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Assume a 38% tax rate and a 10% discount rate when discounting future dividends

Assume a 38% tax rate and a 10% discount rate when discounting future dividends. Assume that the new debt is constant and perpetual and that the buyback operation is unexpected by stock market participants.

1) What are the primary business risks of UST? Evaluate them from the point of view of a bondholder.

2) Why is UST considering a leveraged recapitalization after such a long history of conservative debt policy?

3) Should UST undertake the $1bn recapitalization? Prepare a pro-forma income statement for 1999 to analyze whether UST will be able to make interest rate payments. How sensitive is your conclusion to the rating UST bonds receive?

Sample Answer

This information suggests that the investor is willing to pay for future dividends at a discount rate of 10%. This means that they expect a 10% return on their investment each year. The tax rate of 38% will reduce the after-tax return on the investment.

Here’s how these figures can be used in different calculations:

1. Discounted Present Value (DPV) of Dividends:

Formula: DPV = (Dividend in Year 1) / (1 + Discount Rate)^1 + (Dividend in Year 2) / (1 + Discount Rate)^2 + …
Example: If the expected dividend for the next year is $5, the DPV would be:

DPV = $5 / (1 + 0.10)^1 = $4.55

2. Required Rate of Return:

Full Answer Section

Formula: Required Rate of Return = Risk-Free Rate + Beta * Market Risk Premium
The 10% discount rate can be used as a benchmark for the required rate of return. If the calculated required rate of return is higher than 10%, the investment may not be attractive.

3. Valuation of a Stock:

Dividend Discount Model (DDM):
- Formula: Stock Price = (Dividend in Year 1) / (1 + Discount Rate)^1 + (Dividend in Year 2) / (1 + Discount Rate)^2 + … + (Terminal Value) / (1 + Discount Rate)^n
- The terminal value represents the value of the stock at a future point in time, often calculated as the present value of all future dividends beyond a certain point.

4. Cost of Equity:

The discount rate can be used as an estimate of the cost of equity, which is the return that investors demand for investing in a company’s stock.

Important Considerations:

Tax Implications: The 38% tax rate will affect the after-tax return on the investment. This should be factored into the calculations.
Risk Premium: The 10% discount rate may not account for additional risks associated with the investment. A higher discount rate may be appropriate for riskier investments.
Dividend Growth: If the company is expected to grow its dividends over time, this can be incorporated into the calculations using a dividend growth model.
Other Valuation Methods: While the dividend discount model is a common approach, other valuation methods, such as discounted cash flow analysis and comparable company analysis, may also be used.

By understanding these concepts and how these figures are used, you can make more informed investment decisions.

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Assume a 38% tax rate and a 10% discount rate when discounting future dividends

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