Pacific grove case study

EXECUTIVE SUMMARY

By 2015, Pacific Grove (hereafter referred as “PG”) will reach a 55% ratio of interest/bearing debt to total assets and their equity multiplier will be 2.77 which is consistent with Peterson’s expectation. I must be noted that over the next 4 years, PG’s interest coverage is forecasted to increase suggesting that they will gradually be building up more earnings to cover its debt payment which is a good sign for the banks.

Dilution of shares seems have to have little impact on the EPS of PG shares.

Therefore, it is expected that PG shareholders would accept the issuing of shares. However, this information has to be clearly communicated by PG’s management to its shareholders in order to gain support of this share issuance.

It is also fairly safe to say that it is a good decision for PG to enter into the television deal. It is noted that the project would yield a positive NPV at 10%, 15% and 20% discount rates.

These include improving their supply chain efficiency and forecasting so that they can reduce their inventory levels, negotiating with suppliers to reduce the rate they are paying for inventory and can extending the length of their accounts payable.

Overall, it is recommend that PG accepts the investment group’s offer of $27.50 and issue 400,000 common stock to raise $11M for reasons mentioned earlier in the report. The extra funds will give PG more capacity to fund the television program in addition to reducing its debt to meet their bank’s requirement, as well as purchasing an underpriced High Country.

1.0 DEBT

According to the forecast in Exhibit 1, PG seems to be on course in meeting their bank’s demand of 55% Debt to Total Asset ratio and 2.7 equity multiplier. Table 1 in the appendix illustrates a number of ratios relating to PG’s debt. Just by following their expected future growth plans they will almost reach the requirements of the bank within 4 years. Using the information provided from their forecasted financials, by 2015 Pacific Grove will reach a 55% ratio of interest/bearing debt to total assets and their equity multiplier will be 2.77 which is consistent with Peterson’s expectation.

Although PG’s current future is projected to meet the bank’s demands, the issue that is yet to be known is whether the banks are willing to allow PG 4 years to achieve this. If the banks are reluctant to grant PG such a lengthy time period, PG will need to make smart changes in reducing these ratios. Recommendations for PG in to solve this problem are discussed later in the report. An another note, it must be noted that over the next 4 years, PG’s interest coverage is forecasted to increase suggesting that they will gradually be building up more earnings to cover its debt payment which is a good sign for the banks. This positive factor might help influence the bank to give PG the entire 4 years to meet their requirements.

2.0 SELLING NEW COMMON STOCK

The issue with selling new common stock is that it can create dilution amongst existing shareholders. Shareholder dilution will lower share price in addition to sending a negative signal to the company’s shareholders. PG’s common shares outstanding would increase from 1,165,327 by 400,000 to 1,565,327. PG’s current EPS in 2011 is 2.037. According to the earning figures from the forecast in Exhibit 1, the EPS will be 2.136 after issuing the new shares at year 2012. Table 2 (attached in the appendix) illustrating the EPS from 2012 to 2015 shows that dilution of shares seems have to have little impact on the EPS of PG shares. Therefore, it is expected that PG shareholders would accept the issuing of shares. However, this information has to be clearly communicated by PG’s management to its shareholders in order to gain support of this share issuance.

3.0 ACQUISITION OF HIGH COUNTRY

The enterprise value of High Country was estimated in order to compare whether the acquisition price asked for it is would create impairment in the future. The forecasted financials of High Country is attached in the appendix. The discounted cash flow method gave an enterprise value of $37.56M. Assumptions are given in the appendix as to how this amount was achieved. This amount is way above the asking price of $13.2M (in excess of $24.36M). The excess amount will be recorded on PG’s balance sheet as goodwill if the acquisition occurs. As this goodwill amount is very large, it is expected not to be amortized in the future.

Peterson has noted that PG would not consider the acquisition if it is anticipated that there will be future impairment and write-down of goodwill created by the purchase of High Country. As the book value(37.56M) is so much higher than its current market value ($13.2M), it is very unlikely that the goodwill will be impaired in the future. With that said, there will be no write down of goodwill. It must also be noted that based on the analysis of this report, High Country is heavily undervalued. The acquisition of High Country will be come off as a smart buy for PG. Overall, PG should look into acquiring High Country not only because of the unlikely write-down, but also because it is undervalued for what it is truly worth.

4.0 TELEVISION DEAL

Judging by Exhibit 3, it seems fairly safe to say that it is a good decision for PG to enter into the television deal. It is noted that the project would yield a positive NPV at 10%, 15% and 20% discount rates. The project also requires only a modest initial investment of $1,440,000. Working capital for the following years significantly lowers after the first year of operations from $2,459,543 to $122,977. On top of that, the show’s star is a reputable name in the cooking industry. This will boost PG’s perception in the market relative to its competitors. All these factors contribute to making the television deal an attractive deal for PG to undertake.

5.0 IMPACT OF ECONOMIC CLIMATE

PG is exposed to difficult credit environment as banks are facing pressure from regulators following the financial crisis of 2008. Due to the loss of confidence in credit by the overall market, PG was left with no choice but to obey the demands of their bank as it would be difficult to obtain credit from other institutions during the time. This has impacted PG in the sense that PG might have to make changes in their operations to suit the bank’s needs if the bank demands that their requirements be met before 2015.

In addition to poor confidence in the credit market, PG is also in the midst of a bearish stock market. From the fact that investors were anxious about the market and only willing to offer $27.50, which is below the market price, justifies that market participants have lost confidence in the stock market. Due to this market condition, PG will receive less capital funding if they were to accept the offer from the investment group. Overall, the market conditions are not in PG’s favour. The loss of confidence in both credit and stock market has negatively impacted PG.

6.0 RECOMMENDATIONS

In terms of reducing PG’s debt if the bank want the debt figures lowered to the required levels before 2015 then Pacific Grove must do something more aggressive reduce interest bearing debt levels. It is recommended that the company explore ways to reduce its need for working capital financing. They should see if there are ways of improving their supply chain efficiency and forecasting so that they can reduce their inventory levels. They should look to negotiate with suppliers to reduce the rate they are paying for inventory. PG should also see if they can extend the length of their accounts payable.

Even if they have to pay a slight price premium, if the rate (APR) is less than what the banks are charging them in interest, it could help to both save money and reduce their capital needs. They should also see if they can adjust the credit policy terms with their customers to shorten the number of days before payment. By reducing receivables and increasing payables they should be able to reduce their financing needs from the bank in notes payable and thus lower their interest-bearing debt. Another option to help PG meet the bank’s demand faster would be to accept the offer by the investment and raise funds by selling common stock. This would store up more cash for future usage and PG will be able to reduce their debt levels in the following years.

7.0 CONCLUSION

Overall, it is recommend that PG accepts the investment group’s offer of $27.50 and issue 400,000 common stock to raise $11M for reasons mentioned earlier in the report. The extra funds will give PG more capacity to fund the television program in addition to reducing its debt to meet their bank’s requirement, as well as purchasing an underpriced High Country.