Pressed Paper Products, Inc. (PPP) operates a paper mill on the White River in central New Hampshire.

Mount Washington and the Presidential Ranges can be seen on the horizon to the north of the plant. The plant
has been operated continuously since 1710 and produces many non-woven paper pulp products. Its most
famous product is tea bag paper, which the company started producing in the late 19
th
century.
Tea bag paper is manufactured from trees and recycled paper pulp. Sheets of fibrous, non-woven
material are pressed and cut to tea bag size, and then sold to tea manufacturers where they are filled with
chopped tea leaves, sealed, and strings or tags are attached. The fibrous paper is completely porous and
allows water to flow freely through the tea, while the leaves are contained within the bag. The tea bag method
of tea brewing is used primarily in Europe and the Americas. Asian cultures normally prefer to brew tea with
whole leaves and without paper filtering bags.
PPP is one of the oldest companies on the American Stock Exchange but has been publicly traded for
only 50 years. It has broadened its product line to include numerous specialty materials, including medical
gauze, egg carton board, cigarette wrappers and filters, and food and beverage can varnishes. The company
also owns controlling interest in a very profitable Silicon Valley technology firm. Although now a diversified
company, tea bag paper is the root of the company.
Currently, three companies produce 88% of the tea bag paper in the world: Pressed Paper Products,
The Great Paper Company of Edinburgh (located in Scotland) and Lincoln Paper and Fiber (located in
northern Illinois). The tea bag paper market is nearly evenly split among these three companies, and prices
have been driven to commodity levels that are only slightly more than the variable costs of production. For
years, rumors have persisted about Edinburghs financial struggles and that management may entertain
acquisition offers. Last year their investment bankers began discussing the possibility of a sale with potential
buyers. Because of the Edinburghs debt levels (85% debt to total capital) and slipping market share, PPP was
hesitant to pursue an acquisition. However, management believes that Lincoln Paper and Fiber is considering
the acquisition. The Board of Directors is concerned that if their primary competitor controls a major interest
in the market, additional price and cost pressure will hurt PPPs tea bag paper unit. Therefore, PPPs Board of
directors is considering the acquisition to keep Lincoln from increasing their market share. To help in the
decision process PPP is interested in determining whether the return generated from the purchase will cover
Lincoln's cost of capital. Analysts believe that, given current market and company conditions, Lincoln is at its
target capital structure and the company will maintain this mix of debt and equity.
Relatives of Lincolns founder own forty percent of Lincoln's equity. The company has a high
dividend payout ratio that provides a major source of income for these family members, and therefore, it is not
expected to change. Additionally, it recently completed an acquisition of another paper company bringing tea
bag paper to about 25 percent of company sales. Because of this purchase, near-term free cash flow is tight,
new debentures were issued and the company maintains a two-year-old callable bond that was issued with a
five year deferred call provision requiring a call premium of one-year interest. Assimilating the acquisition
Case 100
Cost of Capital
Directed
Pressed Paper Products, Inc.
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was more difficult than what analysts initially believed and share price has dropped since the acquisition was
first announced.
Based on information obtained at a recent trade fair, PPP estimates that Lincoln will require $20
million to maintain its core business operations. These essential activities must be funded. After that, the
company will consider other optional but interesting capital projects requested by its division managers. A
table of estimated available projects with corresponding capital requirements and expected returns is listed
below:

Investment Opportunity Schedule
Capital Required Rate of Return
Essential Projects $20 million 9.25%

Edinburgh Acquisition $150 million 9.00%
New Paper Machine $55 million 12.25%
Plant Construction $120 million 10.50%

Assume it is 2004 and interest levels are at historically low levels. PPP's management has asked you
to prepare a report analyzing whether Lincoln can profitably take on the purchase of Edinburgh and whether
PPP should pursue the acquisition to preserve its market position. Since the report will be presented to the
Board of Directors, it is critical to address all of the issues that affect capital costs. In the process of preparing
your report, you have gathered the following supplemental information from publicly available sources:

1. The current bond quotes for the callable bond followed by the debentures:
BONDS Coupon Maturity Est. Vol.
(000s)
Last Price
Lincoln National (LCN) - callable 10.500 2019 90 112.500
Lincoln National (LCN) 7.7500 2020 530 98.400

This senior debt is not mortgage debt or otherwise covenanted. Assume that the book value of property,
plant and equipment is approximately equal to its market value and a 50 basis point (0.5%) discount is
available for mortgage debt. However, total mortgage debt cannot exceed 10% of the book value of
equity.
Based on discussions with market analysts and investment bankers, PPP believes that the costs associated
with a debt issue, including legal fees, investment bank fees and other costs, are 2% of the proceeds of the
debt issue. The company considers these costs relevant to the cost of debt.
2. Lincoln's current debt rating is BBB. This is the lowest debt rating that is considered investment-grade.
Based on other debt issues, analysts expect that the ratings agencies would allow an additional
$50,000,000 in straight debtures before grading any additional subordinated debt lower. A lower debt
rating for the subordinated or junior debt would add 300 basis points (3.0%) to the expected yield of the
companys senior debt.
3a. Quotes on long-term Treasury Bonds (decimal represented in 32nds). The company assumes the bond
closest to a 10-year maturity represents the risk-free rate.
Rate Maturity Bid Asked Change Ask Yield
3.250 Aug 07 104:12 104:13 +.08 1.74%
10.625 Aug 15 165.28 165.30 Unch 3.39%
5.375 Feb 31 112.19 112.20 +.017 4.56%

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3b. Quotes on Treasury bills
Maturity Bid Asked Change Ask Yield
Jul 08 1.08 1.07 Unch 1.07%
Sep 23 1.12 1.11 Unch 1.11%
Jan 13 1.15 1.14 -0.02 1.167

4. Lincoln's current common stock quote:
52-week YLD VOL
HI LO Stock (SYM) Div % PE (100s) Close
9.06 19.13 Lincoln (LCN) .70 6.63 12.28 127 10.56

5. The company prefers dividend payout ratios of 22 percent, however last year the company faced unique
circumstances resulting in a higher payout ratio. The company prefers share repurchase to dividend
payout increases in years that earnings are abnormally high. Generally, the company has returns on equity
of around 12.5%.
6. Assume a historical market risk premium of 7.1% (according to Stocks, Bonds, Bills, and Inflation
Yearbook, Ibbotson Associates). Lincoln has a beta of 0.89, as reported by Market Guide analysts.
Assume the corporate beta will be stable for this transaction, as analysts estimate that paper products
follow similar volatility patterns across the paper production industry.
7. Wall Street growth projections for Lincoln's earnings suggest long-term corporate growth of 5%,
according to Bloomberg Network.
8. Equity flotation costs are expected to be 7% of proceeds.
9. Ibbotson data indicates that historically bonds have yielded about 7 percent more than stocks, but their
report indicates that the historical risk premium may be too high. Thus, the company feels a 4% premium
is more representative.
10. Lincoln has a corporate tax rate of 34.6%.
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Lincoln Paper and Fiber - Consolidated Balance Sheets (December 31)
(in thousands)
2003 2002
ASSETS
Cash and cash equivalents $ 10,079 $ 9,234
Marketable securities 58,932 65,457
Accounts receivable
a
183,727 168,874
Inventories 168,724 158,819
Other Current Assets 32,457 26,895
Prepaid expenses 3,560 2,426
Total current assets 457,479 431,705
Property, Plant & Equip. 758,197 785,818
Accumulated Depreciation 375,537 359,275
Net Prop & Equip 382,660 426,543
Other non-current assets 201,098 166,461
Total assets $ 1,041,237 $ 1,024,710

LIABILITIES AND SHAREHOLDERS' EQUITY
Notes Payable 30,137 25,247
Accounts payable 43,462 42,299
Current portion of long-term debt $ 13,432 $ 12,975
Accrued compensation, other expenses 69,807 67,022
Accrued 'Federal, state and local taxes 19,154 24,545
Other current Liab. 7,577 7,243
Total current liabilities 183,569 179,331
Deferred Charges 52,179 47,824
Long-term debt
b
330,000 330,000
Total liabilities 565,748 557,155

SHAREHOLDERS' EQUITY
Common stock
c
654 654
Capital in excess of par value 51,148 50,921
Retained earnings 423,688 415,980
Total Shareholders equity 475,489 467,555

Total liabilities and shareholders' equity $ 1,041,237 $ 1,024,710
a.
Less allowance for doubtful accounts.
b.
All bonds were issued at par. The mix of long term debt is one-third debentures and two-thirds
callable bonds all issued at par.
c.
Common stock has a par value of $.01; 120,000,000 are shares authorized and 65,421,877 are
shares issued.
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Lincoln Paper and Fiber - Income Statement
(in thousands)

Sales $652,189
Other income $52,465
Total income $704,654

Cost of products sold $506,796
Depreciation Charged $42,955
Selling, general and administrative expenses $44,171
Total Operating Costs $593,922
Earnings before interest and taxes (EBIT) $110,732
Less Interest $22,440
Earnings Before Taxes (EBT) $88,292
Taxes $30,549
Net Income before preferred dividends $57,743
Preferred dividends $0
Net income available to common stockholders $57,743

Common dividends $45,795
Addition to retained earnings $11,948


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QUESTIONS
1. Analyze Pressed Paper Products strategy in this acquisition decision. Is it
appropriate to consider the acquisition only to preempt the competition from
gaining market share?
2. On the balance sheet, all assets must be covered by the company's liabilities and
shareholders equity.
a. For capital budgeting purposes, identify the specific balance sheet liabilities that
typically are included and those that typically excluded in finding the WACC.
Explain your answer.
b. Find the book value and market value weights for the weighted average cost of
capital WACC.
c. Explain the weights that are preferred when determining Lincolns WACC.
3. Based on Lincolns current cost of debentures:
a. What is Lincoln's nominal after tax cost of debentures under semiannual
compounding?
b. What is the effective cost of debentures?
4. Based on Lincolns current cost of callable bonds:
a. What specific features distinguish a callable bond from a debenture? What is
the cost of debt based on Lincoln's current callable bonds?
b. Discuss why, all else equal, the cost for callable bonds is higher than that of
debentures.
5. What is the term structure of interest rates? Based on the long term Treasury Bond
information provided in the case, discuss the shape of the yield curve. Relate this to
the companys decision to issue callable vs. non-callable bonds.
6. Based on Lincoln's existing bonds, what is the best estimate of the company's cost of
debt? What are some of the problems with using existing debt to determine the cost
of acquiring Edinburgh? How else can PPP determine the cost of Lincoln's debt if
current bond quotes were not available?
7. Lincoln has the potential of issuing both mortgage debt and junior/subordinated
debt. Explain these types of debt and why the costs differ from the companys
debentures. What is the cost of Lincoln's mortgage bonds and of its subordinated or
junior debt?
8. Estimate the cost of new retained earnings under various methods.
a. Why is there a cost associated with retained earnings?
b. Determine the cost of retained earnings using the CAPM approach. Why should
Treasury bonds, rather than Treasury bills, be used? Discuss generally how the
analysts would determine Lincoln's beta. How would the calculated beta be
adjusted?
c. Calculate the cost of retained earnings using the DCF and the analysts expected
growth rate. Determine the cost of retained earnings based on a growth rate
from Lincoln's historical return on equity (ROE) of 12.5% and its preferred
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payout ratio. In this case why would the company prefer the analysts forecasts
of growth? What other methods can be used to find a growth rate? Why do
these methods differ from the cost found using the CAPM?
d. Find the yield on Lincolns debentures and find the cost of retained earnings
using the bond-yield-plus-risk-premium method. Explain the rational behind
this method.
9. Given the different costs found by the DCF, the CAPM and theond-yield-plus-risk-
premium method, what is your best estimate for the cost of internal equity? Explain
how you decided what weight to give to each estimating technique.
10. Estimate the cost of external equity under various methods.
a. What is your estimate of Lincolns cost of new common stock using the DCF
method and the analysts expectations of long term growth?
b. Based on the DCF what is the flotation adjustment for new common stock over
retained earnings?
c. Adjusting for flotation what is the estimate of the cost of external equity.
11. What are the limits of funding for equity and debt? Based on its market value
capital structure, at what points in required funding would Lincoln be required to
use more expensive capital to fund its capital budgeting needs.
12 The Marginal Cost of Capital schedule (MCC)
a. Explain and construct the MCC using the market value capital structure. Ignore
depreciation at this point.
b. Would the MCC schedule remain constant beyond the final WACC break point,
no matter how much new capital is raised? Explain. Again, ignore
depreciation.
13. The Investment Opportunity Schedule (IOS)
a. Explain and construct the companys IOS realizing that the essential projects
are required.
b. Using the IOS and MCC, explain which projects are acceptable.
14. How does depreciation affect the MCC schedule? If depreciation were included,
could this affect the acceptability of proposed capital projects? Explain.
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