UST Inc. should increase the leverage in its capital structure by incurring $1 billion in debt. Through debt financing, it will increase the value of the firm by creating a tax shield, allowing UST to repurchase up to 28,669,725 share. In addition, this will enable UST Inc. to increase the amount of dividends per share without increasing without having to increase dividends paid. Repurchasing of the shares should also re-gain industry analysts’ confidence.
• $1 billion debt is constant and perpetual.
• Currently, UST Inc. has a AAA debt rating. Even though they will be downgraded if they take on the debt, UST Inc. wants to maintain investment grade ratings.
• UST Inc. will use the entire incremental debt to repurchase stocks.
• Cost of Debt: 5%
Traditionally, UST Inc. has a conservative debt policy that does not allow them to take advantage of tax shields. Since the Master Smokeless Tobacco Settlement has been signed and the risks of state Medicaid litigation is reduced, UST Inc. should restructure its capital policies in response to recent market share decline. By using debt financing to repurchase shares, UST Inc. will create a tax shield (Exhibit 4) and increase the value of the firm (Exhibit 5). At the same time, it can increase their lagging dividends payments to shareholders without increasing the total amount of dividends paid.
Break-even point for EBIT is $373,511,997. If EBIT is higher than this number, debt financing should be used. However, if EBIT is lower than the break-even point, equity financing will be the better option.
From EBIT analysis, it is found that debt financing is the better option for UST Inc. By using debt to repurchase shares, UST Inc. will create a tax shield. At the same time, this increases the value of the firm from $6,470,800,000 to $6,790,400,000 (Exhibit 5).
Effects of Recapitalization
• Market value of the firm increases by $319,600,000 after recapitalization...