to assign credit ratings by adopting a “comparables” approach, this was not possible and could lead to misleading results. Table 3 Philip Morris

RJR Nabisco

American Brands

18203

14030

3231.5

Market Equity

68853.9

9786.4

8204.5

Total Value of the Firm

87056.9

23816.4

11436

Total Debt %

20.91%

58.91%

28.26%

Total Equity %

79.09%

41.09%

71.74%

Interest expense

1513

1449

270.1

Interest rate

8.31%

10.33%

8.36%

Credit Rating

A

BBB

A

Total Debt

Figure displays comparable companies that have similar business activities to UST. However despite widely different capital structures, their interest rates and to a certain extent their credit ratings are similar. For example, American Brands has approximately 10% more debt in its capital structure and yet the difference between their interest rates is almost negligible. Hence clearly in the real world, there are several factors, from market share to debt structuring that come into deciding a firm’s

13


credit rating. Therefore, while our estimates are rough, their reliability is enhanced because of our conservative stance and represents the better of the two alternatives.

7) EPS analysis As the share of debt increases from zero to 10% of the firm’s value, the EPS ratio rises from $1.68 to $1.72. The highest EPS ($1.74) is achieved with 20% debt, and the ratio declines slightly as the percentage of debt reaches 30%. A stock repurchase decreases the number of outstanding share, hence net profits are shared by fewer shareholders, which pushes up the value of EPS. However, the debt raised to finance the stock repurchase leads to interest expenses, therefore eroding the net income available to the residual claimants, i.e. equity investors. The net impact on EPS depends on which of the two effects prevails. Generally, EPS increases with leverage, thus one would expect EPS to rise as the share of debt financing grows compared to equity. This is the case as long as the interest expenses resulting from the debt increase are not disproportionately large. In the case of UST, each level of debt is associated with a corresponding credit rating, which in turn determines the appropriate interest rate. Therefore, the increase in interest expenses is not only the result of the larger amount of debt; indeed, a rise in the borrowing rate contributes to making the downside of debt issue even more severe for the firm. By raising the percentage of debt from 0 to 10% and subsequently to 20%, the drop in outstanding shares more than offsets the decline in net earnings, leading to a rise in EPS. This is clearly shown in the table below. On the contrary, further increasing debt to 30% of total value, causes the ratio to drop, although only marginally. Table 4 Debt level

0%

10%

20%

30%

Bond Rating

-

AA

A

BBB

Interest Rate

-

7.30%

7.80%

8.50%

353

325

292

254

-

-8.07%

-9.98%

-13.22%

210

189

168

147

-

-10.00%

-11.11%

-12.50%

1.68

1.72

1.74

1.73

Net Earnings ($mln) % Change Shares Outstanding (mln) % Change EPS ($)

14


If UST could borrow any amount at 7.30% (that is the interest rate associated with AA rating), EPS would increase every time the firm raised more debt. In particular, the ratio would be equal to $1.72, $1.76 and $1.82 for 10%, 20% and 30% debt respectively. EPS is sometimes looked at as a measure of value creation. The argument is based on the fact that leverage increases earnings per share, which should necessarily translate into a higher share price. However, what the argument fails to consider is that a rise in EPS may simply be the required compensation for the additional risk that shareholders take on. Leverage has the effect of increasing the cost of equity, therefore, although future earnings may be higher, they are discounted at a higher rate, exactly to reflect the greater risk associated with those earnings. For this reason, using EPS as an indicator of value creation could lead to wrong conclusions. Leverage does not necessarily lead to a rise in the share price as there are costs associated with it. Therefore, one should be very careful when analysing the effects of leverage on EPS and on value creation for equity investors.

8) Value creation and costs The share repurchase scheme allows UST to benefit from the tax shield. This is the value that the firm can create thanks to the tax deductibility of interest expenses. Please refer to Table 2 for the values associated with each debt level. The calculations that result in the tax shield are based on a number of assumptions. Firstly, the capital structure is assumed to stay constant over time; additionally, the applicable marginal tax rate is anticipated to remain unchanged. In order for the company to take full advantage of the tax shield, UST is presumed to keep generating profits virtually forever. Lastly, the validity of our results rest on the assumption that the appropriate discount rate for the tax shield coincides with the interest rate on debt. The present values of the tax shield shown in Table 2 are most likely optimistic estimates, due to the assumptions of permanent debt level and continuous profitability. Also, the marginal tax rate could vary in the future, however the effect that this will have on the tax shield depends on the sign of the change. If τ decreases, overestimation of the tax shield will be magnified. Furthermore, resorting to debt financing means that the firm might run into financial distress if cash flows decrease to a point where they become insufficient to service the debt. If revenues were to fall, the distress costs associated with this would be larger, the bigger the share of debt in UST’s capital structure. The costs associated with financial distress can be categorised as direct bankruptcy 15


costs and indirect costs. Direct costs arise because, when a firm is bankrupt, external experts such as lawyers, accountants and consultants are hired. But also the time necessary to deal with the bankruptcy represents a significant cost. However, expected direct costs are generally smaller than indirect ones. As for the latter, these are harder to assess than legal and administrative costs, and can stem from a number of sources. Indirect costs may derive from a loss of customers, especially when the value of a product is contingent on the firm being able to provide future support to the buyer. However, this does not apply to UST because of the nature of its products. Secondly, suppliers may stop trading with a distressed client if they fear that these will fail to pay them. In the case of UST this may represent an issue and could translate into a self-fulfilling process. Additionally, key employees may well decide to leave a firm in distress is they felt that the security of their job was at risk. Most importantly, the need to raise cash quickly to avoid bankruptcy is often a cause of fire sales, whereby a firm’s assets are sold at a substantial discount to their fair value. It is worth noting that administrative costs related to bankruptcy proceedings can be limited to the extent that shareholders and debt holders are willing to renegotiate the terms of the debt. However, customers, suppliers and employees can generate potentially unlimited indirect costs. From the debt holders’ perspective, leveraging leads to agency costs. Financial distress provides incentives to the equity holders to essentially gamble with the debt holders’ money, often translating into decisions that raise the overall risk of the firm even further. For example, shareholders may find it profitable to undertake negative NPV projects. This is referred to as the asset substitution problem, whereby it makes financial sense for equity holders to make the asset side of the balance sheet riskier, thus decreasing the proportion of low-risk assets. Additionally, debt overhang is a potential issue too. This happens when most of the benefit of a positive NPV project goes to the debt holders, making the project a de facto negative NPV investment for the shareholders. This causes the latter to reject profitable investments and is therefore a cost to the firm and particularly to its creditors.

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Appendix 1 (DDM) Dividend Discount Model Approach Future periods Dividends($) Discount Rate; Required Return on Equity Discounted Dividends($) Stock Price

1993

1994

1995

1996

1997

1998

1999

2000

2001

0.95

1.12

1.33

1.57

1.86

2.21

2.61

3.09

3.66

Terminal 2002 value 4.34

151.35

0.8245 0.6797 0.5604 0.4620 0.3809 0.3141 0.2589 0.2135 0.1760 0.1451

0.1451

0.78

0.76

0.74

0.73

0.71

0.69

0.68

0.66

0.65

0.63

21.96

$ 28.99

Appendix 2 (FCF Method) Free Cash Flow Model Approach

Terminal

Future periods Free Cash Flow to the Firm (FCFF) ($) Discount Rate; WACC=Re Discounted FCFE=FCFF ($) FCFE Stock Price

1993

1994

1995

1996

1997

1998

1999

2000

2001

1068.42 1265.27

2002 value

327.09 387.35 458.72 543.23 643.31

761.84 902.20

1498.38

52253.80

0.8245 0.6797 0.5604 0.4620 0.3809

0.3141 0.2589

0.2135

0.1760

0.1451

0.1451

269.67 263.29 257.07 250.99 245.06

239.27 233.61

228.09

222.69

217.43

7582.52

$ 10,009.69 $ 47.44

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References American Cancer Society. 2015. cancer.org. [ONLINE] Available at: http://www.cancer.org/cancer/cancercauses/tobaccocancer/smokeless-tobacco. [Accessed 11 February 16].

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