Microsoft Word - Pacific Container Corp (2021)
Pacific Container Corporation: Some
On January 5, 2021, his first day as chief executive officer (CEO) of Pacific Container
Corp. (PCC), Chris Chen confronted a host of management problems at the company.
One week earlier, PCC’s president and CEO had abruptly resigned to take a CEO position
at another company. Soon thereafter, Chris was appointed to fill the position – starting
immediately. Several issues in his in-box that first day were financial in nature, either
requiring a financial decision, or with outcomes that would have major financial
implications for the firm. That evening, Mr. Chen asked to meet with his assistant, Mark
Tan, to begin addressing the most prominent issues.
PACIFIC CONTAINER CORPORATION AND THE CARDBOARD BOX AND
CONTAINER MANUFACTURING INDUSTRY
The Pacific Container Corporation had been founded as a joint venture between Carolina
Pulp & Paper and an Asian venture-capital firm, New Era Partners. Based in Singapore,
PCC’s sole business mission was to manufacture boxes from cardboard packaging known
as corrugated Fiberboard. PCC served as a supplier of cardboard boxes to other
manufacturing firms in the Pacific Rim and was known for producing some of the best
cardboard packaging material in the industry.
Given its ubiquity in packaging, revenue for the global cardboard box and container
manufacturing industry is highly correlated with global demand from manufacturing and
retail sectors. The industry is highly fragmented with an estimated 15,700 companies
operating in the industry (globally) and only 4 companies controlling more than 1.0% of
the market. The majority of companies operate locally or regionally, providing cardboard
boxes to companies within a relatively short distance from their facilities. Barriers to
entry are relatively low; a new, small plant would cost between SGD1 10 million and
SGD 20 million. Easy entry had led to price competition in recent years among cardboard
box manufacturers. One analyst said,
The gross margins on cardboard boxes have eroded tremendously over the past
five years. I don’t see there’s any more maneuvering left on the price.
Despite increasingly intense competition for cardboard packaging material, PCC’s growth
prospects looked bright. At the regional level, demand was strong and PCC’s focus on
customer service and quality products had resulted in a strong and expanding customer
1 SGD = Singaporean dollars
FINANCIAL QUESTIONS FACING VICTORIA YU
That evening, Mr. Chen met with Mark Tan, a promising new associate whom he had
brought along from New Era. Mr. Chen’s brief discussion with Mark went as follows:
Back at New Era, we looked at PCC as one of our most promising venture-capital
investments. Now it seems that such optimism may not be warranted – at least until we
get a solid understanding of the firm’s past performance and its forecasted performance.
Did you have any success on this?
Yes, the bookkeeper gave me these: the historical income statements [Exhibit 1] and
balance sheets [Exhibit 2] for the last four years. The accounting system here is still
pretty primitive. However, I checked a number of the accounts, and they look orderly. So
I suspect that we can work with these figures. From these statements, I calculated a set of
diagnostic ratios [Exhibit 3].
I see you have been busy. Unfortunately, I can’t study these right now. I need you to
review the historical performance of PCC for me, and to give me any positive or negative
insights that you think are significant.
When do you need this?
At 7:00 A.M. tomorrow. I want to call our banker tomorrow morning and get an extension
on PCC’s loan.
The banker, Jesse Liu, said that PCC was “growing beyond its financial capabilities.”
What does that mean?
It probably means that she doesn’t think we can repay the loan within a reasonable period.
I would like you to build a simple financial forecast of our performance for the next two
years (ignore seasonal effects) and show me what our debt requirements will be at the
fiscal years ended 2021 and 2022. I think it is reasonable to expect that PCC’s sales will
grow at 15 percent each year. Also, you should assume capital expenditures of SGD 54.6
million for plant renovations spread out evenly over the next two years and depreciated
over seven years on a straight-line basis. Use whatever assumptions seem appropriate to
you based on your historical analysis of results. For this forecast, you should assume that
any external funding is in the form of short-term debt.
But what if the forecasts show that PCC cannot repay the loan?
Then we’ll have to go back to PCC’s owners, New Era Partners and Carolina Pulp &
Paper for an injection of equity. Of course, New Era Partners would rather not invest
more funds unless we can show that the returns on such an investment would be very
attractive, and/or that the survival of the company depends on it. Thus, my third request is
for you to examine what returns on book assets and book equity PCC will offer in the
next two years and to identify the “key driver” assumptions of those returns. Finally, let
me have your recommendation about operating and financial changes I should make
based on the historical analysis and the forecasts.
The plant manager revised his request for a new packaging machine and thinks these are
the right numbers [see the plant manager’s memorandum in Exhibit 4]. Essentially, the
issue is whether to invest now or wait three years to buy the new packaging equipment.
The new equipment can save significantly on labor cost but carries a price tag of SGD
1.82 million. My hunch is that our preference between investing now versus waiting three
years will hinge on the discount rate.
[laughing] The joke in business school was that the discount rate was always 10 percent.
That’s not what my business school taught me! New Era always uses a 40 percent
discount rate to value equity investments in risky start-up companies. But PCC is
reasonably well-established now and shouldn’t require such a high-risk premium. I
managed to pull together some data [see Exhibit 5] on comparable companies with which
to estimate the required rate of return on equity.
Fine. Please estimate PCC’s weighted average cost of capital and assess the packaging
machine investment. I would like the results of your analysis tomorrow morning at 7:00
PACIFIC CONTAINER CORP.
Historical Income Statements
Fiscal Year Ended December 31
(SGD XXXXXXXXXX 2020
Sales 71, XXXXXXXXXX, XXXXXXXXXX, XXXXXXXXXX,042
Production costs and expenses 33,703 38,393 46,492 53,445
Admin. and selling expenses 16,733 17,787 21,301 24,177
Depreciation 8,076 9,028 10,392 11,360
Total operating expenses 58,512 65,208 78,185 88,983
Operating profit 13,412 14,908 14,429 17,059
Interest expense 5,464 6,010 7,938 7,818
Earnings before taxes 7,949 8,897 6,491 9,241
Income taxes* 2,221 2,322 1,601 2,093
Net earnings 5,728 6,576 4,889 7,148
Dividends to all common shares 2,000 2,000 2,000 2,000
Retentions of earnings 3, XXXXXXXXXX, XXXXXXXXXX, XXXXXXXXXX,148
*The expected corporate tax rate was 24.5%.
PACIFIC CONTAINER CORP.
Historical Balance Sheets
(Fiscal Year Ended December 31)
(SGD XXXXXXXXXX 2020
Cash 4, XXXXXXXXXX, XXXXXXXXXX, XXXXXXXXXX,795
Accounts receivable 22, XXXXXXXXXX, XXXXXXXXXX, XXXXXXXXXX,486
Inventories 23, XXXXXXXXXX, XXXXXXXXXX, XXXXXXXXXX,778
Total current assets 50, XXXXXXXXXX, XXXXXXXXXX, XXXXXXXXXX,059
Gross property, plant & equipment 64, XXXXXXXXXX, XXXXXXXXXX, XXXXXXXXXX,153
Accumulated depreciation (4, XXXXXXXXXX, XXXXXXXXXX, XXXXXXXXXX,339)
Net property, plant & equipment 60, XXXXXXXXXX, XXXXXXXXXX, XXXXXXXXXX,814
Total assets 110, XXXXXXXXXX, XXXXXXXXXX, XXXXXXXXXX,873
Liabilities and Stockholders' Equity:
Short-term borrowings (bank)1 29, XXXXXXXXXX, XXXXXXXXXX, XXXXXXXXXX,981
Accounts payable 12, XXXXXXXXXX, XXXXXXXXXX, XXXXXXXXXX,370
Other accrued liabilities 24, XXXXXXXXXX, XXXXXXXXXX, XXXXXXXXXX,318
Total current liabilities 65, XXXXXXXXXX, XXXXXXXXXX, XXXXXXXXXX,669
Long-term debt2 10, XXXXXXXXXX, XXXXXXXXXX, XXXXXXXXXX,200
Shareholders' equity 34, XXXXXXXXXX, XXXXXXXXXX, XXXXXXXXXX,004
Total liabilities and stockholders' equity 110, XXXXXXXXXX, XXXXXXXXXX, XXXXXXXXXX,873
1 Short-term debt was borrowed from City Bank at an interest rate equal to Singaporean prime lending rates + 1.5 percent.
Current prime lending rates were 5.2 percent. The benchmark 10-year Singapore treasury bond currently yielded 3.6 percent.
2 Two components made up the company's long term debt. One was a SGD10 million loan that had been issued privately
in 2015 to New Era Partners. This debt was subordinate to any bank debt outstanding.
The second component was a SGD8.2 million from a 5-year bond issued on a private placement basis last January 3, 2019 at
a price of SGD97 and a coupon of 5.75% paid semi-annually. The bonds in the debt issuance were SGD100 par value.
PACIFIC CONTAINER CORP.
Ratio Analyses of Historical Financial Statements
Fiscal Year Ended December 31
Operating margin (%) 18.6% 18.6% 15.6% 16.1%
Tax rate (%) 27.9% 26.1% 24.7% 22.6%
Return on sales (%) 8.0% 8.2% 5.3% 6.7%
Return on equity (%) 16.7% 16.9% 11.7% 15.2%
Return on assets (%) 5.2% 5.2% 3.0% 3.9%
Debt/equity ratio XXXXXXXXXX XXXXXXXXXX XXXXXXXXXX
Debt/total capital (% XXXXXXXXXX XXXXXXXXXX XXXXXXXXXX
EBIT/interest (x XXXXXXXXXX18
Sales/assets 65.2% 64.0% 57.2% 57.4%
Sales growth rate (%) 15.0% 11.4% 15.6% 14.5%
Assets growth rate (%) 8.0% 13.5% 29.3% 14.2%
Days in receivables XXXXXXXXXX122.1
Payables to COGS 36.5% 33.4% 25.6% 25.0%
Inventories to COGS 69.1% 72.1% 115.8% 119.3%
Current ratio XXXXXXXXXX
Quick ratio XXXXXXXXXX
EXHIBIT 4 Lim’s Memo Re: New Packaging Equipment
TO: Chris Chen, President and
CEO, Pacific Container
FROM: Esmond Lim, Plant Manager
DATE: December 30, 2020
SUBJECT: New Packaging Equipment
Although our box packaging equipment is adequate at current production levels, it is
terribly inefficient. The new machinery on the market can give us significant labor
savings as well as increased flexibility with respect to the type of packaging used. I
recommend that we go with the new technology. The considerations relevant to the
decision are included in this memo.
Our current packaging equipment was purchased five years ago as used equipment in a
liquidation sale of a mid-sized company. Although the equipment was inexpensive, it is
slow, requires constant monitoring, and is frequently shut down for repairs. Since the
packaging equipment is significantly slower than the production equipment, we routinely
have to use overtime labor to allow packaging to catch up with production. When the
packager is down for repairs, the problem is exacerbated and we may spend several two-
shift days catching up with production. I cannot say that we have missed any deadlines
because of packaging problems, but it is a constant concern around here and things would
run a lot smoother with more reliable equipment. In 2021 we will pay about SGD 15,740
per year for maintenance costs. The operator is paid SGD 63,700 per year for his regular
time, but he has been averaging SGD 81,900 per year because of the overtime he has
been working. The equipment is on the tax and reporting books at SGD 218,400 and will
be fully depreciated in three years’ time (we are currently using the straight-line
depreciation method for both tax and reporting purposes and will continue to do so).
Because of changes in packaging technology, the equipment has no market value other
than its worth as scrap metal. But its scrap value is about equal to the cost of having it
removed. In short, we believe the equipment will have no market value at all when
The packager offers many advantages over the current equipment. It is faster, more
reliable, more flexible with respect to the types of packaging it can perform, and will
provide enough capacity to cover all our packaging needs in the foreseeable future. With
suitable maintenance, we believe the packager will operate indefinitely. Thus, for the
purposes of our analysis, we can assume that this will be the last packaging equipment we
will ever have to purchase. Because of the anticipated growth at Pacific Container, the
current equipment will not be able to handle our packaging needs by the end of 2023.
Thus, if we do not buy new packaging equipment by this year’s end, we will have to buy
it after three years’ time anyway. Since the speed, capacity, and reliability of the new
equipment will eliminate the need for overtime labor, we feel strongly that we should buy
now rather than wait another three years.
The new equipment currently costs SGD 1.82 million, which we would depreciate over
10 years at SGD 182,000 per year. It comes with a lifetime factory maintenance contract
that covers all routine maintenance and repairs at a price of SGD 3,640 for the initial
year. The contract stipulates that the price after the first year will be increased by the
same percentage as the rate of increase of the price of new equipment. Thus, if the
manufacturer continues to increase the price of new packaging equipment at 5 percent per
annum as it has in the past, our maintenance costs will rise by 5 percent also. We believe
that this sort of regular maintenance should ensure that the new equipment will keep
operating in the foreseeable future without the need for a major overhaul.
Pacific Container’s labor and maintenance costs will continue to rise due to inflation at
approximately 1.5 percent per year over the long term. Because the manufacturer of the
packaging equipment has been increasing its prices at about 5 percent per year, we can
expect to save SGD 286,878 in the purchase price by buying now rather than waiting
three years. The marginal tax rate for this investment would be 24.5 percent.
Pacific Container Corp.
Data on Comparable Companies
% of Sales XXXXXXXXXXMarket Shares 5-Year
Cardboard Box Price/Earnings Book Book Value Price Outstanding Last Annual Earnings Growth
Name Production Ratio Beta D/E per Share per Share (millions) Dividend Forecast
Sing Products, Inc. 20% XXXXXXXXXX XXXXXXXXXX XXXXXXXXXX%
IBBEX Corp. 95% NMF XXXXXXXXXX XXXXXXXXXX XXXXXXXXXX%
STOR-Max Corp. 90% XXXXXXXXXX XXXXXXXXXXnone 21.3%
Zeport 30% XXXXXXXXXX XXXXXXXXXXnone 38.2%
Wymax, Inc. 60% NMF XXXXXXXXXX XXXXXXXXXX XXXXXXXXXX%
Note: NMF means not a meaningful figure. This arises when a company's earnings or projected earnings are negative.
Singapore's equity market risk premium could be assumed to be close to the global equity market premium of 6 percent, given Singapore's high rate of
integration into global markets.