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Debt Policy at UST Inc.

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Probability of bankruptcy as a proportion of the firm value. VL = VU Tax Shield Expected Bankruptcy Cost. VL = VU D - PV (Financial Distress) ... – PowerPoint PPT presentation

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Title: Debt Policy at UST Inc.


1
Debt Policy at UST Inc.
  • Should UST undertake debt recapitalization?

Beidi Gu Minhua Zhang
2
Recap What the pro-side said about the company
value?
  • Tax Shield
  • UST wants to increase the firm value by enjoying
    the huge tax shield provided by more leverage.
  • Tax Shield ?D (0.38)(1billion) 0.38billion

3
Recap What the pro-side said about the company
value?
  • The incremental effect on USTs value of
    implementing the recapitalization, assuming that
    the plan is implemented immediately on January 1,
    1999.
  • VU The firm value before the debt
    recapitalization
  • VL The firm value after the debt
    recapitalization
  • ? Tax rate
  • D Debt issued
  • ? Probability of bankruptcy as a proportion of
    the firm value
  • VL VU Tax Shield Expected Bankruptcy Cost
  • ? VL VU ?D - PV (Financial Distress)
  • ? VL VU ?D - (probability of bankruptcy
    cost of bankruptcy)
  • ? VL VU ?D - (probability of bankruptcy (?
    VU))
  • Where ? is some constant that is usually valued
    between 5 and 30

4
Recap What the pro-side said about the company
value?
  • Incremental chanceVL-VU?D - (probability of
    bankruptcy (? VU))
  • 0.381 billion-0.00280.36.5billion
  • 0.375 billion
  • So, the incremental change the added leverage
    causes is a increase of the firm value by 0.375
    billion375 million!

5
Really?
6
Real World
  • There are Personal taxes!
  • VLVu1-(1- ?C)(1- ?pe)/(1-?y)D
  • Rich investors faces marginal income tax ?y
    50
  • Original tax on dividend ?pe20
  • Now ? effective ? 1-(1- ?C)(1- ?pe)/(1-?y)
    (1-.38)(1-.20)/(1-.50).008
  • Tax Shield is only .008 billion 8 million!

7
Company Value
  • Incremental chanceVL-VU?D - (probability of
    bankruptcy (? VU))
  • 0.0081 billion-0.00280.36.5billion
  • 0.003 billion
  • So, the incremental change the added leverage
    causes is a increase of the firm value by only
    0.003 billion3 million!

8
Oh!
3 Million NOT 375 Million
9
Risk, Risk
  • Tough market perspective
  • Higher bankruptcy cost

10
Tough market perspective
  • Why UST did not lever the firm earlier?
  • Low Tax Shield!
  • High market occupancy and natural market
    expansion guarantees constant availability of
    positive NPV projects to enhance company value
  • Customers shifted from smoking cigarette
  • But the company realized that such momentum will
    not continue into the future!

11
Risk, Risk
  • Lets use the debt shield as a last resort then ?

12
Tough market perspective
  • What if the EBIT doesnt grow with 11?
  • 9 ? Unable to maintain the dividend stream in
    2007
  • 7 ? Unable to maintain the dividend stream in
    2005

13
Risk, Risk
  • Tough market perspective
  • Higher bankruptcy cost

14
Higher Bankruptcy Cost
  • Litigations and fines on health related issues
  • Pending law suits at the end of 1998
  • Litigations on anti-trust law suits
  • UST vs. Conwood Co.
  • 1 Billion Case lost over last summer (2002)

15
You Decide Please
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