UST RECAPITALIZATION
Question A: Based on the information provided on the case, the approach we took was to first determine the correct cost of debt by adding the $1B issue of 30-year bonds. As per S&P and EBITDA Interest Coverage ratio, it was determined that UST bond rating should be A:

Investment grade

AAA
AA
A
BBB

Debt yield 20Y
6.47
6.76
7.05
7.82

UST
EBIT
753.3
753.3
753.3
753.3
UST
EBITDA
785
785
785
785
UST
Interest expense
62.5
65.4
68.3
76

UST
EBIT interest coverage
12.1
11.5
11.0
9.9
UST
EBITDA interest coverage
12.6
12.0
11.5
10.3

Industry
EBIT interest coverage
12.9
9.2
7.2
4.1
Industry
EBITDA interest coverage
18.7
14
10
6.3

For bondholders of grade A debt, there would not be a significant risk of default from UST although the company would be considered more susceptible to adverse effects of changes in economic conditions.
Investment grade A corporate debt is valued at 7.05% (for 20-years which is the closest to our 30-year bond) which will be used as our cost of debt.

Value of UST Prior to Taken Over Debt:
The enterprise value of UST is determined based on their current market equity which equals $6,470.8M, calculated based on the following information:

UST Enterprise Value
Stock Price $34.88
Average Basic Shares Outstanding
185.5 M
Equity (Market Value) $6,470.80 M
Debt (Book value)
$100 M
Total Firm Value (Market Value) $6,570.80 M

If UST decides to go ahead with the recapitalization, the cash flow savings will be the tax shield cost of the debt, and the new value for the firm will be $6,920.8M (higher than the unlevered value). The tax rate used was 40%. The value was calculated as follows:

APV Method- PV Tax Shield
New Debt $1,000 M
Tax Rate
40%
Cost of Debt Rb- A Bond 20-Year
7.05%
Semi-annual interest payment
$35.25 M
Tax Shield Semiannual $14.1 M
Semi-annual yield
3.525%
Number of periods
30x2
PV of Tax Shield $350 M
New Firm Value (Debt + Equity) $6,920.8 M
New Equity Value (Firm Value - Debt)
$5,820.8 M
New Share price $36.77

Under the assumption of capital markets efficiency, the share price changes on the date the company announces its plan to leverage, not on the date when the shares are actually repurchased.

After the issuance of the new debt and taken into consideration the new value of the levered firm, the firm will buy back shares at the new share price:

New Shares Repurchase and Price
Old Shares Outstanding
185.5M
Old Stock price $34.88
New Stock Price after announcement $36.77
Number of Shares Repurchased = (1,000/36.77)
27.196 M
New Number of Shares Outstanding = (185.5-27.196)
158.304 M
New Shareholder’s Equity (Market Value) = (158.304*36.77)
5,820.84 M

The cost of equity is calculated based on the US Treasury rate for 20-Years (risk-free rate) of 5.45% and a market risk free premium of 6%, yielding an RE of 10.25% prior to recapitalization.
Re CALCULATION β 0.8
Market Risk Premium
6%
Rƒ (20Y - U.S. Treasury)
5.45%
Re= Rf + β(Rm-Rf)
10.25%

The unlevered and new levered cost of equity is derived as follows:
Ro CALCULATION
Re
10.25%
D/E = 100/6470.8
0.015
Rd
0%
1-Tc (40%)
0.6
Re= R0 + (D/E)(R0 – Rd)(1 – T) => R0=
10.16%

New RE - After New Debt Issued
R0
10.16%
D/E = 1100/5820.84
0.19
Rd
7.05%
1-Tc (40%)
0.6
Re= R0 + (D/E)(R0 – Rd)(1 – T) => Re=
10.51%

The WACC:
WACC - After New Debt Issued
Debt
$1,100 M
Equity
$5,820.84 M
Total Value (Market Value) $6,920.84 M
D/V
0.16
E/V
0.84
Tax
40%
Re
10.51%
Rd
7.05%
WACC = (E/V)Re + (D/V)Rd(1-T)
9.51%

Question B:
1. Recapitalization has a few positive outcomes for UST. First, by adding debt to repurchase shares the value of the firm will increase by $350 million, which is an increase resulting from tax savings on the new debt. Second, the value of the stock price increases by 5.4%, which will add more value to shareholders equity and third, UST will have higher market