UST decides to borrow 1 billion (by issuing bonds)
1. In order to apply an APV type model we will need to estimate the interest tax shields that are a result of the new bond issuance. Therefore, we will need to have an estimate of the cost of debt that UST would face if it moved forward with this transaction. To estimate the cost of debt, begin by estimating the credit rating UST would get if it moves forward with the transaction. To do this, first calculate the following financial ratios for UST after it issues the new bonds using the data in Exhibits 5 and 8. Then using the data in Exhibit 8 to estimate the bond rating you would give UST based on these three ratios.
Hint: you can use the data for 1998 but you must adjust the ratios for the new amount of debt UST will take on as a result of issuing the new bonds.
| | Financial Ratios | Implied Bond Rating |
| Fund Flow/Total Debt (in %) | | |
| Free operating cash flow/Total Debt (%) | | |
| Operating income/Sales (%) | | |
200-069 14- Exhibit 8 Key Financial Ratiosa Adjusted Key Industrial Financial Ratios-Senior Debt Ratings Noninvestment Grade/Speculative Industrial Long-Term Debt Three-Years (1996-1998) Medians Investment Grade AAA AA A EBIT interest coverage (x) EBITDA interest coverage (x) Fund flow/total debt (%) Free operating cash flow/total debt (%) Return on capital (% Operating income/sales (%) Long-term debt/capital (% Total debt/capital (including ST debt) (% 9.2 7.2 1.2 (0.9) 0.2 7.4 12.9 18.7 89.7 40.5 4.1 2.5 3.9 20.1 1.0 14.0 67.0 21.6 10.0 49.5 17.4 19.6 6.3 32.2 6.3 2.3 10.5 (4.0) (25.4) (8.8) 5.0 30.6 30.9 25.1 25.2 15.4 15.8 40.8 46,4 12.6 9.2 11.2 68.8 71.4 17.9 33.3 39.2 14.4 21,4 29.3 55.3 58.5 71.5 79.4 31.8 37.0 Corporate Bond Yields BBB U.S. Treasury Debt Yields-December 22, 1998 I- AAA AA A BB+ 10-Year (%) 20-Year (%) 11.19 4.70 5.60 6.47 5.84 6.76 6.12 7.05 6.84 7.82 7.70 8.72 5.45 Formulas for Adjusted Key Industrial Financial Ratios EBIT Interest coverage Earnings from continuing operations before interest and taxes/ Gross interest incurred before subtracting capitalized interest and interest income EBITDA interest coverage = Earnings from continuing operations before interest, taxes, depreciation and amortization/ Gross interest incurred before subtracting capitalized interest and interest income Funds from operations/Total debt Net income from continuing operations +depreciation, amortization, deferred income taxes, and other noncash/ Long-term debt+current maturities, commercial paper, and other short-term borrowings Free operating cash flow/Total debt Funds from operations capital expenditures (+) the increase (decreas e) in working capital (excluding changes in cash, marketable securities and ST debt Long-term debt +current maturities, commercial paper, and other short-term borrowings Pretax return on capital EBIT interest expense Average of beginning and ending year capital, including short-term debt, current maturities, long-term debt, noncurrent deferred taxes and equity Operating income/Sales Sales minus cost of goods manufactured (before depreciation and amortization), SG&A and R&D costs/ Sales Long-term debt/Capitalization - Long-term debt 200-069 14- Exhibit 8 Key Financial Ratiosa Adjusted Key Industrial Financial Ratios-Senior Debt Ratings Noninvestment Grade/Speculative Industrial Long-Term Debt Three-Years (1996-1998) Medians Investment Grade AAA AA A EBIT interest coverage (x) EBITDA interest coverage (x) Fund flow/total debt (%) Free operating cash flow/total debt (%) Return on capital (% Operating income/sales (%) Long-term debt/capital (% Total debt/capital (including ST debt) (% 9.2 7.2 1.2 (0.9) 0.2 7.4 12.9 18.7 89.7 40.5 4.1 2.5 3.9 20.1 1.0 14.0 67.0 21.6 10.0 49.5 17.4 19.6 6.3 32.2 6.3 2.3 10.5 (4.0) (25.4) (8.8) 5.0 30.6 30.9 25.1 25.2 15.4 15.8 40.8 46,4 12.6 9.2 11.2 68.8 71.4 17.9 33.3 39.2 14.4 21,4 29.3 55.3 58.5 71.5 79.4 31.8 37.0 Corporate Bond Yields BBB U.S. Treasury Debt Yields-December 22, 1998 I- AAA AA A BB+ 10-Year (%) 20-Year (%) 11.19 4.70 5.60 6.47 5.84 6.76 6.12 7.05 6.84 7.82 7.70 8.72 5.45 Formulas for Adjusted Key Industrial Financial Ratios EBIT Interest coverage Earnings from continuing operations before interest and taxes/ Gross interest incurred before subtracting capitalized interest and interest income EBITDA interest coverage = Earnings from continuing operations before interest, taxes, depreciation and amortization/ Gross interest incurred before subtracting capitalized interest and interest income Funds from operations/Total debt Net income from continuing operations +depreciation, amortization, deferred income taxes, and other noncash/ Long-term debt+current maturities, commercial paper, and other short-term borrowings Free operating cash flow/Total debt Funds from operations capital expenditures (+) the increase (decreas e) in working capital (excluding changes in cash, marketable securities and ST debt Long-term debt +current maturities, commercial paper, and other short-term borrowings Pretax return on capital EBIT interest expense Average of beginning and ending year capital, including short-term debt, current maturities, long-term debt, noncurrent deferred taxes and equity Operating income/Sales Sales minus cost of goods manufactured (before depreciation and amortization), SG&A and R&D costs/ Sales Long-term debt/Capitalization - Long-term debt
