EXECUTIVE SUMMARY

INTRODUCTION
This report is mainly about the financing plan for Stone Container Corporation operating in a
cyclical industry and experiencing financial distress in early 1993. To choose between
refinancing debt and issuing equity at a lower price, we study the corporate strategies and
financial policies pursued by Roger Stone and his predecessors. The analysis is based on
financial data of the Stone Company from 1983 to 1992.
ANALYSIS
We assume Stone Container’s sales volume approximates its 1992 production level of 7.5
million tons per year, and costs, other than interest expense, remain the same. According to
calculation of net profit and cash flow, we estimate in1993 a $50 per ton industry-wide increase
in prices will lead to net profit after tax of $112.8 million and a net increase in cash and cash
equivalents of $278.1 million. Based on the same assumptions, the effect of a $100 per ton
industry-wide increase will be net profit after tax of $356.5 million and a net increase in cash
and cash equivalents of $521.8 million. If production and sales volume increased to full
capacity of 8.3 million tons per year, a $50 and a $100 per ton industry-wide increase in prices
will respectively lead to the net profit after tax of $211.3 million and $481.1 million, and net
increase in cash and cash equivalents will be $376.6 million $646.4 million. We found that
Stone’s net income and cash flows have a high correlation with the industry-wide change in
prices. Under such premise, if the company's leverage ratio is too high, the company is at risk
of bankruptcy and default when the cyclical fluctuation of industry price reaches a low point.
Therefore, the company should reduce its leverage ratio to below 50%.
RECOMMENDATION
We believe that the issuance of convertible bonds may be the most effective method and Stone
can easily achieve its goal of reducing debt ratio through certain contract terms. We recommend
that Stone can set a relatively high conversion price or further reduce the interest expense in
the first few years by setting a stepped interest rate. When the stock price does not reach the
conversion price, the Stone Company can use the method of downwardly modifying the
conversion price to promote the conversion. If the initial funding pressure is tremendous, we
recommend that Stone resort to discussing loans with the bank and selling some assets. In
conclusion, combination of issuing convertible bonds, discussing loans with the bank and
selling some assets is an appropriate solution.

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 Q1：How would you assess Roger Stone? Do you think he has done well with the family

firm?
Before Roger took office, the company's overall business style was relatively stable because
of the obvious price cycle in the paper industry. At the bottom of the industry cycle, producers
generally prefer to lower prices rather than reduce production, causing that the industry itself
has higher fixed costs. The business strategy formulated by its founders is to "provide high-
quality services at reasonable prices while occupying the least amount of funds in inventory."
Although the company went public in 1947, its overall financial strategy was relatively
conservative, with family-owned shares accounting for 57% of the total equity and a high
degree of control.

After Roger took office, he began to acquire other manufacturers with high leverage. Mergers
and acquisitions are a faster way to expand. It may take three years to build a new factory, but
acquisitions only take a short time to increase production capacity and costs only one-fifth of
the cost of building a new factory. Initially, Roger's strategy achieved certain results and
thereby increased the company's own production capacity. The acquisition of Bathurst
enabled Stone to enter the European market. At the same time, it could achieve greater
expansion at a lower cost and was highly competitive in the same industry in the North
American and European markets. Its EBITDA/Net sales also showed rapid growth, which
reflected the improvement of the company's business capabilities.

However, the excessive fixed assets and large amount caused by large-scale expansion also
made Stone face huge financial pressure when the industry cycle declined. The company's
debt-to-asset ratio has risen sharply (the long-term debt/total capital ratio reached a record
high in 1992), and tremendous interest expenditures seriously affected the development of
Stone. Its acquisition of Bathurst caused a premium of 47% at the peak of the industry cycle,
which was incompatible with Stone's consistent principles. At the same time, the increase in
debt also increased the company's future financing costs, and the family's share of the
company's equity recessed to 30%. These are undoubtedly very dangerous to the Stone
Company and its family.

Q2: How sensitive are Stone Container’s earnings and cash flow to the paper and
linerboard pricing cycle? Estimate for the next twelve months the effect on earnings and

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 cash flow of a $50 per ton industry-wide increase in prices. Assume Stone Container’s
sales volume approximates its 1992 production level of 7.5 million tons per year, and costs,
other than interest expense, remain the same. Also assume a 35% tax rate.

Stone Container’s earnings、cash flow and paper and

linerboard pricing
$600.0 400.0
$500.0 300.0
$400.0 200.0

million
Price

$300.0 100.0
$200.0 0.0
$100.0 (100.0)
$0.0 (200.0)
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

Paper Price/Ton
Linerboard Price/Ton
Net Income
Net increase (decrease) in cash and cash equivalents

We can see from the known data, the company's net income and cash flow have a very high
correlation with the paper and linerboard pricing cycle (as can be seen from the picture), and
our following correlation calculations using the prices as variables will also prove this point.

From the article, we can assume that the interest expense in 1993 was $400 million. If we have
a $50 per ton industry-wide increase in prices, we can calculate:
The net sales = 5520.7+50*7.5=5895.7 million and the EBITDA is 877.7.
The net income=EBITDA-Depreciation and amortization-Interest Expense = 877.7-304.2-
400=173.5 million
The Profit after tax=173.5*(1-TAX) =173.5*0.65=112.8 million

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 As for effect of price change on the cash flow, we assume that cash flows from operating
activities except net income, financing activities and investing activities other than new capital
expenditure remains the same. According to the information provided, we know that the
company was required to make $100 million of new capital expenditures to obey new
secondary-waste treatment regulations in Canada. Therefore, cash flows from investing
activities will decrease $100 million. As the following table shows, the effect on cash flow,
which is net increase (decrease) in cash and cash equivalents, equals $278.1 million.

Effect on Cash Flow

1992 1993

Cash flows from operating activities

Net loss ($170.5) 112.8
Adjustments to reconcile net loss to net cash provided
by (used in) operating activities:
Depreciation and amortization 304.2 304.2
Deferred taxes (37.0) (37.0)

Foreign currency transactions (gains) losses 15.0 15.0

Other—net
Changes in current assets and liabilities—net of 55.7 55.7
investments Decrease
for acquisitions and divestitures:
(increase) in accounts and notes
receivable—net (66.6) (66.6)
Decrease (increase) in inventories 10.5 10.5
Decrease (increase) in other current assets 9.2 9.2
Increase (decrease) in accounts payable and
other current liabilities Net cash provided by (34.9) (34.9)
operating activities 85.6 368.9

Cash flows from financing activities

Borrowings 1,024.8 1,024.8
Payments made
Non-recourse on debt of consolidated
borrowings (909.2) (909.2)
affiliates
Payments by consolidated affiliates on 40.0 40.0
non-recourse debt (13.6) (13.6)
Proceeds from issuance of preferred stock 111.0 111.0
Proceeds from issuance of common stock 0.1 0.1
a
Cash dividends Net cash provided by (30.7) (30.7)
financing activities 222.4 222.4

Cash flows from investing activities

Capital expenditures:
Funded by project financings (79.1) (281.4)
Other (202.3) (100.0)
Total capital expenditures (281.4) (381.4)

Payments made for businesses acquired (27.2) (27.2)

Proceeds from sales of assets 9.5 9.5
Other—net (10.7) (10.7)
Net cash used in investing
activities (309.8) (309.8)

Effect of exchange rate changes on cash (3.4) (3.4)

Net cash flows

Net increase (decrease) in cash and cash
equivalents (5.2) 278.1
Cash and cash equivalents, beginning of period 64.1 58.9
Cash and cash equivalents, end of period $58.9 337.0

Question 3. What would be the effect of a $100 per ton industry-wide increase under
the same assumptions given above?

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 This scenario is similar with the previous one, we only need to enlarge the price increase to 100.
The net sales = 5520.7+100*7.5=6270.7 million and the EBITDA is 1252.7.
The net income=EBITDA-Depreciation and amortization-Interest Expense
=1252.7-304.2-400=548.5 million
The Profit after tax=548.5 *(1-TAX) =548.5 *0.65=356.53 million
As for effect of price change on the cash flow, we just need plug new date into the Excel to get
result. (Answer displayed with that of question 4)

Question 4. What would be the effect under both these pricing scenarios if production and
sales volume increased to full capacity of 8.3 million tons per year (for simplicity, assume
costs per ton remain constant)

Case 1: $50 price increase：The net sales = 8.3*(5520.7/7.5+50) = 6524.57 million and Cost

of products sold=4474.5*8.3/7.5=4951.78 and the EBITDA is 1029.29.

The net income=EBITDA-Depreciation and amortization-Interest Expense
= 1029.29-304.2-400=325.09 million
The Profit after tax=325.09*(1-TAX) = 325.09*0.65=211.31 million

Case 2: $100 price increase：The net sales = 8.3*(5520.7/7.5+100) = 6939.57 million and
Cost of products sold=-4474.5*8.3/7.5=4951.78 and the EBITDA is 1444.29.
The net income=EBITDA-Depreciation and amortization-Interest Expense
= 1444.29-304.2-400= 740.09 million
The Profit after tax= 740.09*(1-TAX) = 740.09*0.65= 481.06 million
Effect on earnings of four scenarios

($50/Ton Increase） ($100/Ton Increase）

1993（7.5 1993（8.3 Million 1993（7.5 million 1993（8.3 million

(Year Ends
Million Tons） Tons） tons） tons）
December 31) 1992
Summary of Operations
Net Sales 5520.70 5895.70 6524.57 6270.70 6939.57
Cost of products sold -4474.50 -4474.50 -4951.78 -4474.50 -4951.78
Selling, general and administrative
-543.50 expenses
-543.50 -543.50 -543.50 -543.50
EBITDA 502.70 877.70 1029.29 1252.70 1444.29
Depreciation and amortization
-304.20 -304.20 -304.20 -304.20 -304.20
Interest Expense -386.10 -400.00 -400.00 -400.00 -400.00
Net Income -170.50 173.50 325.09 548.50 740.09
Profit after tax 112.78 211.31 356.53 481.06
Interest coverage 1.43 1.81 2.37 2.85

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 Effect on cash flow of four scenarios

Question 5.What are the options for funding going forward? Which option would you
recommend Stone Container pursue?

We can see that the cyclicality of the paper industry still exists, so Stone's goal is to avoid going
bankrupt or default at the bottom of the industry, reduce the company's financial pressure, and
wait until the price cycle recovers to achieve stable development of the company. In this case,

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 Stone's primary goal is to reduce its ratio of leverage. We find that the Debt/Total Capital of its
main competitors are generally below 50% and their ratios of Market Value D/V are at 30%-
40%. Obviously, Stone needs to issue shares to adjust its capital structure.
We believe that the issuance of convertible bonds may be the most effective method and Stone
can easily achieve its goal of reducing debt ratio through certain contract terms. For example,
stone can set a relatively high conversion price (because of the nature of cyclical products in
the paper industry, the market welcomes convertible bonds in the cyclical industry and the
interest rate of convertible bonds is relatively low). We can further reduce the interest expense
in the first few years by setting a stepped interest rate (the annual interest rate gradually
increases with the number of years, such as 2% in the first year, 5% in the second year, and 10%
in the third year). Besides, once the stock price does not reach the conversion price, the Stone
Company can also use the method of downwardly modifying the conversion price to promote
the conversion. This method is obviously more flexible for the stone company and has relatively
low the financial cost and when the stock price rises, the amortization of original equity is
relatively small.
We believe that issuing common stock to reduce leverage may not be the best choice for Stone.
Because the issuance of common stock may trigger further market concerns about the
company's financial pressure, which will cause chain pressure. Moreover, the issuance of
common stock will further dilute the equity of the Stone family, which is detrimental to the
management of the company.
If the initial funding pressure is heavy, we recommend the method of discussing loans with the
bank and selling some assets to alleviate the temporary funding pressure. In conclusion,
combination of issuing convertible bonds, discussing loans with the bank and selling some
assets is an appropriate solution.

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