URGENT - I have attached to this submission 3 documents: 1. Assignment questions I want you to answer, 2. The case document itself in a PDF, and 3. The case exhibits in excel format.

As she sat in her office during July of 2011, CEO Debra Peterson reflected on the opportun ities and

challenges facing Pacific Grove Spice Company. Cooking and the culinary arts had been riding a wave of

popularity and growth for several years, and as a manufacturer, marketer, and distributor of high -quality

spices and seasonings, Pacific had benefited from a mass change in perception : food as fuel was “out,” and

food as a celebration of taste and camaraderie was “in.” Peterson and her staff had identified attractive internal

and external opportunities for the company, but like many firms growing rapidly, Pacific’s financial position

and ability to fund this growth was stretched to the breaking point.

Pacific Grove Spice Company

Pacific had opened for business as a small specialty grocer on the Monterey Peni nsula of California in the

mid -1980s, selling a selection of foods, coffees, teas, and spices. Within 10 years the company became known

as “the” place to find spices in Central California, and spices dominated the company’s sales mix. B y the 2 5th

anniversary of its founding, the company’s reputation, sales, and shipped orders cov ered all 50 states , with

over 9 0% of sales made to high -end grocery stores — such as Whole Foods Market — and the remainder through

an internet sales platform .

Debra Peterson had been hired to manage the company’s retail distri bution channel in the late 1990 s, and

soon after she assumed the role of Chief Operating Officer. In 2006 the founders stepped away from a ctive

management, naming Peterson president and CEO of the company. The transition had gone very well;

Pacific’s sales and profits had increased a t a rapid rate, and this growth was forecast to continue. The

company’s most recent income statements and balance sheets, and four years of projections, are presented in

Exhibits 1 and 2.

Pacific’s mission statement emphasized a commitment to the highest qu ality and freshest spices. Its

business model required significant investment in accounts receiva ble, inventory, and net property &

equipment to support sales, and as the company’s sales increased, i ts assets also increased . Although the

company was profitable and all of its net income was re -invested in the firm, retained earnings were not

sufficient to fund the growth in assets nece ssary to support growing sales. The remainder of Pacific’s fi nancing

was provided by a region al bank, through short -term notes payable backed by the company’s accounts

receivable, and long -term debt supported by the firm’s other assets and earnings power.

The bank was willing to lend up to 81% of the company’s accounts receivable balances, and giv en its robust

growth in sales and assets, Pacific was continually at this limit. The bank liked to see notes payable below the

limit in the loan agreement, but the receivables were of excellent quality and the bank was comfortable with

the amount borrowed . In addition, all of Pacific’s bank debt carried an interest rate of Prime plus 500 basis

points (Prime + 5%), earning a significant margin above the bank’s cost of money.

The bank was not comfortable , however, with the total amount of interest -bearing d ebt on Pacific’s balance

sheet. Beginning with the financial crisis of late -2008, banks had been under increasing pressure to limit

exposure to potential loan losses. At the end of its most recent fiscal year the company had total debt of $37.172

million , equal to 62% of total assets and 216% of owners’ equity. In addition, Pacific’s equity multiplier

(calculated as total assets divided by owners’ equity) was 3.47 times , and times interest earned w as only 2.15

times. The bank recently told Peterson that it wanted to see an action plan to reduce interest -bearing debt to

less than 55% of total assets and the equity multiplier to less than 2.7 times by June 30, 2012 . If this requirement

was not met, the bank would refuse to extend any additional credit to Pacific, forcing the company to find a

new source of funding at a time when credit was difficult to obtain.

Pacific’s four -year financial projections in Exhibits 1 and 2 had been prepared join tly by Peterson and CFO

Fletcher Hodges, and they agreed the f orecasts were reasonable and attainable . They expected the growth rate

of sales would gradually decrease over the next four years, from the robust 19% achieved in fiscal 2011 to 9%

in fiscal 2015 , and that operating income would stabilize at 8.4% of sales . As the growth rate of sales decayed,

the additional investment required each year to support sales would also decrease, and Peterson wondered if

this combination of slower sales growth, slower asset growth, and additional profitability would be sufficien t

to quickly reduce the company’s interest -bearing debt percentage and equity multiplier to the numbers

demanded by the b ank.

Beyond the financial constraints imposed on current operations by its bank, Peterson and Hodges were

also evaluating three opport unities:

1. Should Pacific accept an offer from a cable cooking network to produce and sponsor a new program?

This opportunity would increase the company’s sales, profits, and cash flow above that presented in

Exhibit 1 , but would require investment in television equipment, capacity and working capital.

2. Should Pacific raise new equity capital by selling shares of common stock?

3. Should Pacific acquire High Country Seasonings — a privately owned spice company with sales

revenue approximately 22 % of Pacific’s?

There’s no Business l ike Show Business

A well -known cooking network had signed a popular young chef, Lesley Buller, to a five -year contract to

star in a new half -hour program. Negotiations with the network had produced a tentative agreement, and the

fina nce team had prepared an investment analysis of the proposed deal.

Everyone believed the new program would have a significant positive impact; incremental sales created

by the program in year one were expected to be $8,100,000, equal to one -tenth of Pacific’s sales in fiscal 2011,

with these sales growing at a 5% annual r ate in the remaining four years. Cost of goods sold and promotional

expense would be 58.5% and 11%, respectively, of each year’s sales. General and administrative expense

would be $760,000 in year one of the program, and would increase at a 5% rate per y ear. Depreciation expense

on the capital investment associated with the program was not included in any of these cost numbers, and

Pacific’s marginal income tax rate would be 27%.

The up -front capital investment required to produce the program was relat ively modest. Television

equipment and productive capacity were expected to cost $1,440,000 and this investment would be

depreciated straight -line over five years to zero salvage value. Pacific must also invest in more working capital

to support the addit ional sales, with the investment in any year driven by the increase of sales or costs of goods

sold in that same year compared to the prior year. The forecast bases for this working capital investment were

that accounts receivable would equal 75 days of s ales, inventory would turn over 4 times, and accounts payable

would equal 30 days of cost of goods sold.

The investment analysis of the new television program is presented in Exhibit 3 , and Peterson was very

pleased with t he cash flows, IRR and NPV . The 41% IRR was outstanding, and the NPV was large and positive

at any reasonable cost of capital. “We’re going into show business,” thought Peterson, “if we can find a way

to finance it.”

Selling New Common Stock

One alternative to finance growth and reduce debt was to sell new common stock to outside investors.

Pacific’s common stock was traded on the NASDAQ, and with 1,165,327 shares outstanding and a current

stock price of $32.60, the company’s market value of equity was almost $38 million. Insiders own ed approximately 30 % of these shares, with the remainder owned by outside investors. Pacific’s common stock

was sufficiently active that its common stock could be easily bought or sold through stock exchanges or

electronic communication networks (ECNs).

Peterson hoped the liquid market for Pacific’s common stock would facilitate its sale, but she knew that

financial markets had been experiencing very high levels of volatility since the financial crisis of 2008 , which

she assumed would make the sale of ne w common stock more difficult and possibly more expensive. One

month ago Peterson had met with William Rodriguez, a college classmate and San Francisco investment

banker, to explore the possible sale of new shares, and she had just received his report and offer : an investment

group was willing to purchase 400,000 shares at a price which , after subtracting transaction costs and fees,

would result in net proceeds to Pacific of $2 7.00 per share. Peterson had hoped to receive net proceeds much

closer to the company’s current market price, but Rodriguez told her that investors were especially anxious

right now, and after approaching several potential investment groups, this was the best h e could do. Peters on

respected Rodriguez, so she realized the company would not be able to sell new common stock to outside

investors on better terms.

High Country Seasonings

Peterson had one more opportunity to consider —the possible acquisition of High Country Seasonings , a

small and successful privately held firm located along the Colorado Front Range. The company had been

founded by Martha and Carol Atwood in 1991, and the company produced and sold a selection of quality

spices and unique seasonings. The most recent i ncome statements and balance sheets for High Country are

presented in Exhibits 4 and 5.

After 20 year s of hard work, the sisters agreed it was time to sell their 100% ownership stake in the business

and pursue other interests. They had contacted several larger spice companies about a possible sale, and a

strong mutual attraction developed between High Country and Pacific. High Country’s products and brands

would be a nice extension of Pacific’s own offerings, and the Atwood sisters liked the idea of bei ng acquired

by Pacific; as long as the price was right. Negotiations between the parties revealed that the Atwood sisters

woul d sell their company for $13.2 million, and they were firm on this price. This number represented 16

times High Country’s fiscal 2011 net income, which was equal to Pacific’s price -earnings ratio, and barely less

than industry -leader McCormick & Company’s P/E ratio of 17. The Atwood s told Peterson and her team,

“T he price is 16 time earnings. This multiple matches yours, and is j ust below McCormick’s. We’re a well -

run and profitable company, and we’re happy to be acquired by Pacific, but the price is 16 times earnings.”

The Atwood sisters also insisted on a common -stock -only transaction; their entire ownership interest in

High Co untry would be exchanged for 404,908 shares of Pacific worth $32.60 per share. This was very

important to Martha and Carol Atwood, as their receipt of Pacific stock would not be a taxable event. They

would recognize income and pay income taxes if and whe n they sold their Pacific stock in the future.

Peterson was confident that sales of High Country’s spices and seasonings would increase when they were

added to Pacific’s larger marketing and distribution network. She anticipated High Country’s revenues wo uld

grow by 7 .2% in year 1, 6 .4% in year 2, 5 .5% in year 3, and 4.9 % in later years (fiscal years 2012, 2013, 2014 and

beyond, respectively). She also believed operating costs for High Country’s products would quickly converge

to Pacific’s expected relat ionship with sales, as follows:

2012 2013 and Beyond

Cost of goods sold 61.5% 58.5%

Research & development 1.0% 1.6%

Selling, general & administrative 30.1% 31.5%

Acquiring High Country also meant increasing operating asset and liability accounts to support sales ,

reducing free cash flows. When forecasting the asset accounts, Peterson anticipated that cash would equal 20

days of operating expenses, accounts receivable would be 75 days of sales, both inventory and net property &

equipment would turnov er 4 times, prepaid expenses would be 1.2% of sales, and other long -term assets

would equal 4.5% of sales. For the liability accounts, accounts payable would equal 30 days of cost of goods

sold, and accrued expenses would be 1.66% of sales.

Discounting the expected free cash flo ws from the acquisition at the appropriate cost of capital would

reveal the value of High Country to Pacific. If this amount was greater than $13.2 millio n, then Pacific should

accept the Atwoods ’ price and buy the company. The forecasts of sales, expenses, assets and liabilities were

sufficient to calculate free cash flows, but Peterson also needed to determine the correct risk -adjusted discount

rate. The cost of equity capital could not be directly calculated for High Country, since its equity beta

coefficient was unobservable. The finance team had, however, collected financial information and equity beta

coefficients for three peer firms in the industry, as well as other current financial market information, which is

presente d in Exhibit 6 . Peterson also knew that High Country paid an interest rate of Prime + 4% on its bank

loans —less than Pacific —due to its limited use of debt finance.

Peterson wondered how the acquisition would impact Pacific’s financial statements. CFO Hodges told her

that once the acquisition was completed the two firms’ financial statements would be consolidated; High

Country’s income statement items would all be added to Pacific’s, and the value of its assets and liabilities

would be added to Pacific’ s balance sheet. If the Pacific stock issued to the Atwoods equaled High Country’s

book value of equity, then Pacific’s common stock would increase by the value of the stock issued , and the

balance sheet would balance. But if the value of the Pacific sto ck issued was greater than High Country’s book

value of equity, then common stock would still increase by the value of the stock issued, and the excess amount

would be allocated to the intangible asset goodwill on Pacific’s balance sheet. This goodwill wo uld not be

amortized like other physical assets; as long as the goodwill was not impaired , it would remain on the balance

sheet, and Peterson would agree to the acquisition only if the like lihood of succe ss was very high, so s he did

not anticipate future i mpairment and write -down of any goodwill created by Pacific’s purchase of High

Country.

When forecasting the consolidated financial statements, all net income would be retained, and bank notes

payable would be the amount required to make liabilities plus o wners’ equity equal total assets.

After working through these issues, Peterson thought to herself, “ The bank wants our debt percentages

reduced, we have a great opportunity to partner wit h Lesley Buller, we can sell 400,000 new shares of common

stock to outside investors, and for $13 .2 million of our stock we can acquire High Country Seasonings. How

do we select among these alternatives for maximum shareholder benefit?”