calculate WACC with their current debt and equity

Case Study Prepared By Trevor Larkan[footnoteRef:1](updated Jan 2018) [1: This case has been prepared solely as the basis for class discussion and is not based on any specific actual event (s). Reproduction and use of this case is to be made only with the express permission of the author. ]

Insight Inc

Howard Casey, Chairman of Insight Inc, a leading USA coated paper producer, had opened the mid-October 2017 offsite strategic review meeting of senior management in the White Mountain region of New Hampshire with a rather somber outlook. He stated that contrary to the rather pleasant weather now prevailing in the surrounding mountains, the company had not met the investment sector’s expectations for the recently ended fiscal year and was also losing market share to its main competitors in certain regions. In Howard’s opinion, one of the primary reasons for the deteriorating market share lay in Insight’s inability to compete with the larger and more modern paper machines of key competitors in Europe. The competitive threat was very real when considering Insight’s sales to the important European markets. He closed off his opening comments with the following statement:

“Last night I received an e-mail from Pieter Ulrich, Chairman of Duizepapier AG, the large German headquartered tissue and paper group, indicating that their board had decided to exit the coated paper sector in order to concentrate on their global aspirations in the tissue business. Consequently they would be disposing of, by auction, their coated paper manufacturing facility in Hamburg, Germany. This could be an ideal opportunity to regain a competitive position in our core business. We have our quarterly board in two weeks and, although this may be a tight deadline, I want to present a recommendation to the board on whether to bid for this facility and, if so, a comprehensive preliminary outline on how much we should pay and how to accomplish it. If it is a go, we could potentially close the acquisition by end-2017.”

Turning to Peter Smith, CEO of Insight, he remarked: “I feel it will be best if you could present the detail at the board meeting after I have outlined our recommendation. Please feel free to bring John Perry who, as Financial Director, may be best placed to answer, and/or present, the more complex financial issues. Having Jack Dunn available to, as our Manufacturing Director, answer any technical questions will also be useful.”

“This acquisition will definitely mean that we will be raising additional funding – will it be a problem if John invites Paul Lawson, our treasurer, to the presentation?” queried Peter Smith. “Not at all – that should round off nicely the core team to work on this initiative” answered Howard Casey.

Peter Smith decided that, given the tight time frame, it would be best if the presentation team left the strategic review meetings at the end of day one and returned to the Boston corporate office to work on the project.

Background: Insight Inc

Insight Inc is listed on the New York Stock exchange and ranks within the top ten international coated paper producers. It sells mainly within the USA and Europe with a small amount of exports to Africa and Asia.

The company has total assets of US $ 2.3 billion with a mill in Maine, Michigan and Alabama. It operates sales offices in specific major cities in the regions in which it sells its products, with its corporate headquarters in Boston.

The financials of the company as at 30th September 2017 are summarized as follows: $ Mill.

Ordinary Share Capital 1500

Long Term Funding

Bank Debt – term loan facility of $500, incl. a revolving credit line of $75 450

Bonds – 6% Subordinated Notes repayable on Dec.31, 2021 350

____

Total Capital Employed 2,300

The company does not have a consistent dividend and shareholders hold the shares mainly for capital growth. Certain additional information is provided in Appendix 3.

The Opportunity

Peter Smith had called the first of what was to be a regular late afternoon meeting on the opportunity to acquire the coated assets facility from Duizepapier, now code named Project Castle.

“We need to identify the key aspects of this acquisition – obviously a big question in my mind is whether it will represent the best strategic solution in the long term?” expressed Peter.

“Our gearing (leverage) is relatively high at the moment and current cash flow is really just maintaining our present capital expenditure commitments on our USA mills. This acquisition would need to be funded with new money.” added John Perry. “What is the Euro bond market like at the moment?” he queried looking at Paul Lawson.

“Transactions are closing up to the $300 million level, although the margin over LIBOR for our credit rating would need to be at least 400 points. We may have to offer more if we were raising more than, say, $200 million.’ answered Paul. ‘The bank market is more attractive and I would be confident of raising up to $250 million at 200 points over LIBOR. The repayments will, however, be annual over a five year term rather than a bullet repayment at maturity as for bonds.”

Peter reminded the group that if it was the right opportunity, funding should be achievable, even if it meant going to shareholders with a rights issue for the additional amount once the debt sources were saturated.

He asked Jack Dunn to summarize the Hamburg manufacturing facility’s key attributes:

“The plant consists of two paper machines, a pulp mill and an engineering research facility. Paper Machine # 1 (PM #1) is 40 years old with an output of only 60,000 tons per annum. The new machine (PM#2) is state-of-the-art with a rated capacity of 400,000 tons per annum. The pulp mill (105,000tons) supplies all of the pulp for PM #1 (a half a ton of pulp is required for one ton of paper which is similar to our USA machines) but only half of the required 150,000 tons of pulp for PM#2, based on its current output of 300,000 tons.”

“The research facility is great although it would be questionable whether we need to maintain the 50 engineers – half that number should support a viable research operation. The costs, as provided by Duizepapier in their offering document, are summarized on Appendix 1.”

“What is the current run rate of the new paper machine” asked John Perry.

“They have just completed a record month with a production of 25,000 tons. I know that asset will achieve its rated capacity within two years – and could marginally exceed it soon thereafter” answered Jack.

Burning the Midnight Oil

The team worked through the next week knowing that they would need to allow time to prepare the formal board presentation, as well as conduct various reviews and have a dry run.

Peter Smith had assumed responsibility for the market having recently been promoted from the position of Marketing Director. He circulated Appendix 2 with his projections.

“Although it is clear to us that Paper Machine #1 will not be retained, in discussing the fixed costs of €40million (Appendix 1) with the accounting department, it appears that we will not avoid €5 mill. of these costs after disposing of this machine” concluded Peter.

Paul had prepared a summary (Appendix 4) of current interest rates, exchange rates and marginal tax rates which he felt would not change much over the next five years.

John Perry had discussed the question of a hurdle rate to use for discounting the projected cash flows:

“The board has specified that a hurdle rate of 8% be used for strategic acquisitions. We use 10 % for new plant equipment, and 12% for other investments. This clearly falls in the category of a strategic acquisition but I feel uneasy on not recalculating our cost of capital given the new funding that would be taken on.”

“I agree” answered Paul. “We will need to use a weighted cost of capital based on our current debt/equity ratio.”

“In my due diligence, I discovered that Duizepapier recently spent €20 mill. on their bleaching section of PM#2 which will allow us to run the new environmentally free product. We were not in a position to make this investment, due to technical reasons, on any of our existing machines. This investment will also relieve us of our requirement to pay an environmental levy to the EU of €2 million for each of the next three years, as we would fall into a levy-free category, if we owned PM#2”, added Jack Dunn.

“One final matter that the team will need to decide on is whether to show a cash flow forecast for Insight which incorporates the potential acquisition. Although this document would obviously be prepared before closing, I tentatively feel that it is debatable as to its value for the board at this forthcoming meeting”, concluded a rather tied Peter Smith.

The meeting adjourned with the team agreeing to meet the next day and begin putting their recommendation and presentation together for the fast approaching board meeting.

Appendix 1

Cost Summary: Duizepapier AG

2018		PM#1	PM#2
Variable costs		€/ton	€/ton
- Own Pulp - Bought In Pulp		300 -	300 Based on cost in USD
Other Variable Cost		250	250
Fixed Costs for Duizepapier		€’000’s	€’000’s
Depreciation (4)		-	40,000
Other		40,000	50,000
Total Fixed Costs		40,000	90,000

Notes

1. Duizepapier has forecast unutilized tax losses to be carried forward at 31st December 2017 of €50 million arising from tax allowances on the building of PM#2.

2. The remaining tax depreciation on PM#2 will run at €25 million per annum for the next four years.

3. The above “Fixed Cost: Other”, for PM#2, includes €20 mill. for the research facility which is basically people cost.

4. Accounting depreciation above is primarily for PM#2 and is straight-line over the next 10 years

5. Capital expenditure to maintain PM#2 is estimated to be €30 mill. per year.

6. Other Variable Cost is calculated on the basis of a ton of total paper production.

Appendix 2

Market Projections : Hamburg Facility

		2019	2020	2021	2022	2023
Coated Paper Price	€/ton	950	1000	1100	1050	1000
Sales Volume	PM#2	300,000	300,000	400,000	400,000	450,000

Notes

1. Paper Machine #1will be sold immediately following the acquisition (assuming Insight does acquire the Hamburg mill). Net proceeds are estimated to be €15 million. The book value is zero, but, due to certain recent modifications, it has a tax value (basis) of €3million.

2. The coated paper prices reflected above are net of the cost of delivery.

Appendix 3

Insight Inc.: Financial Information of its Current Business (excludes the contemplated acquisition of Duizepapier’s Hamburg facility)

1. Based on projections of the market for Insight’s current product range, EBITDA is forecast to continue for at least the next five years at their current level of $200 million.

2. The investment in net working capital, excluding cash, is forecast to remain steady at $90 million.

3. Annual capital expenditure is estimated to run at $40 million.

4. Tax paid is estimated to be 20% of EBITDA.

5. Total assets comprise of S50 mill in cash, $90mill in net working capital, $150 m in intangible assets and $2010 mill in Fixed Assets.

Appendix 4

Treasury Indications

Interest Rates/Returns (2018)

LIBOR: One Year 1.5%

Average Return: Government bonds (risk free rate) 3.0%

Frankfurt Stock Exchange

· Top 300 Average Return 9.0%

Insight Inc.’s – average bank rate (current) 4.0%

Exchange Rates

USD/Euro. (economic forecast: 2018) 1.15

Tax Rates

Duizepapier AG (2018) 35.0%

Insight Inc (2018) 30.0%

Note: Should the shares of the subsidiary company of Duizepapier, which has as its only asset the Hamburg manufacturing facility, be acquired rather than purchasing the assets, German tax law allows the transfer of any assessed tax loss, or brought forward tax loss, to the new owners. However, if the assets, rather than the shares, are purchased, the tax treaties between the USA and Germany effectively results in the Hamburg facility being taxed at the USA rate.

Pulp Prices

Bought In Pulp – Duizepapier (2018) USD 660

Additional Notes

1. Rating agencies have indicated that Insight Inc needs to maintain a capitalization ratio (Net Debt/ Total Net Assets) of no more than 40% in order to maintain its current investment grade rating.

2. The beta for comparable international paper companies has been published by a number of financial institutions as 0.95.

3. Insight’s current bank term loan is repayable with effect from 2020 in equal annual installments through the end of 2024.

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