|Padgett Paper Products Case Study Solution
This solution is set-up in the order if you were to present this case.
Case Solution Outline
-Current Capital Structure
-Proposed Capital Structure
Objective: To find a mutually acceptable debt structure that will
minimize lender risk while increasing company value.
Constraints: 1) realistic cash flow projections, 2) Bank safety levels
Situation for each Business Group
Bank: Over extended and is in a bad situation. Lending exceeds reasonable levels and is not collateralized or subject to convenants.
A $8 million loan is abnormal for the bank. The companies management does not appear to understand the unrealistic debt
situation, the impact on firm value and impact on the upcoming audit report.
Management: Has unrealistic expectations and a lack of understanding of impact of current structure of firm value.
Company: The company has considerable levels of equity and is not maximizing its financial structure. It is capable of taking on
considerably more debt, however, the debt needs to be more appropriately structured.
Ownership: Closely-held company with owner having little interest in management. Owned for dividend distribution.
The Company Background
1. Closely held public company (OTC)
2. MFG stationery including notebooks, loose leaf binders, filler paper
3. 100 years old
4. Management is professional but not finance savvy
5. Customers: 5,000 wholersalers and retailers in US & Canada (not subject to concentrations)
6. Seasonal cash needs - back to school push
7. Minor acquisitions, until recent purchase of Tri-Star
-Larger companies begin to dominate
-Price of paper increases
-Increased international competitors
Key Operating Ratios
1993 1994 1995 1996
Operating Expenses 22.1 25.6 26.4 26.5
Gross Profit % 40.3 39.1 38.7 38.8
Pre-Tax Margin 17.9 13.5 11.8 11.5
After Tax Margin 7.6 6.6 5.8 6.3
-Operating margins have declined due to competition and rising paper prices.
-Stationery including notebooks, loose leaf binders, filler paper
-Low margins business
-Seasonal business (Back to School dominates)
Current Capital Structure
-Too much short-term debt
-90 day terms
-Significant level of equity - D/E is not maxmimized and value from tax shield is lost
-Portion of debt through insurance company
-Continue at 90 day terms
-Mortgage general purpose building
-Independent Canadian Financing
-Payment Terms - accelerate receipt
-LIFO / FIFO
Pros and Cons of Options
Debt through insurance company
Pros: longer maturity schedule, reduce risk to bank and company
Cons: Management is against this option due to restrictive convenants and interest rate uncertainty
Recommendation: This could be used as a second tier of leverage, to increase debt levels as needed. But not necessarily needed
Continue at 90 day terms
Pros: Management likes
Cons: Subject to short term rate increases, going concern issues with upcoming audit, Callable in 90 days, no collateral or covenants,
bank management is negative on situation, significant distress costs reduce stock value.
Recommendation: Not an acceptable option
Pros: Increase cash flow, payroll savings in collections and credit departments, reduces risk to bank and bank's required
due-dillegence in regards to collateralized receivables.
Cons: Additional costs associated with factoring
Recommendations: Not advised as a first tier method, but we recommend the company pursue a relationship with a factoring firm to
allow for as needed.
Pros: Longer maturity schedule, reduce risk to bank and company
Cons: Restricts management's flexibility
Recommendation: Will be a required option
Mortgage General Purpose Building
Pros: Longer maturity schedule, reduces risk to bank and company, use of previously untapped funds
Cons: Management is against this option due to restrictive covenants and interest rate uncertainty
Recommendation: Company should use this option as a first tier of debt
Independent Canadian Financing
Pros: Risk reduction; foreign exchange risk reduction, untapped source of leverage.
Cons: Uncertainty related to Canadian compliance and different laws and practice.
Recommendation: This option should be used in first tier.
Payment Terms - Accelerate Receipt
Pros: Increase cash flow
Cons: Not something to depend on
Recommendation: Absolutely strive for, but we do not recommend structuring current debt based on this
Pro: Flat dividend provides additional cash to shore up debt situation
Cons: Ownership may be unhappy, negative signalling in market place
Recommendation: This should not be necessary given the strong equity situation of the company. Better payable and receivables
management should be acheived first.
LIFO / FIFO
Pros: $0.5 million tax deferral
Cons: Difficult to implement and administer
Recommendation: This option should be used
Summary of Recommendations
Collateralize Assets and add convenants
Mortgage on general purpose building
Independent Canadian financing
Shift from FIFO to LIFO method for inventory
Establish relationship for factor receivables
Accelerate customer payment terms
Pursue long-term financing from various sources
Proposed Capital Structure
Increase levels of financing to optimize debt to equity levels and achieve greater tax shield benefits.
Phase 1: Before the audit reduce approx. $8m ST debt and $5m LT debt with Calson Trust secured by all asset of the compay.
Phase 2: Secure $1m Canadian financing and 66% loan to value mortgage on the general purpose warehouse in order to eliminate
all remaining ST debt.
Impact of New Capital Structure
-Eliminate going concern issues
-Increase tax shield value
-Provide flexibility to grow
-Maintain dividend stream to owners
-Decrease risk to bank, while increasing revenue
Lost Value of Tax Shield
Unachieved Tax Shield Value
Tax Rate = 35%
$1m Incremental Debt = $1.0m
Value of Incremental Debt = $0.35m
Self-Sustaining Growth Rate
SSGR = ROE * (1-DPO)
SSGR = .146 * (1-.429)
SSGR = 8.35%