iii. siebbdes: \"S3igees CHARTERED . ; HERR COMPTABLES = \"tT PROFESSIONAL a i A PROFESSIONNELS Ld fom [Le ACCOUNTANTS | Nene ee r-rel Finance Integrated Problem 4 Scenario (100 minutes) You, CPA, work as an associate with Campbell and Associates LLP, a financial and business advisory firm. The board of directors of Pembroke Pulp and Paper Inc. (PPPI) has engaged your firm once again to provide some guidance and assistance. You have been asked by your boss, Heather Larimer, to assist on this engagement for PPPI. Heather recently met with the board of directors of PPPI, who expressed concern about the pulp and newsprint industry. For the newsprint industry, sale volumes and selling prices have been falling, while costs have been increasing. After waiting many years for an improvement in market conditions, it has now become clear that the company cannot continue losing money. PPPI's ongoing poor performance has reached a point where it is now undermining the company's viability. The board is fully committed to maintaining operations but emphasizes that the company needs to become profitable and self- sufficient. The directors have concluded that the newsprint industry will continue to decline. One suggestion is to use the excess capacity in the plant to serve a different market, allowing PPPI to diversify and become less reliant on newsprint. PPPI's CFO and his staff have been exploring other uses of pulp, including the production of diapers. The diaper market is a growing segment, and products include infant diapers as well as incontinence products for the elderly and injured. Diaper prices are increasing with this increased demand, while costs to manufacture are declining, and there are only a few key competitors in the market. The directors believe that diapers represent a good opportunity for the company to participate in a growing global market and is the best way to leverage its existing infrastructure. However, before the analysis of the capital spending required to move into the diaper business can be completed, the directors want to understand how the cost of capital differs between the two businesses and the implications of any differences. The board has provided Heather with information on its assumptions on the diaper business's cost of capital (Appendix |) and PPPI's current cost of capital (Appendix II). Chartered Professional Accountants of Canada. All rights reserved. No part of this publication may be reproduced or transmitted, in any form or by any means, without the prior written consent of CPA Canada. For information regarding permissions, please contact permissions@cpacanada.ca. 2023-09-22 Finance Integrated Problem 4 Problem Task #1 Calculate the cost of debt and the levered and unlevered cost of equity for the diaper business. Because PPP is a private company, use the modified capital asset pricing model formula when calculating the cost of equity. Explain what the different costs of equity represent, why they are different, and how the injection of debt impacts financial risk. Your response should be no longer than one page, excluding any Excel files. Task #2 Calculate the weighted average cost of capital (WACC) for the diaper business. Explain how this rate can be used in assessing the expansion opportunity into the diaper industry. Compare and discuss the differences between the diaper business and PPPI for the following: 1. WACC 2. beta 3. cost of debt Your response should be no longer than one page, excluding any Excel files. Task #3 Discuss financial leverage and why it differs between industries. Discuss the three primary factors that are considered in determining the optimal proportion of debt versus equity for an industry, and compare these factors to both the pulp and newsprint industry and the diaper industry. Discuss what optimal capital structure means, the trade-offs between the benefits and risks of adding debt, and how increasing or decreasing debt affects the cost of equity. Calculate and explain the impact on PPPI's capital structure if it decides to go ahead with the expansion into the diaper industry. For your analysis, assume that the diaper business would represent 50% of the value of the combined business. Your response should be no longer than two pages, excluding any Excel files. \"i: ik. oeaRHE- CHARTERED . \"TERRE. COMPTABLES >= ; PROFESSIONAL Of4 _ A PROFESSIONNELS La fmm fd ACCOUNTANTS AGREES i Finance Integrated Problem 4 Problem Appendix | Diaper business cost of capital assumptions Relevant financial benchmarks for the diaper business: Bank of Canada 10-year bond yield 3.50% Peer beta for the diaper industry 0.70 Market risk premium 5.00% Small company size premium (Note 1) 9.81% Specific company premium (Note 2) 4.00% Prime rate 4.50% Debt risk premium (based on trading value of the public bonds) 2.18% Target debt to equity for the diaper industry 1.22 Income tax rate 25.00% Notes: 1. PPPI is considered a small company with a market capitalization of less than $250 million. 2. This premium is determined based on the nature of the business, the location of the business, the quality of the management team, the product life cycle, and other specific considerations relevant to the company. i CHARTERED * : ERR COMPTABLES "= PROFESSIONAL 3/4 ree A PROFESSIONNELS ACCOUNTANTS AGREES Finance - Integrated Problem 4 Problem Appendix II Pembroke Pulp and Paper Inc.'s cost of capital assumptions Summarized by the CFO: Peer beta 1.50 Cost of debt before tax 7.7% Proportion of debt 40% Proportion of equity 60% WACC 13.5% Income tax rate 25% Note that PPPI's current debt-to-equity ratio is in line with industry standards. CPA CHARTERED PEP COMPTABLES PROFESSIONAL 4/4 PROFESSIONNELS ACCOUNTANTS CPA AGREES PFP