J.C.Penney Restructuring

Applied Corporate Finance

Case Study – Atlantic Corporation

Team Member: HUANG Alyssa ▪ LI Bo ▪ LIU Nancy ▪ TAO Kaylie

Executive Summary

1. This report focuses on the valuation of Royal Paper Corporation’s assets that Atlantic Corporation intended to acquire

• Atlantic Corp., one of America’s largest forest products/ paper firms, decided to increase capacity to capture higher profit from the linerboard market of strong demand
• To avoid enormous costs of building new capacity, Atlantic Corp. considered to acquire a linerboard mill, 16 box plants, and 328K acres of timberlands (the “package”) from Royal Paper Corporation
• The objective of this report is to propose a more reasonable and justifiable valuation of the package, given the dispute in the high estimate of $740.1M suggested by Royal Paper

1. To thoroughly explain the package value of $537M estimated with our approach, the report consists of the following sections

• Methodology: the valuation methods and guiding principle used
• Assumption: the conditions that are reasonable, relevant, and applicable for the acquisition
• Analysis: the valuation model and results under the assumptions
• Other supporting details for justification and further notable concerns

Methodology

• The valuation of the mill and plants ($407M) was completed with Discounted Cash Flow Analysis, based on the actual business performance of FY1983 and a 10-year forecast (terminal value estimated at the end of FY1993)
• The market valuation of timberland is approximately $130M, agreed by both parties and applied directly without further modification

Assumptions

1. Discount rate – Acquirer’s WACC

In Exhibit 1, Royal Paper proposed to use 6% discount rate in calculating the present value. We believe the discount rate is too low, as it is even lower than the yields of US Government Securities. In an M&A case, while there are always discussions on whether to use acquirer or target company’s discount rate, our group supports the idea of using acquirer’s discount rate. It is recommended due to the fact that post-merger integration is done by the acquirer and that the benchmark for M&A evaluation is referred to acquirer’s expectation. Being integrated into acquirer’s business, the target company has to create enough synergy and generate enough benefit to surpass acquirer’s target. Therefore, in this case, we calculated the acquirer’s WACC with the information provided and used it as the discount rate in calculating present value.

1. MRP – 6%

The market risk premium is the difference between the expected return on a market portfolio and the risk-free rate. It is equal to the slope of the security market line. The market risk premium is the same for both companies since they are in the same market. The historical market risk premium has averaged between 4.5% and 6.5%. In this case, by following the instruction from professor, we assume the MRP is 6%.

1. Risk Free Rate – Intermediate Term Notes 12.40%

In Exhibit 7, we were given the Yields of US Government Securities. Four yields were provided with the maturity ranging from 3-month to 20-year. 20-year government bonds are usually accompanied by a greater interest risk due to its longer maturity, these bonds are more likely to have trading liquidity issues as investors are unwilling to lock in their money at low rates for an ultra long period of time when the interest rate are low, causing the yield not fully reflective of its true value (usually higher than true level to recoup illiquidity). Therefore, we chose the Intermediate Term Notes as our Risk Free Rate for our calculation. We assume the Intermediate Term is 10 years.

1. Cost of Debt – 13.33% for A Credit Rating

Exhibit 7 provides a table of S&P average yields in correspondence to different credit ratings. The bond of Atlantic Corporation was rated “A”, and thus we assume its cost of debt is 13.33%, same as the A-rated bond yield.

In addition, we calculated Atlantic’s interest rate over long-term debt. The average interest rate from 1979 to 1983 was 8.6%, which was lower than the risk-free rate. This implies that there may be some unknown factors, which were not explicitly shown in Exhibit 2. Without a close look at the detailed financial reports of the Atlantic, we decided not to use this method to calculate the pre-tax cost of debt.