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Introduction and Background

On February 5, 1994, Gary Pratt and Roger Wilson III, chairman of GreenEarth Corporation and Wilson Lumber Corporation respectively, met over lunch to discuss a possible cash sale of a group of recently acquired Wilson Lumber assets to GreenEarth.  GreenEarth was a major supplier to Wilson Lumber and, as such, Pratt and Wilson had known each other for about 10 years and enjoyed a good relationship.  The asset Pratt sought to buy was a large-scale paper mill that produced rolls of high quality coated paper used in magazines and other glossy printing. If Pratt could acquire the mill at a reasonable price, GreenEarth would be able to diversify into high quality paper capacity.

GreenEarth Corporation was one of the U.S. largest forest products/paper firms, with 1993 sales of $6.5 billion and net income of $105 million (see Exhibit 1). The firm competed in two businesses: building products and paper and pulp. Analysts tended to classify GreenEarth as a “forest products” firm, due to the fact that 70% of its 1993 sales and 60% of its operating profits stemmed from the firm’s building products division, which was the largest producer of plywood in the U.S. They also had a large presence in wood siding and wood shingles. Years ago, GreenEarth had started to use the scrap from their lumber products division to make pulp and eventually paper. This division had grown considerably, it now used much more than just scrap product, and represented 30% of sales. GreenEarth concentrated in producing uncoated offset paper and newsprint. It did not produce high end products, such as coated offset paper, but felt that this was a potential area for growth although it required specialized plants to produce the paper used primarily in magazines and other glossy applications.

Most people can tell you that paper (or stock) is made from wood, but many don't know how a tree is transformed into a sheet of paper. The basics are pretty simple.

Logs are stripped of their bark, and then chipped into very small and thin pieces. The small pieces of stripped logs are placed in a large cooker with chemicals and steamed under pressure until the wood fibers are removed from the lignin (the glue that holds the individual wood fibers together). The resulting pulp is then processed through several machines which will separate the fibers, remove the chemicals, and bleach to proper shade of whiteness.

GreenEarth's intention to add coated offset paper capacity was well known in the paper and pulp industry. The firm's existing Toledo, Ohio paper mill produced nearly 4000 tons of non-coated offset paper and newsprint per day. Although this was a small percentage of domestic capacity, GreenEarth was one of the largest producers in this fragmented industry. GreenEarth currently did not have a share in the coated offset paper market. More importantly, GreenEarth was the only major paper producer that did not supply this segment of the market. As such, GreenEarth’s sales force carried a less complete line than all of its competitors and had even lost some wholesale customers to competitors who could accommodate their entire printing needs. Pratt felt that GreenEarth’s current sales force could also sell the coated offset paper with minor training, although it would mean that they would have to call on additional customers.  While this would initially take additional onsite visits, most interaction would occur over the phone once a sales relationship was established.

GreenEarth's Interest in Coated Offset Paper

GreenEarth had studied possible remedies to the limitation in their product line. A new 3,000-daily-tons coated offset paper mill would cost $2 billion for PP&E, require investing $70 million in working capital, and take three years to build. With cash costs and interest rates at historically high levels, building a new plant did not seem like a financially viable proposition. Moreover, Pratt believed that it might be possible to buy existing plant capacity at a cheaper price. Purchasing had an additional advantage of allowing GreenEarth to enter this market more quickly. Other firms seemed to reach the same conclusion, as indicated by the lack of new coated offset paper plants in the industry.

GreenEarth then surveyed and rated (A, B or C) the existing U.S. coated offset paper mills depending on capacity, age, etc. Unlike business school students, many received a C. Pratt called the owners of the 11 “A”-rated mills, testing whether they had any interest in selling their mills. None was interested, including Wickes Paper, whose Charlotte mill GreenEarth had ranked as the fourth best in the country.

In late 1993, Pratt became aware that the Continental Group, Inc. was interested in selling a package including three smaller coated offset paper mills, with a combined capacity of over 1.1 million tons per year (or 3,014 daily tons). However, GreenEarth lost the bid to Stone Container Corp., whose product line consisted almost exclusively of coated offset paper. Juan Stone, Stone Container’s chairman and CEO, summarized the deal:

“The three mills were purchased for around $400,000 per daily ton, excluding working capital. This represents only about 60% of the cost of building new capacity, which, if started today, could not be brought in for less than $670,000 per daily ton three years later.”

Completed in 1978, the state-of-the-art mill produced magazine quality coated offset paper as well as lower-quality coated paper used to produce gift wrapping paper. Prior to the acquisition by Wilson Lumber, Wickes Paper had announced a modernization plan, which involved spending $70M over three years to convert all of the mill's wrapping paper capacity to magazine quality coated offset paper capacity. This move would increase the mill's coated offset paper capacity from 1,191,000 to 1,346,000 annual tons (or 3,688 daily tons). As of early 1994, the conversion process had not yet been started.

It is essential that you state clearly all the assumptions you are making, and why you make them. Without your assumptions and work, there is no partial credit.

The amount of time allocated to each question is meant to be suggestive of the depth of analysis expected.

1. Estimate GreenEarth’s valuation for Charlotte Mill .

    1. Estimate separately each of the components of the relevant WACC for the valuation, and the WACC itself. State explicitly the assumptions you are making, and why you are making them. Assume that the market risk premium is 7%.
    2. Estimate carefully the value of the Charlotte mill to GreenEarth. From a financial standpoint, at which price would the purchase be a value-making proposition for GreenEarth?
    3. Would your estimate of the value of Charlotte Mill increase or decrease if GreenEarth were allowed to step up the tax basis of the mill to reflect the purchase price. Assume that everything else (i.e., EBITDA, CapEx, and working capital) stays the same; only the depreciation goes up. (No calculationsneeded – conceptual answer only)
    4. What would be the transaction price suggested by Stone Corporation’s recent comparable transaction?

2. Suppose that GreenEarth could expand the capacity of the mill after 5 years.  Explain how you would value this scenario (10 pts).

Depending on economic conditions in 1998, GreenEarth could decide to expand the capacity of the paper mill. In this case, GreenEarth would need to invest an additional $600 million in CAPEX and net working capital in late 1998. GreenEarth expects that after this investment is made, the mill will generate an expected $90 million in additional free cash flow each year starting from 1999. This amount will not grow. There is considerable uncertainty about the projected profitability, and the realized free cash flow could be 50% lower than expected at $45 million each year, or 50% higher at $135 million. Both outcomes are equally likely. GreenEarth expects to know which of the two scenarios will occur by the time the investment decision has to be made in 1998. No additional investments in working capital or additional capital expenditure will be needed beyond 1998.

  1. How much value does the expansion project add to the value of the paper mill in early 1994, assuming that GreenEarth has to commitin early 1994 whether to undertake the expansion?
  2. How much value does the expansion project add to the value of the paper mill in early 1994, assuming that GreenEarth can delay the decision of undertaking the expansion until 1998 at an additional cost of $100 million today?

3.Determine the strategic reasons for the transaction .

Does it make strategic sense for GreenEarth to acquire the mill from Wickes? Should GreenEarth bid its full valuation of the mill or some price below that?  Do you expect GreenEarth to be the high bidder? As a shareholder of GreenEarth, couldn’t you diversify your investment just as well as by buying a company that specialized in offset coated paper?

5 .Advise on the financing of the deal .

Independent of whatever valuation you calculated, for this next question assume a purchase price of $1.6 billion.

  1. How should GreenEarth finance the purchase given the financing alternatives described in the case?  How does your decision affect the capital structure and other financial policies of the firm? Explain the argument behind your recommendation in detail.
  2. Wickes offers to sell the mill but wants GreenEarth to accept their existing mortgage debt on the facilities as part of the transaction. The mortgage debt is approximately $500 million and carries an average interest rate of 10% over 20 years. Does this change our decision to acquire the assets? Does it change the price we offer?  Does it change our financing decision?

Introduction and Background

a) Evaluating the components of WACC for the valuation:

Particular

Value

Corporate Bond

42.00%

Yield

9.50%

Equity

58.00%

Risk free rate

8.49%

Beta

1.35

Market Premium

7.00%

Cost of equity

17.94%

Tax

34.00%

WACC

13.04%


There are specific components of WACC, which is used for detecting the level of cost of capital required for GreenEarth. In addition, from the evaluation it can be detected that WACC is mainly at the levels of 13.04%, which is calculated from cot of equity and cost of capital. Moreover, the major components of WACC is Debt, Equity and tax rate, which helps in determining the cost of capital of the firm. The corporate bond composition is 42%, while equity is at 58%. The cost of debt is calculated at 9.50%, while the cost of equity is 17.94% with a tax rate of 34%.

Charlotte Mill

1994

1995

1996

1997

1998

Capex

18

18

18

18

18

Change in working capital

19.2

33

19.2

9.9

8.1

Free Cash flow

113.1

145.7

223.2

219.3

223.1

WACC

15%

Growth

5%

NPV

$591.58

Terminal Value

$2,231.00

PV of the Terminal Value

 $    1,109

Enterprise Value

$1,701

Debt

$0

Equity Value

$1,805


The above table directly indicates the level of Equity level, which is mainly calculated with the help of terminal value. The calculation directly helps in detecting the total equity value of $1,805 is mainly calculated from the free cash flow, which also include the 104.5 million of net working capital (Koziol, 2014). The calculation would eventually help in detecting the level of minimum purchase value of Charlotte Mill. Thus, GreenEarth needs around $1,805 million for purchasing Charlotte Mill.

The increment in depreciation value of the Charlotte mill would eventually reduce the overall taxes, which will increase the level of Free cash flow in the long. This would eventually raise the value of NPV and the Equity value of the company. The rising values of free cash flow would eventually help in detecting the level of cash that is being present within the operations of the company. Thus, the equity value of Charlotte Mill would eventually increase with the increment in deprecation value (Harris, 2017).

Particular

Value

Value

Daily value

                 400,000

     670,000

daily tons

                     3,688

         3,688

60% of the purchase value

                     1,475

         2,471

Purchase value

                     2,459

         4,118


The transaction cost that will be suggested by Stone Corporation is mainly calculated in the above table, where the purchase values will be ranging from $2,459 million to $4,118 million. This measure is mainly conducted with unique ability of the company to ensure the relevant purchase price of Charlotte Mill. The calculation conducted by Stone Corporation will eventually raise the level of purchase price of Charlotte mill from the calculated equity value of $1,805 million.

a) Indicating the vale that will be added from the expansion project to add the value of paper mill:

Particulars

1994

1995

1996

1997

1998

1999

Free Cash flow

113.1

145.7

223.2

219.3

223.1

234.255

Capex

-600

FCF

113.1

145.7

223.2

219.3

-376.9

324.255

FCF@higher

113.1

145.7

223.2

219.3

-376.9

279.255

FCF@lower

113.1

145.7

223.2

219.3

-376.9

369.255

Estimated cash flow

113.1

145.7

223.2

219.3

-376.9

324.255

WACC

15%

Growth

5%

NPV

$433.46

Terminal Value

$3,242.55

PV of the Terminal Value

 $    1,402

Enterprise Value

$1,835

Debt

$0

Equity Value

$1,940

Old Equity Value

$1,805

Value Added

$135

From the overall calculation it can be detected that the value of equity will mainly increase by $135 after adopting the $600 million expenses in 1998. This expense will ensure the continuity of the operations, where the probability of 50% increment in free cash flow and decline in free cash flow is estimated. This expense will eventually raise the level of equity to $1,940 million from $1,805 million.

b) Indicating the value that will be added by the expansion project to the paper mill with an additional cost of $100 million:

Particulars

1994

1995

1996

1997

1998

1999

Free Cash flow

113.1

145.7

223.2

219.3

223.1

234.255

Capex

-100

-600

FCF

13.1

145.7

223.2

219.3

-376.9

324.255

FCF@higher

13.1

145.7

223.2

219.3

-376.9

279.255

FCF@lower

13.1

145.7

223.2

219.3

-376.9

369.255

Estimated cash flow

13.1

145.7

223.2

219.3

-376.9

324.255

WACC

15%

Growth

5%

NPV

$346.50

Terminal Value

$3,242.55

PV of the Terminal Value

 $    1,402

Enterprise Value

$1,748

Debt

$0

Equity Value

$1,853

Old Equity Value

$1,805

Value Added

$48

The calculation indicates that the expenses conducted in 1994 for around $100 million will increase the equity value of $48 million. This increment in value is estimated with probability condition, which will generate high level of income from operations. The equity value will increase to $1,853 from 1,805 million with the extra income and capital expense conducted in 1994 and 1998.

Yes, it does make strategic sense to purchase the mill from Wickes, as it will increase profitability and income of the organisation in the long run. GreenEarth needs to provide the full valuation of the mill, as other competitors would also be bidding for the mill. No, I do not expect that the bid value of GreenEarth will be the highest bidder for the mill. Diversification is an adequate measure, which allows in minimising the risk attributes of the organisation. However, diversification will raise the level of expense for GreenEarth and investing in offset coated paper would increase value of the firm in the long run. Hence, the investment would eventually help in generating high level of income for GreenEarth after acquiring the mill (Frank & Shen, 2016).

a) Explaining the argument behind the recommendation in detail:

Particular

Value

STD (Short-term debt)

 $                  10

LTD, current portion

 $                  95

LTD (Long-term debt)

 $             1,523

Credit line

 $                600

Total Debt

 $             2,228

Common stock issue

 $             1,000

Common Equity

 $             2,242

Total Common Equity

 $             3,242

Total Capital

 $             5,470

Particular

Value

Corporate Bond

41%

Yield

9.50%

Equity

59%

Risk free rate

8.49%

Beta

1.35

Market Premium

7.00%

Cost of equity

17.94%

Tax

34.00%

WACC

13.19%


The combination of credit line and common stock issue would be an effective measure for securing the capital that will be required for acquiring the mill. The capital from credit will be at the levels of $600 million, while the common stock issue will be conducted for $1 billion. The capital structure indicates the debt weighted of the firm to 41%, while the equity weightage is 59%. Therefore, the capital structure proposed for the organisation is following the financial policies and the debt is within the confinements of 45%. However, the inclusion of debt and equity capital has not altered the WACC of the organisation significantly, which mainly depicts the financial viability of the acquisition of the mill.

Particular

Value

STD (Short-term debt)

 $      10

LTD, current portion

 $      95

LTD (Long-term debt)

 $ 1,523

Additional debt

 $    500

Total Debt

 $ 2,128

Common stock issue

 $ 1,000

Common Equity

 $ 2,242

Total Common Equity

 $ 3,242

Debentures

 $    600

Total Capital

 $ 5,970

Particular

Value

Corporate Bond

36%

Yield

9.50%

Equity

54%

Debentures

10%

D-Yield

10.25%

Risk free rate

8.49%

Beta

1.35

Market Premium

7.00%

Cost of equity

17.94%

Tax

34.00%

WACC

13.01%

The inclusion of debt will not change the decision for acquiring the mill, as the value is derived from the calculation, which is at $1,305 million. Hence, investment in the mill would eventually help in generating high level of income from operations. Yes, the additional debt will change the overall price that we offer, as the equity valuation of the company will decline. No, the decision for acquiring the asset will not change, as it will increase the capability of the organisation to generate high revenues in the long run. Yes, the addition debt will change the financing decision, as debentures will be used for supporting the finances, as it will reduce the debt composition of the organisation (Curry, Xia & Chen, 2018).

References:

Curry, J., Xia, H., & Chen, K. C. (2018). To Sell or Not to Sell? a Case on Business Valuation. Journal of the International Academy for Case Studies, 24(2), 1.

Frank, M. Z., & Shen, T. (2016). Investment and the weighted average cost of capital. Journal of Financial Economics, 119(2), 300-315.

Harris, R. S. (2017). A Comparison of the Weighted-Average Cost of Capital and Equity-Residual Approaches to Valuation. Darden Business Publishing Cases, 1-5.

Koziol, C. (2014). A simple correction of the WACC discount rate for default risk and bankruptcy costs. Review of Quantitative Finance and Accounting, 42(4), 653-666.

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[Accessed 01 March 2024].

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