Case 1 Atlantic Corporation Maastricht University School of Business and Economics Corporate Governance and Restructuring 1. Is the acquisition of Royal’s linerboard mill and box plants a sound strategic move? Consider the short- as well as long-term outlook for linerboard prices and the profitability of the linerboard industry. Furthermore, what basis, if any, is there for expecting AtlanticRoyal’s combined linerboard and box mill operations to do better/worse than the industry overall?

The background information about the industry and also a detailed description of the competing firms represent a good base for evaluating the firm’s decision making when engaging in the purchasing project. From industry background perspective The outlook of the linerboard and box industry promises a healthy and stable economic recovery. First of all, the demand of linerboard and box were predicted to increase approximately by 7 percent annually. Furthermore only 1 to 2 percent new capacity might be available in the market until 1986 which results in a capacity utilization of almost 100%.

The linerboard price for the year of 1987 was predicted $410 indicating high profitable sales. Thus increasing the linerboard production seems to be a smart and profitable strategic move. Especially due to its missing production capacity for linerboards the purchasing project asks for in time decision in order not to lose customers to competitors. Purchasing linerboard from Atlantic’s competitors to retain customers will have a tremendous effect on the profits. Noting that 70% of the Atlantic profits came from its building products until 1983 it faces a large capacity lack compared to its competitors.

The forest products industry was directly linked to the interest rate fluctuations, thus after the acquisition of Royal’s linerboard mill and box plants would reduce Atlantic’s potential economic risk. From market perspective The competitive environment of linerboard industry was unfavorable to Atlantic. Although Atlantic Corporation was one of the nation’s largest forest products and paper companies, it only took 1. 8 percent of the whole U. S. linerboard market. Atlantic’s daily output of linerboard was 780 tons, but it still had to purchase 411 tons of linerboard per day from the external market to meet production requirements.

If the Atlantic aimed to increase profits and market control, the only way was to expand production capacity. U. S. Market (1983) Production (tons) the whole U. S. 14900000 Atlantic Corporation 280000 Stone Container 1147000 Royal Paper Corporation 747000 Market share (%) 100% 1. 88% 7. 70% 5. 01% From post-acquisition prospect perspective The 16 corrugated box plants from the Royal Paper Corporation were ideal for the Atlantic’ plants, as the combined locations of the Royal’s and Atlantic’s plants would cover most of the United States market, helping the company to cut the higher shipping cost.

Secondly, if Atlantic increases its productivity it will reduce its dependence on the external market, while improving profits and enhancing position in the linerboard market. Thus, the post-combined company will greatly narrow the gap to other major competitors such as Stone Container. This will help Atlantic Corporation to achieve its strategic goal. Atlantic-Royal’s combined linerboard and box mill operation will be able to compete in the industry. The capacity of linerboard production appears to will run up to almost 100% in 1986, not leaving many options to produce the demanded product.

The currently linerboard mill of Atlantic produced 780 tons per day that represented only 1. 8 percent of domestic capacity, however, incorporating the Monticello mill of Royal Corporation will help Atlantic increase its linerboard capacity and market performance. If Atlantic could buy Monticello linerboard mill and 16 box plants, the chances for a strong positioning in the industry increase. Secondly, the linerboard and box sales was 8. 8% as real GNP in 1983, therefore Atlantic should draw its attention on the development of linerboard industry as it would increase its utilization due to the strong demand in the market.

As we know, Atlantic Corporation was considered as one of the nation’s largest forest products producer, its operations in the linerboard industry have not been strong. Hence, if Atlantic purchased Royal’s Monticello mill, it would increase its profit margin greatly. Additionally, it was expected that 1984 would be a healthy year for this industry, the chances got higher again that Atlantic could position well in the overall industry. 2. Is the price of $319 million reasonable for the Monticello Mill and Box Plants based on a cash-flow analysis?

Assume cash flows consistent with Table A, Table B and Exhibit 3, a discount rate of 13%, and a terminal value equal to the book value of assets in1993. Since this case deals with the purchase of cash flow generating assets, we will conduct a cash flow analysis in order to determine the financial validity of Atlantic Corporations’ offer. (1) FCFF EBIT(1 T ) Depreciation GrossFixedAssetExp. NetWorkingCapital The above formula isolates free cash flows to the firm from earnings before interest and tax (EBIT). It can be noted that FCFF are after tax (1-T) but prior to interest expense.

This initial overstatement of due tax is by design; the tax deductibility of interest payments will be accounted for when incorporating the after-tax cost of debt in the weighted average cost of capital (WACC) to determine the present value of free cash flows. Capital expenditures (GrossFixedAssetExp. ) are recognized as cash outflows, whereas depreciation, covering both capital expenditures as well as book value of initial asset investments, contributes to cash flows. Yearly changes in cash outflows needed to finance ongoing operations ( Net Working Capital) are accounted for.

Solving for equation (1) using data provided in the case material yields the following result. Free Cash Flow Analysis EBIT – Tax payable + Depreciation expense – Gross fixed asset exp. – ? Net working capital Free cash flow 1984 31,4 11,3 20,9 19,2 9,0 12,8 The above methodology can be applied to determine the free cash flows to the firm covering the period 1983-1993. The cash flows are now discounted at the weighted average cost of capital (WACC) to arrive at the present value of those future cash flows (this parameter is initially set to 13%). To this aim, we introduce the present value formula in equation (2). 2) PV ( FCFt ) FCFt (1 WACC ) t $12 ,8million (1 13 %) 1 $11,3million The sum of present values of all cash flows in the period under investigation yields a combined present value of $253,1 million. The case material suggest that the terminal value is assumed to be the book value of assets at the end of 1993. According to exhibit 3 of the case material, the book value of mill and box plants is $93,7 million at the end of 1993. We also chose to include this year’s net working capital ($118,0 million) in the terminal value since it may constitute a cash outflow.

Discounting the terminal value at the 13% weighted cost of capital yields a present value of $62,4 million. It follows that the combined present value of cash flows from the operation of the Monticello Mill and box plants sums to $315,5 million. This valuation estimate indicates that with an NPV of -$3,5 million an offer of $319,0 million for Royal Paper’s assets is not maximizing shareholder value and should therefore not be in the best interest of Atlantic Corporation’s shareholders. 3a. What is a reasonable discount rate at which to discount the cash flows?

What would the value of Monticello Mill and Box Plants be at the new discount rate? In order to test whether the 13% weighted cost of capital is an adequate estimation of the mill and box plant’s required return, we take a close look at both, cost of equity and cost of debt. The following equation describes the composition of the cost of equity (rs). (3) rs rrisk free i (rmarket rrisk free ) Exhibit 6 of the case material suggests an equity beta for Royal Paper of 1,25. We estimate the risk-free rate to be 7,99%.

This estimation is based on the fact that the project has an economic lifetime of 15 years and therefore the duration has been matched with the government obligations presented in exhibit 5 of the case material by linear extrapolation: (4) 7,99% = (7,53% + (15y – 1y) x (8,49% – 7,53%) / (30y – 1 y) The market risk can be extracted from Fernandes, Pablo (2010). We chose to adopt an equity risk premium of 4%. Solving for equation (4) yields a cost of equity estimate of 12,99%. The cost of debt can be determined using the 10,25% BBB corporate bond rating presented in exhibit 5 of the case material.

Drawing funds from the bank credit line would mean a higher cost of debt of 10,75% (prime + 1-1/2%). Applying the 36% tax rate to the chosen pre-tax cost of debt results in an after-tax cost of debt of 6,56% (10,25%*(1-36%). After assigning appropriate weights to both cost of equity and debt, the weighted average cost of debt can be calculated according to equation (5) below. (5) WACC wd rd (1 T ) ws rs Since Royal Paper is currently carrying a financial mix of 40% debt to 60% equity, we can solve (5): (6) WACC 40% 6,56 60% 12,99 10,42%

The above WACC represents an increase of valuation estimation to $370,1 million as compared to the value calculated with the 13% WACC; a difference of $51,4 million. 3b. Is the terminal value reasonable? Provide a better alternative and recalculate the value of Monticello Mill and box plants. Instead of taking an accounting approach to determine terminal value of the project yielding a terminal value of $211,7 (see question 2), we opt to estimate terminal value by forecasting cash flows beyond 1994 to cover the project’s entire lifetime until 1998.

The mill and box plants’ operating cash flows are assumed to grow 7% after 1984 and no salvage value can be assigned to its assets in 1998. The resulting forecasted cash flows to the firm can be seen in the below table. Furthermore, we depreciate the $93,7 million of asset book value over the forecast period in order to reflect the fact of no salvage value at the end of 1998. Assuming a constant positive change in net working capital of $5 million, we calculate an alternative terminal value of $143,0 million.

Free Cash Flow Analysis EBIT – Tax payable + Depreciation expense – Gross fixed asset exp. – ? Net working capital Free cash flow Terminal value Discount factor Present Value PV [CF] 1984 31,4 11,3 20,9 19,2 9,0 12,8 13,00 % 0,88 11,3 1985 44,4 16,0 28,3 30,5 16,0 10,2 1986 65,0 23,4 35,0 41,7 10,0 24,9 1987 57,6 20,7 39,3 10,2 5,0 61,0 1988 60,5 21,8 41,3 10,3 4,0 65,7 1989 67,8 24,4 39,3 8,2 5,0 69,5 1990 78,6 28,3 34,3 6,2 5,0 73,4 0,78 0,69 0,61 37,4 0,54 35,7 0,48 33,4 0,43 31,2 8,0 17,3 363,930 8 991 90,9 32,7 27,1 6,2 4,0 75,1 0,38 28,2 1992 97,6 35,1 26,3 4,2 6,0 78,6 0,33 26,2 1993 104,6 37,7 25,3 4,2 5,0 83,0 0,29 24,5 1994 1995 1996 1997 1998 111,92 40,3 23,4 119,76 43,1 23,4 128,14 46,1 23,4 137,11 49,4 23,4 5,0 90,1 0,26 23,5 5,0 95,1 0,23 21,9 5,0 100,4 0,20 20,5 5,0 106,2 0,18 19,2 146,71 52,8 0,0 5,0 88,9 143,0 0,16 37,1 Discounting all cash flows back to present at the initially assumed weighted average cost of capital, we arrive at a value for the Monticello mill and box plants of $363,9 million. c. What are the assumptions underlying the cash flow forecasts? How sensitive is the value to different (more reasonable) assumptions of the cash flow forecasts? We consider several factors would impact on free cash flow and PV. In order to analyze sensitivity of cash flow forecast, there are multiple factors that can be observed in this question, including linerboard sales, growth, capital expenditures, working capital, tax rate and economic lifetime. We use a PV estimate of $370. million from question 2 as the reference for a sensitivity analysis. We find that the value of the project is most sensitive to changes in linerboard sales and growth, WACC and economic lifetime. d. How do the cash-flow-based values compare to a value obtained from comparables? Due to its focus on linerboard and box production and sales with 53,03% sales/total sales ($350 millon/$660 million=53,03%), Stone Container is chosen as closest comparable from the companies listed in exhibit 6 of the case material.

Using the below equation, one can define the value generation potential of each dollar of Stone Container earnings before interest and tax to consequently state the Monticello mill and box plants’ implied value as function of this multiple. (7) V project (VStonecontainer / EBIT StoneContainer ) EBIT project Stone Container’ EBIT can be identified by assuming a tax rate of 36% and its book debt ratio of 67%. With 14,1 million shares outstanding (net income/EPS=$22million/$1,56) and a book value per share of $25 (exhibit 6), the book value of equity is $352,56 million.

Given the debt ratio of 67%, one can value Stone Container’s book value of debt at $715,81 million. (8) InterestEx pense (Vequitybook /(1 debtratio) debtratio) rd We assume a cost of debt for Stone Container’s based on the BBB rated corporate bond similar to Atlantic Corporation. Since Stone Container’s book debt ratio is above the BBB rating, 67% as opposed to 40% for BBB rated corporate debt, we must exercise caution when assigning Stone Container the according 10,05% cost of debt.

Solving for equation (8) now reveals interest expenses of $71,9 million. Adding the interest expense to Stone Container EBIAT (net income/(1-T)+interest expense) yields an EBIT of $106,3 million. The market value of Stone Container can be established from outstanding shares at average market price to arrive at the market value of equity using the above methodology. Employing the current market debt ratio of 45% (exhibit 6) yields a market value of Stone Container of $846,2 million.

As shown in equation (9), entering the above results in equation (7) returns an implied value for the Monticello mill and box plants of $249,93 million. (7) $249,92million ($846,2million / 249,93million) 31,4million We can conclude that according to relative valuation, Atlantic’s bid of $319 million overvalues Royal Paper’s assets under consideration by $69,1 million. This result is in contradiction to earlier estimations of value, where we assigned a values of $315,5 million, $370,1 million and $363,9 million from changes in WACC, and terminal value.

It is to be stated also, that according to sensitivity analysis (question 3c), sales and sales growth of linerboard are the main driver for the determination for value of the Monticello mill and box plants. Considering that the linerboard industry might face the threat of new entrants in the long run due to further decrease in interest rates as well as competition from abroad if shipping costs are reduced in the light of a strengthening economy, this sensitivity to moves in prices and demand might lead to an overstatement of the project’s true worth.

Using Stone Container’s ability to create value from earnings in the linerboard industry supports this finding. References: Ross, S. A. , R. W. Westerfield and J. Jaffe. 2002. Corporate Finance. 6th edition, McGraw- Hill. Damodaran, A. 2002. Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. 2nd edition, Whiley Finance.