Calculate WACC, 2021 and 2022 income statement and balance sheet and 3 page write up of questions
Microsoft Word - Pacific Container Corp (2021) 1 Pacific Container Corporation: Some Financial Concerns On January 5, 2021, his first day as chief executive officer (CEO) of Pacific Container Corp. (PCC), Chris Chen confronted a host of management problems at the company. One week earlier, PCC’s president and CEO had abruptly resigned to take a CEO position at another company. Soon thereafter, Chris was appointed to fill the position – starting immediately. Several issues in his in-box that first day were financial in nature, either requiring a financial decision, or with outcomes that would have major financial implications for the firm. That evening, Mr. Chen asked to meet with his assistant, Mark Tan, to begin addressing the most prominent issues. PACIFIC CONTAINER CORPORATION AND THE CARDBOARD BOX AND CONTAINER MANUFACTURING INDUSTRY The Pacific Container Corporation had been founded as a joint venture between Carolina Pulp & Paper and an Asian venture-capital firm, New Era Partners. Based in Singapore, PCC’s sole business mission was to manufacture boxes from cardboard packaging known as corrugated Fiberboard. PCC served as a supplier of cardboard boxes to other manufacturing firms in the Pacific Rim and was known for producing some of the best cardboard packaging material in the industry. Given its ubiquity in packaging, revenue for the global cardboard box and container manufacturing industry is highly correlated with global demand from manufacturing and retail sectors. The industry is highly fragmented with an estimated 15,700 companies operating in the industry (globally) and only 4 companies controlling more than 1.0% of the market. The majority of companies operate locally or regionally, providing cardboard boxes to companies within a relatively short distance from their facilities. Barriers to entry are relatively low; a new, small plant would cost between SGD1 10 million and SGD 20 million. Easy entry had led to price competition in recent years among cardboard box manufacturers. One analyst said, The gross margins on cardboard boxes have eroded tremendously over the past five years. I don’t see there’s any more maneuvering left on the price. Despite increasingly intense competition for cardboard packaging material, PCC’s growth prospects looked bright. At the regional level, demand was strong and PCC’s focus on customer service and quality products had resulted in a strong and expanding customer base. 1 SGD = Singaporean dollars 2 FINANCIAL QUESTIONS FACING VICTORIA YU That evening, Mr. Chen met with Mark Tan, a promising new associate whom he had brought along from New Era. Mr. Chen’s brief discussion with Mark went as follows: Mr. Chen: Back at New Era, we looked at PCC as one of our most promising venture-capital investments. Now it seems that such optimism may not be warranted – at least until we get a solid understanding of the firm’s past performance and its forecasted performance. Did you have any success on this? Mark: Yes, the bookkeeper gave me these: the historical income statements [Exhibit 1] and balance sheets [Exhibit 2] for the last four years. The accounting system here is still pretty primitive. However, I checked a number of the accounts, and they look orderly. So I suspect that we can work with these figures. From these statements, I calculated a set of diagnostic ratios [Exhibit 3]. Mr. Chen: I see you have been busy. Unfortunately, I can’t study these right now. I need you to review the historical performance of PCC for me, and to give me any positive or negative insights that you think are significant. Mark: When do you need this? Mr. Chen: At 7:00 A.M. tomorrow. I want to call our banker tomorrow morning and get an extension on PCC’s loan. Mark: The banker, Jesse Liu, said that PCC was “growing beyond its financial capabilities.” What does that mean? 3 Mr. Chen: It probably means that she doesn’t think we can repay the loan within a reasonable period. I would like you to build a simple financial forecast of our performance for the next two years (ignore seasonal effects) and show me what our debt requirements will be at the fiscal years ended 2021 and 2022. I think it is reasonable to expect that PCC’s sales will grow at 15 percent each year. Also, you should assume capital expenditures of SGD 54.6 million for plant renovations spread out evenly over the next two years and depreciated over seven years on a straight-line basis. Use whatever assumptions seem appropriate to you based on your historical analysis of results. For this forecast, you should assume that any external funding is in the form of short-term debt. Mark: But what if the forecasts show that PCC cannot repay the loan? Mr. Chen: Then we’ll have to go back to PCC’s owners, New Era Partners and Carolina Pulp & Paper for an injection of equity. Of course, New Era Partners would rather not invest more funds unless we can show that the returns on such an investment would be very attractive, and/or that the survival of the company depends on it. Thus, my third request is for you to examine what returns on book assets and book equity PCC will offer in the next two years and to identify the “key driver” assumptions of those returns. Finally, let me have your recommendation about operating and financial changes I should make based on the historical analysis and the forecasts. Mark: The plant manager revised his request for a new packaging machine and thinks these are the right numbers [see the plant manager’s memorandum in Exhibit 4]. Essentially, the issue is whether to invest now or wait three years to buy the new packaging equipment. The new equipment can save significantly on labor cost but carries a price tag of SGD 1.82 million. My hunch is that our preference between investing now versus waiting three years will hinge on the discount rate. Mr. Chen: [laughing] The joke in business school was that the discount rate was always 10 percent. 4 Mark: That’s not what my business school taught me! New Era always uses a 40 percent discount rate to value equity investments in risky start-up companies. But PCC is reasonably well-established now and shouldn’t require such a high-risk premium. I managed to pull together some data [see Exhibit 5] on comparable companies with which to estimate the required rate of return on equity. Mr. Chen: Fine. Please estimate PCC’s weighted average cost of capital and assess the packaging machine investment. I would like the results of your analysis tomorrow morning at 7:00 A.M. 5 Exhibit 1 PACIFIC CONTAINER CORP. Historical Income Statements Fiscal Year Ended December 31 (SGD 000) 2017 2018 2019 2020 Sales 71,924 80,115 92,613 106,042 Operating expenses: Production costs and expenses 33,703 38,393 46,492 53,445 Admin. and selling expenses 16,733 17,787 21,301 24,177 Depreciation 8,076 9,028 10,392 11,360 Total operating expenses 58,512 65,208 78,185 88,983 Operating profit 13,412 14,908 14,429 17,059 Interest expense 5,464 6,010 7,938 7,818 Earnings before taxes 7,949 8,897 6,491 9,241 Income taxes* 2,221 2,322 1,601 2,093 Net earnings 5,728 6,576 4,889 7,148 Dividends to all common shares 2,000 2,000 2,000 2,000 Retentions of earnings 3,728 4,576 2,889 5,148 *The expected corporate tax rate was 24.5%. 6 Exhibit 2 PACIFIC CONTAINER CORP. Historical Balance Sheets (Fiscal Year Ended December 31) (SGD 000) 2017 2018 2019 2020 Assets: Cash 4,816 5,670 6,090 5,795 Accounts receivable 22,148 25,364 28,078 35,486 Inventories 23,301 27,662 53,828 63,778 Total current assets 50,265 58,697 87,996 105,059 Gross property, plant & equipment 64,611 80,153 97,899 115,153 Accumulated depreciation (4,559) (13,587) (23,979) (35,339) Net property, plant & equipment 60,052 66,566 73,920