Padgett Paper Products Case Study Solution Case Solution Outline -Summary -Problem Statement -Company -Market -Product

-Projections -Options -Current Capital Structure -Proposed Capital Structure -Review

Summary 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 covenants. An $8 million loan is abnormal for the bank. The companys 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.

Problem Statement: Because of inflation and an acquisition, Padgett's financial needs have risen to a permanent level rather than being merely seasonal in nature. Management at the company's bank must revise Padgett's debt structure in a mutually satisfactory manner.

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

The Market -Consolidations -Larger companies begin to dominate -Thinning margins -Price of paper increases -Increased international competitors

Key Operating Ratios 1993 Operating Expenses Gross Profit % Pre-Tax Margin After Tax Margin 22.1 40.3 17.9 7.6 1994 25.6 39.1 13.5 6.6 1995 26.4 38.7 11.8 5.8 1996 26.5 38.8 11.5 6.3

-Operating margins have declined due to competition and rising paper prices.

Product -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 maximized and value from tax shield is lost

Options -Portion of debt through insurance company -Continue at 90 day terms -Factor receivables -Collateralize assets -Mortgage general purpose building -Independent Canadian Financing

-Flat dividends -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 now.

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

Factor Receivables Pros: Increase cash flow, payroll savings in collections and credit departments, reduces risk to bank and bank's required due-diligence 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.

Collateralize Assets 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

Flat Dividends 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 achieved 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 covenants 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 company. 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%