Good Low Level Of Borrowed Funds Case Study Example

The key issues in the case include low level of borrowed funds, cash and cash equivalents and reduction in the rate of sales growth. Recommendations on the increase of borrowed funds examine a recapitalization strategy, in which it lends equal to $1 billion to repurchase its shares. Recommendations concerning increase in cash and cash equivalents consider the sale of unused or unwanted objects and reserves for an amount of $456.65 Mio. Recommendations on the increase of sales growth rate to at least 4.4%, including the improvement of advertising campaign and application of the strategy of mergers and acquisitions.

Competent, effective management of the profit formation involves the creation in the company of relevant organizational and methodical support systems of management, knowledge of the basic mechanisms of the profit formation, the use of modern methods of analysis and planning. One of the main mechanisms for the implementation of this task is financial leverage. It is characterized by the use by the company of borrowed funds that influence the measurement of return on equity. By using debt financing the company expands its capabilities: the availability of reasonable amount of borrowed funds will give the company extra benefits in the form of being regular client in the institution of loan issuance, appropriate support in case of force-majeure, expansion of production range and production volumes, saving in future price increase of raw materials, ability to invest in additional projects and ability to have constant profit. Financial leverage is an objective factor that arises with the emergence of borrowed funds in the amount of capital used by the enterprise, allowing it to get more return on equity. It is calculated as the ratio of debt to equity: Total debt / Shareholder’s equity. Since interest on loans belongs to fixed costs, increase in financial costs of borrowings is accompanied by increased power of operating leverage and increased business risk. The normative value for this indicator is in the range 0.5 – 0.8.
So, as the principal producer in the moist smokeless tobacco business, UST Inc. has been known by its capability to make high earnings by means of low financial dependence for quite long period. Capturing 77% of the market the company is definitely its leader, keeping a pricing control that permits it to set twelve-monthly price rises except for losing clients. Due to its reliable label recognition, sustainable pricing flexibility and constant development of moist smokeless tobacco, UST’s gross profit margin of 80% compares to a median of 28% for the group. According to the above formula UST’s Debt-to-equity ratio in 1988 was 0.07 and in 1998 – 0.21 (See Appendix C). Despite the fact that the amount of borrowed funds increased, the ratio remained below the normative value. According to growth analysis the growth rate of borrowed funds was 22.5% and of Debt-to-equity ratio – 20%. The highest Debt-to-equity ratio of 89% was recorded in 1996, when company’s total debt was $250 Mio. It was a little higher than normative, but optimal, compared to the competitors, which have different values of that ratio, from -14 (North Atlantic Trading Co.) to 3.1 (Standard Commercial). Philip Morris had the most adequate value of 0.9 (data for calculation were taken from Exhibit 5 of the Case, Appendix B). Thus, UST does not get some motivation advantage from debt. Thus, such low value of the Debt-to-Equity ratio says about the lost opportunity to use financial leverage – to increase return on equity due to the involvement in the activities of borrowed funds.
Concerning the situation in industry it is worth to mention that the American smokeless tobacco manufacturing generated $2 billion of trade proceeds in 1998 with ca. five million customers of moist smokeless tobacco. It was the fastest rising segment with annual growth rate of 3.7% over the past 17 years. The reason of such positive tendency is in the fact that customers recognize the moist smokeless tobacco as fewer of a well-being threat compared to cigarettes. The same year the tobacco manufacturing faced numeral changes in the lawful and political ground, the majority of which were observed positively by the business. Notwithstanding intense cash flows, the American tobacco business is described by lawful challenges, decreasing capacities, marketing limitations, levies, discounting and merging. Furthermore, UST is affected by negative governmental environment, where it is under advertising and merchandise promotion limitations. According to Smokeless Tobacco Master Settlement Agreement UST Inc. recompense $100 to $200 Mio, or $.015 to $.02 per can, in excess of 10 years and approve advertising and promotion limitations, mostly intended for decreasing youth contact. The company was the lone chief smokeless tobacco producer to conclude this settlement.
The main business risks related to the company include absence of product differentiation (due to the fact that lawsuits against tobacco business are increasing and are rising danger for UST), insufficient position about global expansion (because the consumption of non-tobacco business is not very popular outside the North America), legal concerns (UST is affected by negative governmental environment, where it is under advertising and merchandise promotion limitations), market share loss, threats from minor rivals (minor companies worn UST’s market segment mainly by understating price), levies, discounting and merging.
Therefore, the growing business hazards make UST’s administration to examine a recapitalization strategy, in which it lends equal to $1 billion to repurchase its shares. The role of recapitalization is in the increasing the stability of company’s capital and occasionally raising its stock price (in case of UST it is about the issue of bonds and stocks’ purchase). In case organizations that do not want to turn into aggressive takeover objectives should conduct recapitalization by approval of an extremely great sum of debt and providing shareholders with considerable dividends.
The marginal outcome of the recapitalization is expected to be a $436.05 Mio growth in company’s cost according to EBIT-EPS analysis ((EBIT – Money needed * Interest rate) * (1 – Tax rate) = (753.3 – 1 000 * 0.05) * (1 – 0.38) = 436.05), which is the current cost of interest tax protection. In addition to the recapitalization advantage, supervision also requires to announce the expenses of recapitalization, which consists of higher insolvency expenses and a prospective of poorer credit rating.
Concerning uninterrupted dividends, the company should keep going to pay them. The main reason is in UST’s strong position and net income. Thus, such policy will only raise their value as an organization and make shareholders feel satisfied.
The objective of the UST’s debt-for-equity recapitalization is to improve company’s total cost. Moreover, the recapitalization will cut the amount of outstanding shares and peculiarly generate greater earnings for shareholders. Besides, servicing this debt should not bring any additional threat of economic imbalance because of the great optimistic cash flow reproductive environment of UST’s commerce. Finally, specified debt will benefit the anticipation by managers from investing in ventures that make proceeds lower than the companies’ cost of capital, where UST have factually operated below par.

Low Level of Cash and Cash Equivalents

Companies need to have available cash on their accounts for three reasons:
1. The funds to pay for the goods and services. Cash intended for this purpose forms transaction money balances.
2. Insurance provisions of cash. This is additional money that companies have in contingent need for money, because urgent sale of liquid assets in this case could cost the company additional expenses.
3. Speculative residues. These funds are held by the company when the fall in prices of short-term investments is expected, and managers believe the best option is not to make profit than to receive a loss.
Any failure to make payments adversely affects the formation of inventories of raw materials, labor productivity, sales of finished products, etc. At the same time efficiently organized company’s cash flow, increasing the rhythm of implementation of the operational process, provide output growth and the sale of its products. One of the most important indicators of cash measurement is the Cash ratio. It is the financial coefficient equal to the ratio of cash and short-term investments to current liabilities. It shows the company’s ability to repay current debt by exclusively available cash and cash equivalents at the particular time. The larger the value, the less problems the company has to meet its commitments to creditors. The analysis of UST’s data demonstrates that the company has extremely low Cash ratio, because, first of all, it has insufficient amount of debt in comparison with shareholder’s equity and, secondly, its cash and cash equivalents decreased by 45.7% (See Appendix D). So, its Cash ratio in 1988 was at the level of 0.2, while in 1998 it lowered to 0.07 (data for calculation were taken from Exhibit 3 of the Case, Appendix A). However, decrease in cash and cash equivalents indicate a sufficient decrease in the liquidity and working capital turnover. In order to increase the proportion of liquidity (working capital) assets it is recommended to reduce the proportion of less liquid assets (fixed assets, inventories), transferring them into more liquid (receivables, investments and cash). This means, for example, to sale unused or unwanted objects and reserves for an amount of $456.65 Mio (50% of assets) in order to improve cash ratio value at least to 0.14 (supposing Current liabilities remain at the level of previous period).

Reduction in the Rate of Sales Growth

Within ten years UST’s sales growth level decreased by 79% from 7.2% in 1988 to 1.5% in 1998. Its values fluctuated reaching the peak in 1991 with the rate of 18.8%. In 1998 the lowest rate of sales growth was recorded (data for calculation were taken from Exhibit 3 of the Case, Appendix A). Threats from minor rivals, mainly in the value share, caused neglected incomes and let down Wall Street outlooks. The company had been critiqued in recent times for a decrease in innovation and delay of original merchandise launches and product line extensions. However, it introduced Red Seal and Copenhagen Fine cut brands in order to compete in the market. It is recommended to increase its sales growth rate to at least 4.4% (average in the industry; data for calculation were taken from Exhibit 5 of the Case, Appendix B). Sales growth = (Current Period Net Sales – Prior Period Net Sales) / Prior Period Net Sales * 100. It is necessary to calculate Current Period Net Sales, which should have been in 1999, equal to $1,485.8 Mio.
Critical sales growth is minimally necessary to the enterprise net sales, which allows disadvantaged demand for its products (works, services) to ensure the break-even sales. Break-even output is calculated as FC / EBIT.
Net sales = (FC + EBIT) / EBIT margin,
where FC – fixed cost. FC includes depreciation of buildings and structures; salary of management personnel; administrative expenses; marketing costs; rental of offices and industrial buildings, etc.
Thus, according to above formula in order to find FC, the only unknown element, it is necessary: Net sales * EBIT margin – EBIT. Therefore, FC in 1998 = -0.43, when sales growth was 1.5%. Negative FC would lead to negative break-even that is unacceptable.
The sensitivity analysis, which purpose is to identify important factors that could most significantly affect the performance of the company, in case of sales growth to 4.4% ($1,485.8 Mio), will affect the profit of the company in the following way: Change in profit = Sales growth * EBIT margin = $1,485.8 Mio * 0.529 = $786 Mio.
UST should define its products’ distinguished features and present them in a new way (improvement of advertising campaign). Also, the strategy of mergers and acquisitions can be applied. Such decision requires comprehensive market evaluation of appropriate candidates and selection of the most suitable.

Appendix A

Appendix B
Appendix C
Figure 1. Debt-to-equity Ratio Dynamics
Appendix D
Figure 2. Dynamics of Cash & cash equivalents