A New Financial Policy at Swedish Match

Case 2: A New Financial Policy at Swedish Match

Xavier Dumas (2525562), Reinout Niekrake, Wouter Maas (2525308)

Swedish Match is a company that produces smokeless tobacco, cigars, matches and lighters. The company originated from a merger between J&V and Förenade in 1916. The focus of this case lies with the financial policies at Swedish Match. In the past few years, Swedish Match maintained conservative financial policies. They rapidly paid off their debts, keeping its leverage – the ratio of debt to capital – very low. By doing this, they had a credit rating of A- from rating agency S&P (see Exhibit 1 for data on ratings). In September 2005, Lars Dahlgren, CFO of Swedish Match, is considering a radical proposal. By issuing new bonds for a total of 4 billion SEK, and repurchasing shares with this money, he wants to increase the firm’s leverage. Yet Dahlgren understood that the board would raise several concerns about the proposal. In this paper, the pros and cons of this new financial policy will be addressed, based on arguments and calculations.

One of the reasons Dahlgren wants to propose this new financial policy, is to reduce its annual tax payments. His expectation is that the tax savings from this transaction will boost the stock price and benefit shareholders. For a 4 billion SEK recapitalization, Swedish Match has to pay 180 million SEK interest in the next year. Since the corporate tax rate on income is 28%, Swedish Match will reduce its annual tax payments by 50.4 million SEK. The value of this interest tax shield is 1,12 billion SEK (28%*4 billion recapitalization), so the market value of the firm’s assets will rise by 1,12 billion SEK. As shown in Exhibit 2, the ratio of debt to equity changes radically, but the book value of the assets remains the same. However, the market value of the company’s assets does change (as shown in Exhibit 3).

Too see whether this recapitalization is beneficial for shareholders, the share price for after the debt issuance and the share repurchase should be calculated. The share price already rises at the announcement of the recapitalization. This increase is due to the value of the interest tax shield. Thus even though the recapitalization reduces the total value of equity, the price per share will rise to 80.48 SEK (see Exhibit 3). This means the shareholders will benefit from this recapitalization. After this recap, the total market value of equity will drop to 21,9 billion SEK (also in Exhibit 3).

The expectation of analysts is that the EBITDA will be SEK 3 billion in the next few years. In this case a rating such as BBB+ would be sustainable (see exhibit 1). In the worst-case scenario the conservative board states that the EBITDA will be no more than SEK 1,5 billion. In this case a BB rating is more suitable (see exhibit 1).

The recapitalization has its consequences on the sustainability of the company. The Z-score, developed by Altman, is a commonly used value which determines the chance of a company going bankrupt in the near future (Altman, E. I., 1986), taking into account severable relevant variables (see exhibit 4). For the calculation of the Z-score a few assumptions need to be made, such as constant net sales, constant working capital and the same dividend payout rate (see exhibit 4). The calculations show that in both the expected scenario as in the worst case scenario the Z-score is higher than 3. This means Swedish Match is not facing any chance of going bankrupt in the near future. Nor in the expected case, nor in the worst case, although the worst case scenario is closer to the alarming phase than the expected case (see exhibit 4). However, with the expectation of more competition in combination with the stagnating markets of chewing tobacco and pipe tobacco, the net sales might not be so constant as we assume.