[Solution] Tax Net Income Tax
The CEO of UST would like you to prepare a three to four page case report discussing UST’s current
financial situation and the implications of increasing leverage in UST’s capital structure. The firm is
considering a $1 billion increase in long-term debt. Assume that the debt would be taken on
immediately and held in perpetuity. The $1 billion would be used immediately to repurchase shares.
Also assume that the top marginal tax rate is 38 percent. The following questions should be addressed
when preparing the report for the CEO:
1) Provide an overview of UST’s business operations. In your presentation, feel free to provide
visual detail of the type of products UST sells to its customers.
2) Compile a list of factors that a credit analyst or potential bondholder would take into account
when evaluating UST’s proposed recapitalization. Discuss the important factors.
3) Why is UST considering a leveraged recapitalization after such a long history of conservative
4) Comment on the past and future financial performance of UST. What is the stock market’s
assessment of UST’s long-term growth rate?
a. Hint: use the growing perpetuity formula, ????0 = ????1⁄(???????????? − ????), and solve for ???? to infer
UST’s long-term growth rate. You will need to use the CAPM to find ????????????. (You may want
to do some online research of comparable tobacco companies to figure out the
approximate beta you should use for the CAPM.) Assume that ????1 = ????0 × (1 + ????).
5) Comment on the financial performance of UST relative to other tobacco companies.
6) Create three pro-forma income statements for fiscal year 1999 under each of the following
assumptions: (1) the $1B in debt was not issued; (2) the $1B in debt was issued and is
investment grade; (3) the $1B in debt was issued and is below investment grade. For the latter
two cases, can UST afford to make the interest payments based on the respective pro-forma
In answering this question, the CEO only wants a simplified pro-forma income statement that
takes the following form:
PRE-TAX NET INCOME
7) Calculate the change in UST’s value due to the tax shield benefits of the additional debt. For this
question, it would be useful to create a table containing the following information: value of the
tax shield, value of the firm, value of the debt, value of the equity, number of shares
repurchased, number of shares outstanding, and stock price. The table should cover the same
three cases as Question 6. Assume that the $1B in debt is used to repurchase $1B in shares.
8) Comment on possible changes in value from the recapitalization due to other market frictions
such as bankruptcy costs, information signaling, or other market frictions that you feel are
9) UST has paid uninterrupted dividends since 1912. Will the recapitalization hamper future
dividend payments? Consider, in particular, the dividend paid per share in 1999, with the
assumption that UST will try to maintain a constant dividend payout ratio.
The case report should be three to four pages in length (use the default spacing in Microsoft Word) with
any useful tables or graphs attached. A one-paragraph executive summary should be included at the
beginning of the report. The report should be presented in a professional manner and read as a cohesive
document so that the CEO can easily understand your main points. If you need to make any
assumptions, make them clear. Calculations should be relegated to an appendix. A report that consists
of a mess of calculations and numbers or a series of random paragraphs pasted together would not be
The case presentation should be about 20-30 minutes in length. Similar to the report, it should also be
presented cohesively and in a professional manner so that the CEO can easily understand your main
points. The presentation should be informative, concise, and should keep the listener engaged. The
presenter should also be prepared to answer questions from the audience. A maximum of two people
from your group should present your findings.