Debt Policy at UST Inc.
In the 1990’s, UST was a dominant producer of moist smokeless tobacco, controlling 77% of the market. Smokeless tobacco products consist of snuff (dry and moist) and chewing tobacco (loose leaf, plug and twist/roll) categories. UST was a market leader of the snuff product category, innovating with new product forms and flavors over the years. UST has also been a profitable company, boosting its shareholders’ earnings by undertaking measures such as increasing the cost of its products steadily with time. UST also benefited from the steady increase in market demand for smokeless tobacco given the rising restrictions on cigarette second hand ...view middle of the document...
? Evaluate from the viewpoint of a credit analyst or potential bond holder (1 point). Hint: you may compile a list of factors and comment on them.?
UST has historically been one of the most profitable companies in corporate America and a market leader in smokeless tobacco industry; however there are a few associated business risks with UST as listed below:
• The demand for smokeless tobacco products was minimal in international markets and product expansion outside USA for greater market segment was not much of an option for UST.
• UST had been slow to diversify its product line across various price points, consequently allowing smaller competitors to gain traction for the lower priced smokeless tobacco product categories. Companies like Swedish Match, Conwood and Swisher were reporting rising revenues with snuff and chewing tobacco products.
• Tobacco industries (smoke or smokeless tobacco products) were involved in numerous health related lawsuits and litigations. With FDA regulations, there were increasing restrictions on tobacco use. Consumers were also getting health conscious and understanding the carcinogen effects of tobacco with increasing anti-tobacco campaigns. UST had seven pending health related lawsuits at the end of 1998. Lawmakers were expected to continue to push for new laws to combat youth tobacco use, restrict tobacco advertising and empower FDA to regulate nicotine as a drug. These developments made the distant future of tobacco industry and UST unclear.
2. According to Exhibit 3 of the case, the current P/E ratio is 13.8 (i.e., P0/E0 = 13.8). Using the 20-year T-bond rate of 5.45% from Exhibit 8 of the case, assuming the stock market premium is 7%, and UST’s equity beta is 0.65, and UST will maintain a dividend payout ratio equal to the 5-year average dividend payout ratio from 1994 until 1998, what is the implied earnings constant growth rate, g (2 points)?
5-year average dividend payout ratio
1994 = 58%
1995 = 59%
1996 = 60%
1997 = 67%
1998 = 64%
Dividend payout ratio = 61.6%
i = Rf + β(RM – Rf)
β = .65
Rf = 5.45% 20-year T-bond rate
RM = 7%
i = 5.45% + .65(7% – 5.45%)
i = 6.46%
Constant Dividend Growth Model
P0/E0 = (1+g)*d/(i-g)
P0/E0 = current price to earnings ratio = 13.8
d = dividend payout = 61.6%
i = required rate of return on the stock = 6.46%
g = constant growth rate
P0/E0 = (1+g)*d/(i-g)
13.8 = (1+g)*.616/(.0646-g)
22.4026 = (1+g)/ (.0646-g)
23.4026g = .447208
g = .019109 = 1.91%
3. Assume a 38% tax rate, and net sales will grow at 5% from 1998 level, and the ratio of EBIT to Net sales in 1999 will be equal to the 5-year average EBIT/Net sales ratio from 1994 to 1998 period, prepare a pro-forma income statement as the following table. Will UST will be able to make interest payments (4 points)?
Income Statement Projections (in millions, except per-share data and ratios)
| |Actual ...