Pacific Corporation

Pacific Corporation

In February 2004, the Royal Paper Corp. was discussing the possible sale to Pacific Corp. of its Monticello
linerboard-mill. Negotiations were proceeding well and an agreement seemed within reach. Pacific now had to
put a value on the assets.

The Royal Paper Corporation

Royal began as a paper product manufacturing company. In the 1980s, it had grown into a conglomerate, with
interests in mining, real estate and finance. At the turn of the century, after years of expansion, Royal’s sales
and profits started fading and, in 2002, its stock price reached a 15-year low. Royal cut its workforce by 10%. By
2003, its stock had recovered to some extent but management remained under pressure. Several activist funds
had accumulated a 3.2% equity stake in the company and were calling for a break-up of its different businesses.
Set on protecting Royal’s independence, management elected to sell underperforming assets, which included
the Monticello mill. The plan was to then use the proceeds from the sale to repurchase the funds’ equity stake.

The linerboard market

Linerboard, a stiffened paper product, was transformed into cardboard boxes used to pack goods shipped. As
shipments fluctuated with industrial production, the industry’s health fluctuated with the overall economy.
With strong demand, limited supply, and little new capacity, 2004 looked promising for linerboard. Forecasts in
box and linerboard sales growth averaged 7%. Yet, only 2% new capacity was expected until 2007, and makers
of linerboard would operate at near-full capacity, while linerboard prices were set to top $415 per ton by 2007.
Given the high fixed costs, high operating rates and high prices implied high profits.

Pacific Corp.

Pacific, a major U.S. forest product/paper firm, had three main businesses: building products, paper and pulp,
and chemicals. Building products accounted for two-thirds of sales and were tied to construction activity, which
was very cyclical, even more so than linerboard.

Pacific’s linerboard mill in Toledo (Ohio) represented only 1.8% of U.S. capacity. Pacific could thus not share
much in the market boom. Besides, Pacific was the only main paper producer to be a net buyer of linerboard.
Given the current tight market, linerboard could become very expensive or even unavailable. Pacific ruled out
building a new linerboard mill, and opted to acquire one.

The Monticello mill

In addition to linerboard, the Monticello (Mississippi) mill produced kraft paper used in grocery bags. In 2003,
Royal had announced an ambitious $80m plan to convert the mill’s kraft production capacity into linerboard
production capacity. This would increase the Monticello mill’s linerboard production capacity from 700,000 to
790,000 tons per year. Implementation of the conversion plan had not begun yet.

If Pacific did acquire the mill, part of the output would be transformed into corrugated boxes in Pacific’s own
box plants. Given high shipping costs, box plants tended to be located near end-users. Pacific’s plants were
located in the South, the Midwest, and the West.

Projections

Using information provided by Royal, due diligence, and its own market intelligence, Pacific had produced a
business plan for the mill for 2004-06 and a less precise forecast for the period 2007-2013 (Exhibit 1).

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On top of fixed assets with a $206m book value (in 2003), the purchase would include $49m in net working
capital already in place.

Exceptional capital expenditures would also be needed to complete the mill’s conversion from kraft production
to linerboard production, over and above the level required to improve efficiency, and maintain the facilities.

The mill would have a 10-year economic life (through 2013). Pacific would then decide whether to maintain the
operation by investing in new capacity to replace the mill or simply sell the assets.

Finally, the CFO proposed that a range of discount rates centered on 13% be considered.

Miscellaneous issues

Terminal value

The fixed assets’ value at the end of their economic life had to be considered. That salvage value was uncertain
but $22m seemed a reasonable guess. It would be taxable but only to the extent it exceeded the fixed asset’s
book value (Property, plant and equipment) at that time. If the salvage value was below the book value, the
implied book loss would be akin to a one-off depreciation expense, and would thus provide a tax shield.

Transfer pricing

Pricing was also an issue. Indeed, the Monticello mill’s linerboard would be sold to box plants owned by Pacific.
Transfer prices for such internal transactions rarely coincided with prevailing market prices. As per Pacific’s
estimates, the mill would sell its linerboard at an average price that was about 10% below the market price.

Tax rate

In recent years, Pacific had been able to use different tax credits to reduce its taxable income. As a result, its
average tax rate had been about 30%, below the statutory tax rate of 36%. However, the tax credits were much
smaller than Pacific’s taxable income and would be fully used irrespective of the mill’s acquisition.

Transaction costs

The transaction itself involved substantial costs. Pacific’s due diligence on the mill had engulfed $4.2m. But to
complete the transaction, Pacific would still have to rely on lawyers, bankers and other experts, who would all
demand a fee for their services, likely reach a total of $9.3m pre-tax, to be paid upon the deal’s completion.

For financing the transaction, Pacific had determined it could use up to $177m from its cash reserves, and
would complement this amount with a loan that would carry an interest of 8.1%.

Headquarters

A year prior, Pacific had decided to outsource some functions away from its Detroit headquarters. The plan’s
execution was underway and annual cost savings of $0.8m had already been implemented. The last step was
the sale of one of the headquarters’ buildings, now empty. A buyer had been lined up and the selling price after
tax and other costs was $10.1m. If Pacific cancelled the sale, it would have to pay a penalty of $1m after tax.

However, if the deal with Royal went through, Pacific would have to relocate some functions associated with
the mill to its headquarters. (Their costs were already included in the projections.) Office space was needed
and the empty building had been earmarked for that purpose. In that case, plans to sell it would be abandoned.

Pacific foresaw no other major change at its headquarters implied by the transaction. Yet, for its own internal
control processes, the accounting department’s policy was to assign to each business unit (BU) a fraction of the
headquarters’ costs in proportion to the BU’s sales. If the transaction went through, the Monticello mill would
thus be “charged” a headquarters contribution of about $1.7m in 2004, growing with inflation, at 3% per year.

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Exhibit 1
Projections and Assumptions

Business Plan 2004 2005 2006

Annual capacity (000 tons) 700 743 790
Utilization rate 95% 93% 93%
Market price per ton 320 360 400
Cost of goods sold ($m) 121.3 131.1 144.1
Operating expense ($m) 37.0 42.1 46.8
Property, plant & equipment (PPE)
Capital expenditures ($m) 19.2 30.5 41.7
Depreciation ($m) 20.9 28.3 35.0
Net working capital
Accounts receivable ($m) 34.2 41.7 50.1
Inventories ($m) 38.3 40.6 47.2
Accounts payable ($m) 17.7 22.3 26.3

Projections assumptions 2007-2013

Annual capacity (000 tons) 790
Utilization rate 95%
Growth rate of market price per ton 4.0%
Cost of goods sold/Sales 49.0%
Operating expense/Sales 15.9%
Property, plant & equipment
Capital expenditures/Sales 2.5%
Depreciation/Previous year PPE 20.0%
Net working capital
Accounts receivable/Sales 17.0%
Inventories/Sales 16.1%
Accounts payable/Sales 9.0%

Issues (in USD million except percentages)

Assets
Property, plant & equipment (2003) 206.0
Net working capital (2003) ($m) 49.0
Salvage value (2013) ($m) 22.0
Transfer pricing
Discount to linerboard market price 10.0%
Taxes
Average tax rate 30.0%
Statutory tax rate 36.0%
Headquarters
Cost savings ($m) 0.8
Building selling price after-tax ($m) 10.1
Cancellation penalty after-tax ($m) 1.0
Heaquarters contribution ($m) 1.7
Inflation rate 3.0%
Transaction costs
Due diligence ($m) 4.2
Fees at completion pre-tax ($m) 9.3
Cost of capital and financing
WACC 13.0%
Cash reserves ($m) 177.0
Loan interest rate 8.1%