Pacific Grove Spice Company

Executive summary

Spice industry has become a well potential business as people became more health conscious and popularity of cooking and culinary art increased. As it captured this trend successfully, from a small specialty grocer on the Monterey Peninsula of California in the early 1980s, Pacific Grove Spice Company had become a well-known publicly owned company, providing spices to all 50 states. In 2011, the company was in high growth phase, which indicates that the company’s financial option has improved along with the need of financing extra investment. At that time, the company, however, had issue with its financing. Firstly, due to the nature of its business, it requires significant amount of investment to support its sales and the sale was increasing at that time which called for more investment. Secondly, its retained earning (the internal financing) failed to cover the growth. In addition, the firm had trouble with the external financing as it was far from the bank’s requirement of debt-to-asset ratio and equity multiplier (Table 1). With Pacific’s current situation, would only be able to generate an equity multiplier of less than 2.7 times after the 5 years while the bank wanted to see the result in 2012 or they would take action by refusing extend additional credit (Table 2). Therefore, the company was urgently seeking for an appropriate solution to reduce its interest-bearing debt portion in short term while effectively maximize the shareholder value in the long term. Pacific was currently having 3 opportunities which need to be evaluated so that it reached it financing goal along with maximizing shareholder benefit.

Table 1.

Table 2.

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ID 22848150

THREE POTENTIAL OPPORTUNITIES

1. Sponsoring of new television program

Before considering on the sponsorship, we should consider Pacific’s current position compared to their competitors. Ex.1 and Ex.6 shows that the net profit margin of Pacific is relatively lower than the competitors despite the growing sale. Therefore, the company should consider this opportunity to boost its performance.

Table 3. Profit margin comparision

By sponsoring a television program, the company’s sales, profits and operating cash flow would be potentially increased. As can be seen from Ex.3, this project has tremendous IRR even if the sale is only 75% of expectation.

On the other hand, this project has some drawbacks. Firstly, the company has no expertise in show industry and cannot guarantee the projected performance will be correct. Furthermore, this investment requires substantial investment of $1.44 million as well as other expenses in further years. Given the company’s current financial situation, it is in tight budget. The cash flow from this project in first year would not be sufficient to cover the cost and better Pacific’s current debt level to achieve bank’s requirement in 2012.

Table 4 _ debt/asset ratio & equity multiplier of Pacific with TV program investment

Though this program is beneficial for Pacific, the lack of fund and high debt of Pacific make it impossible for Pacific to take on this project.

• Issuing 400,000 common shares at the price of $27.50

Another option of Pacific is issuing 400,000 common shares to a particular investment group with net proceeds of $11,000,000 as the shares are being sold at discount. This action would reduce the company’s level of debt while generate sufficient fund to finance its growth of sales. According to table 5, it would reach the requirement in 2012 with 52.38% debt level

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and 2.5 equity multiplier due to to cash injection from the share issuing. The second scenario in table 6 is that the company use the cash injection to retire its long-term debt and the result is more sufficient with 43.58% and 2.15. However, lower debt level can affect the company profitability. Therefore, the company should analyze further the debt/equity proportion to maximize profit (using tool such as Solver). For example, company can use

$5million to invest and use $6 million to retire some long-term debt which not only make company reach its debt level requirement but also have extra cash for investment (Table 7). Table 5. 1^st scenario PACIFIC GROVE SPICE COMPANY with extra cash from issuing share based on Appendic 2

Table 6. 2^nd scenario PACIFIC GROVE SPICE COMPANY retire debt

Table 7. 3^rd scenario Pacific use $11m from issuing share: invest $5m and $6m to retire long-term debt

In spite of all the benefits, this option still have several negative impacts. The first one is the dilution of ownership (table 8), the percentage holding of the investment group would be higher than the holding of Founder and Peterson which give them right to take part in board voting as well as management decision making.

Table 8.

Table 9.

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ID 22848150

Nevertheless, it would also lead to a decrease in EPS (Table 9). In addition, when a company further issue shares, it would send false negative signals to outsiders that the company is not doing well and lose investors’ confidence and eventually a further fall in share price.

• Acquire High Country Seasoning

The last option is to expand the business through the acquisition of a small successful company High Country Seasonings in the form of common shares with a sale price of

$13.2 million resulting in 404,902 shares at the current price of $32.60 per share. Apart from the fact that it has the same dilution issue with the 2^nd option, it would be a better option as it put company in the position of increasing it profitability in the future. The figure in Ex.4 and Ex.5 reveals that High Country Seasonings (HCS) was not only having an increasing sale but also having no long-term debt that can worsen Pacific’s situation. After consolidating the balance sheet and income statement of both companies in Appendic 3, it can be concluded that both debt-to-asset ratio and equity requirements have been met and the profitability would be improved.

We further analyze this option using the discounted cash flow method to ensure that the company is not overpriced. (WACC is calculated in Appendic 3). As the firm value is 25.93 the firm is not overpriced. Hence, this acquisition can be a good choice for Pacific. However, it is necessary to address the dilution issue.

Influence of economic

After the global financial crisis in 2008, the most banks and corporation business have been slowed down. The growth rate of business has been decreasing. Furthermore, the banks

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have tightened its banking policy as required by the regulators which effected the financial funding source of company. It explained the situation the company was in.

Plus, the beta used to calculate Pacific’s required rate of return could have high volatility, leading to variation in NPV of acquisition of High Country which make the result become less reliable. The fluctuation of the economic also affect the precise of the projection which make it difficult to predict future outcome accurately.

Recommendation

In short term, the company can exercise option 3 as it brings the most benefit for the company in terms of profit. Or the company can combine option 1 and 2 by funding the TV program using the cash injection from share issue. As mentioned above, this is totally possible since after retire some long term debt to reach the requirements, the company would still have extra cash to fund any project. It depends on the firm situation to allocate how much cash for investment and how much cash to retire debt, which need to be further analyzed.

The company can also propose convertible debt to swap into equity to reduce the level of debt in the company.

Another point is that the firm can adjust its term of sale so that its account receivable can pay faster and its payable term can be longer. This in turn reduce working capital needs as account payable can be seen as a form debt.

In the long term, the company can buy back its share when it passed its growth point and has stable revenue. This can boost company share price.

Appendices

Appendic 1 . FUNDING TV PROGRAM OPTION

Pacific income statement after incorporating TV program funding

5

The balance sheet

Appendic 2 . Issuing 400,000 common shares at the price of $27.50

Scenario 1

6

Scenario 2

7

Scenario 3

8

Appendic 3

WACC CALCULATION

9