Padgett Paper Products

CASE: PADGETT PAPER PRODUCTS COMPANY

As result of inflation and the acquisition of its competitor, Tri-State Tablet Company in 1996, Padgett's financial needs have been risen to a permanent level rather than being merely seasonal in nature. The Company exceeded its bank credit line of USD 5 million to USD 7.2 million. So Padgett Paper requested their bank, the Calson Trust Company for a higher credit limit of USD 8 million. The request was granted under internal guidance line of USD 8 million at prime. The objective is for the Management at the company's bank must revise Padgett's debt structure in a mutually satisfactory manner that will minimize lender risk while increasing company value. The current situation is the bank is now in bad situation because of over extended. Lending exceeds reasonable levels and is not collateralized. A credit line of USD 8 million is not normal for the bank.

Furthermore the Companies management does not appear to understand the unrealistic debt situation and has unrealistic expectations and a lack of understanding of impact of current structure of firm values and impacts on the upcoming audit reports. Another issue is that the Owner of the Company is interested in dividend distribution, which is another reason for the bad debt structure of the Company. Padgett could repay the loan after 8 years which was considerably longer than the typical bank five-year term loan that a company like Padgett Paper's size might expect under the assumption that the company would generate every subsequent year at a Cash Flow of USD 1 million.

The company has significant levels of Equity and is not minimizing its financial structure. It is able of taking more debt, but the debt needs to be more properly structured. The D/E ratio during the years increased significantly. In 1993 the D/E ratio was 22% and in 1996 it grew at 67% (Appendix1). Also the Comparison of the total Equity and the total Liabilities show that the share of Equity of Liabilities was between 1993 to 1996 to high. (Appenix1) The Company had too much short-term debt, from the year 2005 to 2006 and had an increase of 131, 6% (Appendix1). The whole structure of the total Liabilities demonstrate the unstructured and unequally relation. (Appendix1). Through this the Company reached a lost from tax shield value. Because of the low amount of the long- term debt the company had not a huge amount of interest expenses which it would deduct of the Operating profit (EBIT).

Therefore the Company has to tax the whole EBIT. The Income Statement shows that the Tax made almost 57% of the EBIT in 1993 and in the further years the tax alternate between 52% and 42% was very high (Appendix1). This means that the big amount of Equity which the Company had generated was too small of a profit which the tax shield lost. Libris who was the vice president of the Calson Trust Company understood the problem and offered the Company insurance financing. He proposed a 12- to 15- year loan under a fixed rate of 9.5%. The bank would continue to provide for Padgett's seasonal working-capital financing on a floating prime- rate basis which would be approx. 0, 5%. Padgett refused this first agreement. The management did not like the idea of an elaborate set of covenants. After that Libris took a closer look at Padgett's business and entitles and prepared a new set of forecasts for Padgett's books, thus regaining trust from the Padgett Management.

Libris proposed to adopt for 1997 fiscal year to change the Inventory valuation from FIFO to the LIFO method. It would save more cash than the cost of implementing the system and would result in a tax deferral of USD 500,000 thousand but it will be difficult to implement and administer, however it is necessary for the company to do this. Furthermore he proposed to dispose of redundant warehouses that had been part of the Tri-State acquisition. The Management expected to receive USD 700,000 thousand from the cash sale and tax refunds on the book loss. Another option could be some share of debt through insurance company. This would have a positive effect of a longer maturity schedule and would reduce risks to the bank and of the company. But the Management was against this option due to restrictive covenants and interest rate uncertainty.

Another required option was to collateralize Assets. It would also increase the maturity schedule and reduce risk to bank and Company but restrict management's flexibility. Another alternative would be to Mortgage General Purpose Buildings. It would have the same positive affect like the other purposes. But the Management was against this alternative. Another possibility were the flat Dividends. These provide additional cash to shore up debt situation, but the Owner will be unhappy with that, because it is not the focus and also this should not be necessary given the strong equity situation of the company. Another important alternative would be the use in Canadian financing. Securing USD 1 million dollars in Canadian financing and 66% to loan the value mortgage on the general purpose warehouse would be prudent in order to eliminate all remaining short- term debt. It will reduce risk and untapped source leverage. The only problem would be that the U.S banking law and practice are not identical to Canadian practice. Another very important thing is to increase cash flow. There exist different ways to improve cash flow such as reducing direct and indirect costs and the overhead expenses. Improve systems for billing and collection, accelerate receivables. But in the case of Pagdett increase cash flow through payroll savings in collections a credit departments, this would result in reduce risk to bank and bank's required due-diligence in regards to collateralized receivables but also additional costs associated with factoring.

Another aspect which Libris have to take a look was the market situation at this time. Padgett was active in a high competitive market. In this time existed a lot of Consolidations in this market because of the high inflation rate in this time that made difficult for small firms to finance their assets. Many small Companies get in financial troubles due to of acquisitions, larger Companies start to dominate. The sharp drop in the stock market in 1987 had frightened some owners into selling out. The paper price had risen over 50% from mid-1994 and exceeded the previous high prices of 1988/1989. The margins get smaller and have declined due the competitions and the high paper price (Appendix2). The interest rates were volatile and this made the situation more difficult. The question was should the loan be priced at a floating rate or fix rate. The final rate had to be checked against the market. A fixed rate would be better, when the market is suspect like in Padgett's situation, because the

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