UVA-F-1606

Rev. Dec. 4, 2012

CARDED GRAPHICS, LLC: SHEETER REPLACEMENT DECISION

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I don’t play to lose.
—Murry Pitts,
Carded Graphics owner and president

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Murry Pitts was passionate about his business. He firmly believed that to survive and
thrive in the folding carton industry, Carded Graphics needed to be the leanest, most agile, and
most efficient enterprise of its kind. This unyielding commitment was apparent in every aspect of
his company—from the engaged and enthusiastic employees to the state-of-the-art seven-color
Heidelberg printing press that was the centerpiece of his operations. Victory for Pitts was not so
much being a better company than others as it was simply ensuring that Carded Graphics was the
very best company it could possibly be.
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Carded Graphics was a modest-size competitor in the $160 billion U.S. folding carton
industry and specialized in smaller and highly customized orders. Manufacturing folding cartons
was not a complicated business, and the small-order niche was quickly being dominated by those
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that could provide a seamless information infrastructure linking client specifications to final
products. Speed to market and quality were essential dimensions of competition since
competition virtually eliminated price differences.

Despite the growing importance of technology, paper was still at the heart of the folding
carton business. Virtually every process was focused on paper, and virtually all the inventory
was paper in some stage of processing. The very first step of the carton-making process was
called “sheeting,” in which paper was cut from multi-ton rolls into appropriately sized sheets for
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the printing press. A significant decision facing Carded Graphics at the end of 2009 was whether
to replace the current sheeter with a newer and higher-capacity machine.

This case was prepared by Marc Lipson, Associate Professor of Business Administration, with the assistance of
Irene Mastelli (MBA ’10). It was written as a basis for class discussion rather than to illustrate effective or
ineffective handling of an administrative situation. Copyright  2009 by the University of Virginia Darden School
Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
[email protected]. No part of this publication may be reproduced, stored in a retrieval system,
used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying,
recording, or otherwise—without the permission of the Darden School Foundation.
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Folding Carton and Paper Industries

Until the late 19th century, product packages were made by hand, held together with
tacks and string, and used only for expensive items such as jewelry. With the introduction of
mass production, cartons could be cheaply printed, cut, glued, and shipped flat to purchasers,
who unfolded the cartons and filled them with their chosen final products. By providing an

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inexpensive package that displayed information, protected products, and extended shelf life, the
folding carton gave rise to the modern packaging industry and became a ubiquitous part of the
consumer landscape.

Demand for cartons was driven by commercial activity and population growth. Efficiency
of operation was essential given competitive pressures on prices. Generally speaking, there were

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few economies of scale in manufacturing: Large and small producers operated similar kinds of
plants—large producers just had more of them. The exception would have been firms that
specialized in extremely large ongoing orders and that achieved efficiencies by eliminating
flexibility and fully integrating the carton production process.

Because the paper used to make cartons and the completed folding cartons themselves
were bulky but inexpensive, transportation costs were a significant part of the total delivered
cost. The effective sales area for corrugated boxes, for example, was only about 150 miles from
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the production plant. The industry was fairly capital-intensive, with the average revenue per
worker close to $300,000. The technology for making paper products was well known, hence
most R&D focused on greater production efficiency. For the past several years, the focus had
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been on information management solutions that would allow carton manufacturers to integrate
their production processes with their clients. For example, software and hardware systems
directly linked client graphic specifications to the printing, cutting, and quality management
systems. While the industry was still essentially a manufacturing industry, the best companies no
longer fit the noisy and dirty industrial stereotype. Given the nature of the market, small
companies could compete successfully by making specialty products or serving smaller
geographical markets.
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Typically, paper made from reprocessed scrap paper was used in most cartons, while
food containers were made from a lighter and higher-grade sulfate board. The thickness of the
board was generally limited to 0.032 in. (0.81 mm), and folding cartons were limited to holding a
few pounds or kilograms of material.1 Different types of paper were produced by altering the
type of raw wood used, the pulping process, the chemicals used and added, and the rolling
process. The kraft (strength, in German) chemical pulping process was the most common
manufacturing process and used soft woods such as pine to produce paperboard and heavy paper.

About 4,000 companies manufactured paper products in the United States at the end of
2009, with combined annual revenue of $160 billion. The folding carton industry’s estimated

1
Deirdre S. Blanchfield, How Products Are Made: An Illustrated Guide to Product Manufacturing (New York:
Gale, March 2002).
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revenue at the time was $10 billion.2 The industry was only moderately concentrated as a whole,
but it was highly concentrated in specific product segments, where the largest 50 companies
often held close to 70% of the market. A typical manufacturer of paper products had a single
plant with 150 employees and $40 million in revenues.3

A major concern in the industry was the cost of inputs, specifically energy and paper

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prices. Even though oil and gasoline prices had plummeted in 2009, manufacturers were facing a
general trend of rising energy costs, particularly for transportation. New forms of electronic
communication and commerce were having a significant impact on demand for many grades of
paper. In particular, the newsprint segment had been affected by the switch from traditional
newspapers to television and Internet as sources of news and information. 4 This had caused a
decrease in the demand for paper. This phenomenon was counterbalanced by a general increase

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in demand for pulp and paper from the developing world. Furthermore, according to the
American Forestry & Paper Association, U.S. paper and paperboard production capacity
declined nearly 1% per year on average in the period from 2000 to 2008, and this trend was
expected to continue. The industry consensus, however, was that in the medium term, pulp and
paper prices were expected to remain unchanged.

Within the paper product market, the folding carton industry remained relatively strong
for a number of reasons. First was the environmental appeal of cartons. The availability of timber
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resources (virgin wood pulp) had generally been declining. Thanks to the U.S. government’s
environmental protection efforts, the industry had dramatically increased its use of recycled
fiber. Paper and paperboard recovery was 56% in 2008, up sharply from 39% in 1993. While
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flexible packaging in the form of plastic films had increasingly been chosen over more rigid
materials such as folding paperboard cartons and corrugated containers, for cost reasons (plastic
films weighed less and occupied less landfill space at the end of the product’s life cycle),
consumers still favored recyclable materials.

Second was that the surface of the carton provided “billboarding” opportunities. Graphics
and printing were bold and vibrant, and they allowed for enhanced visual effects such as
embossing, foil stamping, and holograms. The ability to attract consumers at the retail level
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remained strongly dependent on the use of color and other eye-catching elements. In fact, a
substantial portion of the folding carton market included product displays. Folding carton
manufacturers were becoming a critical part of a dynamic and complex supply chain. Doug
Rawson, president and CEO of Superior Lithographics, said that “with the growth of Sam’s
Club, Costco, Best Buy, Home Depot and Wal-Mart, the demand for high-quality graphics and
great looking packaging is exploding. Today, the package is the ‘display’ and the product
‘brochure’ is on the box.”5

2
Hoovers, “Paper and Paper Product Manufacturing Industry,” http://industries.hoovers.com/industrial-
manufacturing/paper-and-paper-product-manufacturing (accessed October 22, 2009).
3
PriceWaterhouseCoopers, “Global Forest, Paper & Packaging Industry Survey, 2009 Edition—Survey of 2008
Results.”
4
Standard & Poors, “Industry Surveys, Paper & Forest Products,” March 2009.
5
Mark Spaulding, “‘Superior’ Litho Print Now an Everyday Commodity,” Converting, May 22, 2009, 34.
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Carded Graphics

Carded Graphics provided cartons primarily to the food, medical, and consumer
electronics markets. The company operated in a 125,000-square-foot facility with 90 employees
just off the major North–South trucking line that flowed along U.S. Route 81. Pitts acquired this
facility in 2006, and he consolidated his North Carolina Pell Paper Box operation into this single

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location shortly thereafter. Financial reports for 2007, 2008, and 2009 are presented in Exhibit 1
(income statement) and Exhibit 2 (balance sheet). Carded Graphics experienced little growth
from 2007 to 2008 and saw a tightening of margins that resulted in a loss for the year. The results
were due to the slowing economy and the costs associated with bringing new capacity online. In
contrast, sales for 2009 exceeded 2008 by over 30%, and operating margins had returned to the
2007 level. Due to increased interest expense, however, net income had not improved at a level

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commensurate with sales, though profits had returned to nearly their 2007 level.

Driving much of the expected future success of the company was the purchase in 2008 of
a seven-color Heidelberg printing press with aqueous coating capabilities. The ability to switch
between ultraviolet inks and water-based inks dramatically expanded the company’s range of
possible graphics and printing substrates, which provided an important competitive edge. The
press gave the firm “a value-added sales opportunity for customers looking for higher gloss and
different printing substrates,” Pitts explained.6 The press was capable of printing 18,000 sheets
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per hour. Carded Graphics ran the press in two eight-hour shifts, five days a week. The process
was so completely automated that the operation required only two people: one to position pallets
of blank sheets at one end and to remove pallets of printed sheets at the other end, and one to
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prepare inks and manage quality control.

Of particular importance to Carded Graphics were the efficiencies associated with the
“make-ready” phase of printing: all the activities that prepared the press for printing. This
included the preparation of paper, setting up necessary inks, preparing the printer for a given
substrate, and ensuring proper color control. The Heidelberg was an exceptionally flexible
machine. One could completely change from one multicolor print job to another in 15 to 30
minutes, depending on the number of colors and type of ink and in much less time if the same
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inks were used. The press also facilitated exceptional control over the printing process to ensure
quality. In fact, Pitts often emphasized operating flexibility and quality jointly: “The Heidelberg
allows us to swap inks easily, which facilitates smaller jobs, and the integrated Heidelberg image
control and inspection systems ensure consistency throughout the process.”7 This emphasis on
quality was readily apparent from the newly constructed room (part of a 60,000-square-foot
recent expansion) dedicated to the printer: Clean, bright, and temperature-controlled, the room
was the only one in the United States at that time built to Heidelberg specifications.

6
“Folding Cartons: Carded Graphics Buys Heidelberg Speedmaster XL-105 Hybrid Press,” Film and Foil
Converter, May 1, 2009.
7
Case writer interview with Murry Pitts and Tony Rossi, Staunton, Virginia, July 29, 2009; unless otherwise
noted, all subsequent quotations derive from that interview.
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Another important part of the printing process was prepress: the activities that occurred
before the printing process could be initiated. This included design, graphics, and the preparation
of printing plates. This part of the process, which was directly linked to the quality control
systems of the printer itself, was the most technologically focused part of the business. In
general, one could visualize a folding carton operation as two processes running in parallel: a
manufacturing process that followed paper from its arrival to its shipment as a carton and an

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information process that followed the carton’s graphics and design from the client to quality
assessment of the final product. These processes are shown in Figure 1. As a critical link
between these two processes, Carded Graphics had invested in a Heidelberg platesetter that
generated aluminum printing plates directly from computer-generated graphics. Pitts was proud
of the integration of these two streams: “Every part of our process, from prepress to finishing,
can now connect and work seamlessly to create a finished product with faster turnaround and

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precise color management.”8

The vast majority of the Carded Graphics facility simply held paper in one stage of
processing or another. As shown in Figure 1, the major phases of the process were sheeting,
printing, cutting, and gluing/folding. During sheeting, paper shipped to Carded Graphics on rolls
was cut to size and placed on pallets for later input into the press. Of course, not all the paper
was cut into sheets—some was purchased already cut to size. After printing, sheets were moved
to the die cutter, where the cartons were stamped with a die that both cut out the desired shape
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and added crimps to facilitate and organize later folding. The freshly cut sheets were then folded
and glued in a manner that kept the carton flat but allowed the customer to expand the carton as
it was filled. The speed of the printing press dominated other steps, and one could essentially
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view every other operation as trying to keep up with the press.

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8
“Folding Cartons: Carded Graphics Buys Heidelberg Speedmaster XL-105 Hybrid Press.”
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Figure 1. Paper and information processes at Carded Graphics.

Paper Process Information Process

Roll Paper Sheet Client Concept

Paper

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Sheet Graphics Structural
Prototype

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Client
Approval

Print Plateset
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Die-cut Die-
cutting
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Plate

Fold and Quality

Glue Control

Finished
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Goods

Note: All operations occurred in-house except for the creation of die-cutting plates.
Carded Graphics worked closely with clients on concept development, beyond issues
related to implementation of client designs.
Source: Created by case writer.

Carded Graphics was by definition a made-to-order operation; that is, materials were not
ordered and work was not done until an order had been placed by a client. This minimized levels
of raw-material and work-in-process inventory. But Carded Graphics took on a level of finished
inventory management for its clients. Whereas Carded Graphics favored larger production runs
to minimize make-ready activities, the company’s clients preferred to take delivery in smaller
quantities. The end result was that Carded Graphics would often print the full orders clients
committed to, but would ship (and invoice for) smaller orders over time. This meant a fairly
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large finished-goods inventory. Even so, since Carded Graphics had substantial warehouse space
at the time, it could provide this implicit level of inventory management to clients at low
marginal cost, which provided an additional competitive advantage. In fact, Carded Graphics had
become a full-service third-party logistics provider for its biggest client: The company not only
maintained stocks of finished cartons, but it also packaged, labeled, and shipped the client’s
products.

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Sheeter Replacement

The decision facing Murry Pitts was whether to replace the current sheeter with a new
one that had higher capacity. Exhibit 3 shows a schematic of the proposed new sheeter. At the

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time, the sheeter was operating at capacity and processing 10 tons of roll paper a day. 9 Pitts
estimated he could probably increase his use of roll paper by 60% if he had additional capacity.
Precut paper cost about $1,010 a ton, whereas paper from rolls cost about $915 a ton.

The new sheeter would cost $700,000 installed and would be ready to operate in early
2010. Pitts estimated he would use the new sheeter for nine years and then sell it for $120,000.
Despite the nine-year useful life, the new sheeter would be depreciated over five years on a
straight-line basis. The new machine would take up more room than the old sheeter (15,000
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square feet versus 10,000) and therefore incur an additional overhead fee of $22,500 (at the
warehouse rate of $4.50 a square foot per annum).
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The old sheeter would be sold for $25,000, which was below the current book value of
$36,000. The old sheeter had had two more years of depreciation left at $18,000 a year. Pitts
recognized that comparing a new machine with an nine-year life to an old one almost fully
depreciated was not quite appropriate since the old machine would not be expected to last nine
more years. Operations Manager Tony Rossi estimated that if he spent $125,000 in both 2011
and 2015 to refurbish the old sheeter, it would last another nine years.

The capacity of the new sheeter would be 40 tons a day running two shifts at 20 tons a
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shift, more than enough to handle current maximum sheeting needs. 10 Variable operating costs
(excluding labor) would be $70.25 a ton, which was lower than the current operating cost of
$80.36 a ton. To the extent that the new sheeter could accommodate sheeting needs in one shift
rather than two, Carded Graphics would be able to reassign one sheeting employee and thus
avoid hiring a new employee, saving $60,000 a year. If production required a return to two shifts,
a hire would become necessary.

9
Typically, the sheeting operation would run two shifts a day five days a week. For all calculations, Carded
Graphics assumed 240 operating days a year. The 240-day benchmark reflected the effects of holidays and other
reasons for work stoppage.
10
Capacity is determined by both a machine’s design but also by the mix of work being done. Short jobs or
unusual jobs require more setup time and would reduce capacity. The new sheeter could have a much larger capacity
if the mix of work were to change.
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Rossi estimated that the new sheeter would reduce waste in two ways. First, the waste
produced by the old sheeter during sheeting was 3.8% and that would be lowered to about 2.4%
with the new machine. Second, the sheeting process also affected waste in later (downstream)
processes. Downstream waste for both internally and externally sheeted paper was currently
1.8%. The new sheeter would produce sheets that were far flatter than those produced by the old
machine or purchased externally. This would improve sheet handling in latter operations and

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reduce waste to somewhere between 0.8% and 1.6%.

The net effect of the sheeter replacement on inventory was not entirely clear. Paper
already sheeted would typically arrive four days before it was used. If the paper was bought in
rolls, it would spend five days as a roll and then two days as sheets before being used. Thus,
there would be an extra three days of physical inventory. 11 However, the increase in inventory

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volume would be offset to some extent by the lower roll price.

An important consideration for Pitts was how volumes and costs would evolve over time.
He had seen substantial growth. In the future, he expected a minimum of 3% growth but would
not be surprised to see growth of 7% or 8%. In either event, the unused capacity of the new
sheeter would soon be employed. He estimated that all costs would increase by about 2% a year
except paper. The cost of paper fluctuated widely and was an important source of uncertainty in
his business. It would certainly matter in this analysis since the central motivation for the
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replacement was the cost of paper. Pitts believed that given decreasing demand, the cost of paper
would be unchanged over the next five years. For his analysis, he would assume no change over
the life of the machine.
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Decision Criteria

Pitts said that his central reasoning for any decision, even a capital investment, was
whether “the decision would be good for my operations.” This is not to say he was focused on
annual cash flows: Any large capital investment was going to hurt cash flows in the near term. It
was a philosophy based on a firm belief that to be successful financially over the long run, his
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firm needed to be at peak operating efficiency at all times. Nevertheless, he recognized the need
for careful capital budgeting analysis to be sure that the operating benefits of a project justified
the capital outlay. This financial justification was also something he would use to help secure the
financing he would need for the purchase.12

Aside from the actual cash flow effects, Pitts believed the sheeter replacement provided
one additional capability. As soon as he obtained a customer order, Pitts would order paper. For
precut paper, it would take five to seven days for the paper to arrive at his plant. If he had the

11
The need for extra space was not an issue. Carded Graphics had plenty of extra warehouse space.
12
The purchase would be initially financed from Carded Graphics’ short-term line of credit at prime plus 1% (at
the time, the relevant prime rate was 3.25%). Aside from an 8% subordinated loan equal to about $1 million, the
long-term debt of Carded Graphics comprised a 7.5% $3 million loan secured by real estate due in 2033 and various
other loans with shorter maturities and an average interest rate of 7.25%.
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needed paper type on a roll, he could have it sheeted that day. Even if he had to order a roll, that
roll would arrive within the next two days. Thus, he could more quickly print orders that used
rolled paper. Of course, this capability would not matter to all orders, but shorter customer lead
times, what Pitts referred to as speed to market, was becoming increasingly important. His
thoughts were echoed by Rossi, who said, “One question we always ask when making decisions
is, ‘Will this help us do it faster?’” He also said that “It’s hard to put a price on speed and

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flexibility, but I know that any equipment we run in-house adds to our efficiency.”

Regarding capital budgeting analyses, Pitts employed the traditional net present value
analysis using an appropriate discount rate. In addition, since his firm was highly leveraged, he
needed to be aware of the annual cash-flow implications of any project. To arrive at a discount
rate, Pitts would gather cost-of-capital data from a number of comparable firms. In addition,

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recognizing that his business rose and fell with his customers, he included a sample of firms that
captured the general health of the market in which he sold his products. A representative set of
such firms is listed in Exhibit 4. A summary of capital market data is provided in Exhibit 5.

As Pitts waited for the actual analysis to be completed, he said, “I know what the right
decision is because I know what is right for the business. But I am curious as to what the
numbers will say!”
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Exhibit 1
CARDED GRAPHICS, LLC: SHEETER REPLACEMENT DECISION
Income Statements

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2007 2008 2009
Sales $ 9,398,775 $ 10,593,220 $ 14,100,514
Cost of Goods Sold $ 7,410,572 $ 8,699,476 $ 11,276,894
$ 1,988,203 $ 1,893,744 $ 2,823,620

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Selling and Administrative $ 1,159,635 $ 1,409,408 $ 1,667,717
Other Expenses $ 27,495 $ (88,528) $ (70,951)
$ 1,132,140 $ 1,497,936 $ 1,738,668

Earnings Before Interest and Taxes $ 801,073 $ 572,864 $ 1,226,854

Interest Expense $ 415,848 $ 831,968 $ 937,967

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Income Before Taxes $ 385,225 $ (259,104) $ 288,887

Taxes $ 128,918 $ (207,373) $ 52,689

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Net Income $ 256,307 $ (51,731) $ 236,198

Data source: Carded Graphics financial statements.

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Exhibit 2
CARDED GRAPHICS, LLC: SHEETER REPLACEMENT DECISION
Balance Sheets

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2007 2008 2009
Cash $ 182,493 $ 32,286 $ 489,286
Accounts Receivable $ 1,050,207 $ 959,361 $ 1,229,704
Inventory $ 1,761,583 $ 1,858,447 $ 2,156,091
Deferred Taxes and Other $ 187,370 $ 221,694 $ 225,474
$ 3,181,653 $ 3,071,788 $ 4,100,555

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Goodwill $ 612,968 $ 688,755 $ 707,802
Land and Buildings $ 88,792 $ 4,896,565 $ 4,896,565
Equipment $ 5,139,743 $ 9,096,829 $ 9,203,126
$ 5,841,503 $ 14,682,149 $ 14,807,493
Accumulated Depreciation $ 1,714,099 $ 2,244,921 $ 2,951,139
$ 4,127,404 $ 12,437,228 $ 11,856,354
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$ 7,309,057 $ 15,509,016 $ 15,956,909
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Line of Credit $ 1,055,957 $ 1,093,022 $ 1,083,330

Current Long-Term Debt $ 660,370 $ 759,846 $ 986,531
Accounts Payable $ 664,027 $ 1,248,788 $ 1,837,000
Accrued Expenses $ 162,730 $ 147,293 $ 213,981
$ 2,543,084 $ 3,248,949 $ 4,120,842

Long-Term Debt, net of Current Due $ 2,746,111 $ 9,552,502 $ 9,181,349

Deferred Income Taxes $ 323,377 $ 370,190 $ 389,223
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$ 3,069,488 $ 9,922,692 $ 9,570,572

Shareholders’ Equity $ 1,696,485 $ 2,337,375 $ 2,265,495

$ 7,309,057 $ 15,509,016 $ 15,956,909

Inventory Detail
Raw Materials $ 242,479 $ 311,368 $ 448,040
Supplies $ 120,773 $ 110,974 $ 157,432
Work-In-Process $ 365,655 $ 224,535 $ 219,978
Finished Goods $ 1,032,676 $ 1,211,570 $ 1,330,641
$ 1,761,583 $ 1,858,447 $ 2,156,091
Data source: Carded Graphics financial statements.
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Exhibit 3
CARDED GRAPHICS, LLC: SHEETER REPLACEMENT DECISION
Schematic of Proposed New Sheeter

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Source: Carded Graphics.

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Exhibit 4
CARDED GRAPHICS, LLC: SHEETER REPLACEMENT DECISION
Industry Financial Data by Company

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Shares Share Book Yield
Revenue Outstanding Price Value on LT Debt
Ticker (millions) Beta (millions) (12/28/09) LT Debt Debt Rating
Packaging Companies
Graphic Packaging Holding GPK $ 4,095 1.50 343 $ 3.47 $ 2,892 8.47% B
International Paper IP $ 23,366 1.45 433 $ 26.78 $ 8,729 5.47% BBB

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Packaging Corp. of America PKG $ 2,148 1.15 103 $ 23.01 $ 571 4.61% BBB
RockTenn RKT $ 2,812 1.10 39 $ 50.41 $ 1,293 7.78% BB+
Sonoco Products SON $ 3,597 1.00 100 $ 29.25 $ 462 4.86% BBB+

Paper Companies
Neenah Paper NP $ 574 1.30 15 $ 13.95 $ 264 7.86% BB-
Temple-Inland TIN $ 3,577 0.88 107 $ 21.11 $ 2,850 5.87% BBB
Verso Paper Corp. VRS $ 1,361 0.92 52 $ 2.61 $ 1,192 8.48% B
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Typical Industry Clients
General Mills GIS $ 14,691 0.50 328 $ 70.81 $ 5,755 3.89% BBB+
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Pepsico PEP $ 43,232 0.60 1,565 $ 60.80 $ 7,400 3.52% A-

Target TGT $ 65,357 1.05 753 $ 48.37 $ 15,118 3.72% A+
Wal-Mart WMT $ 408,214 0.60 3,925 $ 53.45 $ 36,401 3.71% AA

Data sources: Company annual reports, moneycentral.msn.com, Value Line, Yahoo! Finance, Bloomberg.
Note: Yields on long-term debt based on maturity close to 2020.
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Exhibit 5
CARDED GRAPHICS, LLC: SHEETER REPLACEMENT DECISION
Capital Market Data as of December 28, 2009

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Estimated Market Premium 6.00%

U.S. Government Bond Yields

2-year 1.14%
5-year 2.69%
10-year 3.85%
30-year 4.63%

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Corporate Bond Yields (long-term)

AAA 5.26%
AA 5.44%
A 5.77%
BBB 6.37%

Data sources: U.S. Federal Reserve and Mergent Bond Record.

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