Recommendation:
United States Tobacco (UST) should increase the leverage in its capital structure by incurring $1 billion in debt. Debt financing will increase the value of the firm by creating a tax shield and allow UST to repurchase approximately 25 million shares, which in turn, will enable UST to increase the amount of dividends per share without increasing the total amount of dividends paid. UST needs to re-gain industry analysts' confidence by using the entire $1 billion to repurchase shares, and in 2-3 years it should consider increasing its leverage up to $1.5 billion.
Assumptions:
The following assumptions were critical for the recapitalization analysis:
? The $1 billion in debt is constant and perpetual, however only the incremental debt ($900 million) was used for analysis purposes.
? UST currently has a AAA debt rating, and even though they will be downgraded if they take on the $1 billion debt, UST wants to maintain investment-grade ratings.
? UST will use the entire incremental debt amount to repurchase stocks
Analysis
Industry attributes
UST currently holds the majority of the smokeless tobacco market share (77%), and has seen consistent increases in sales and earnings in the profitable industry. Federal advertising restrictions has limited competitors from entering the market because they cannot compete with UST's premium product and strong brand recognition. UST can rely on continued sales growth even with product price increases, given the inelastic demand and lack of substitutes for tobacco products. In addition, UST will benefit from recent trends in public smoking bans across the United States and they face less litigation risk than cigare ...