CASE 1 – STAR RIVER ELECTRONICS LTD

Company profileStar River Electronics Ltd is a manufacturer and supplier of CD-ROMS. It was founded as a joint venture between New Era Partners and Starlight Electronics Ltd. It has enjoyed a great deal of success in the past decade, due in large part to their excellent reputation.Star River does need to address several issues with the recent resignation of their former CEO. Digital Video Disks(DVD) are expected to cut into the CD-ROM market in the very near future, and with only 5% of their sales coming from this area, Star River needs capital expenditures to increase their capacity in this sector.

-Following is analysis of Current financial position of Star River Electronics Ltd

Current financial position is related to balance sheet items, particularly current assets and liabilities.Looking at current ratio, we observe that the ability of the firm to meet short term maturing obligations has been increasing slightly. The increase is due to total current assets rising by 16.76%, 49.92% and 19.39% respectively from years 1998 - 1999, 1999 – 2000 and 2000 -2001.

Quick ratio has been stable for years 1998 and 1999, declined from 0.41 to 0.31 and 0.34 in years 2000 to 2001, this is due to increase in short term borrowing by 97% from 1999-2000 and 16% from 2000 to 2001

Both quick and current ratios are below one, meaning that total current liabilities exceed total current assets, we don’t have the industrial bench mark to base our discussion but we have observed that the company is financing some of its short term obligations by short term borrowing. This can be evidenced by comparing cash available and short term borrowings, the ratio of cash to short term borrowing are 17%, 15%, 8% and 7% for years from 1999 to 2001 respectively, the figures clearly indicate the dependant of the company to short term borrowing.

Though the company’s ability to meet short term obligations looks threatening we leant that the company is making profit and allocates dividends to its share holders, this is enough evidence that the liquidity ratios might be within industrial average.

The position of the company can also be measured using efficient ratios, presented below are days to receivables, payables and inventory turnover to be used to establish position of the company in respect of efficiency.

1998 1999 2000 2001

Days in receivables days

112.40 115.60 110.70 122.10

Days in payable 133.00 122.00 93.44 91.25Inventory turnover 252 263 422 435

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The days to receive payment from debtors ought be less than the days the company is paying its payables, the company was better off in the years 1998 and 1999 as they were getting payment earlier compared to the days they were paying, but for the years 2000 and 2001 things were against the company. The days for which they had to receive payments were longer compared to the days they were making payments. In such a situation the company will need to borrow to be able to pay creditors, typically this is what has happened to Star river electronics, we have observed more short term borrowing in these two years.Star River Electronics has to review its credit policy, to make sure it receives from debtors before it can pay its creditors without destroying relationship with their customers.

The inventory turnover, shows that the company takes a long time to clear it’s stocks, in years 2000 and 2001, stocks are held in more than a year, and this is long period given costs of holding stock and also too much of the company’s liquid cash will be held up in stocks that means the company will be short of cash hence difficulty in meeting its short term obligations. We can now agree that the current ratio has also been affected by this scenario.

Again Star River Electronics should review its inventory holding policy, to reflect the actual stock holding days and avoid stock holding costs, which include stock deterioration and obsolescence, interest costs for gone for tiding up cash, storage and others.

Having looked at position for current assets we now turn to the position pertaining to capital structure.

Debt equity ratios have being increasing from year 1999 to 2001 at different proportions, the possible reasons include the increase in both short and long term debts, however in year2001 the borrowing increased hugely from the issue of five year bond amounting to SGD 8.2m.It’s worth mentioning that the long term borrowing might have been used to facilitate purchase of fixed assets; this is supported by the increased value of fixed assets in the financial information provided. Debt to total capital ratio has a similar trend to debt equity ratios, same factors are contributing to this growth.

-Financial performance of the companyThe financial performance of the company can be analyzed by the use of profitability ratios such as the operating margin, return on sales, return on sales, return on equity and return on asset.

It can be observed that the profitability ratios decline from year to year, for instance the return on sales was 8.0 in 1998 and 8.2 in 1999 to its lowest of 5.3 in 2000.

Operating margin for year 1998 and 1999 stood at 18.6% while those for 2000 and 2001 dropped to 15.6% and 16.1% correspondingly other ratios like return on sales, return on equity and Return on asset follow closely the same fashion.

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The decline is a result of increase in total operational expenses largely contributed by production costs and expenses. The plant manager is quoted claiming for the costs paid for an operator due to the costs generated by the old packaging equipment that had frequent shutdowns for repairs, and forced the company to have its employees work overtime. Increase in depreciation due to the increase in fixed assets has a role on this; decline in unit prices caused by competitor Stor- Max Corp is another reason for the decline in operating margin.

Asset utilizationProportional increase of sales to assets indicates that assets have been increasing to a larger rate hence led to decrease in the sales asset ratio.Star River sales grew 15%, 11.4%, 15.6% and 14.5% between 1998 and 2001, but the earnings did not grow correspondingly. However, the company managed to stay profitable during the past four years, and issued dividends consistently to its shareholders.

EBIT/Interest fell below 2 in year 2001; we think this is due to long term debt acquired during this time, resulting to increased interest expenses.

Strength and Weakness we can highlight to Adeline Koh

Weakness:The weakness in inventory control has to be highlighted as one of the most alerting issues on the companies’ financials. Because of the state of the technology industry, the inventory can be a cause for concern for a company that is selling a product that has declining demand. The firm was facing high price competition and the growing popularity of substitute storage devices, particularly digital video discs (DVDs).Exhibit 3 shows the ratio of Inventory to COGS has increased from 69.1% in 1998 to 119.3% in 2001, which is an increase of 73%. The inventory has increased from SGD 23.3 million to SGD 63.7 million. Inventory is a major sign on Star Rivers’ financial statements. Reasons for the increase in inventory is because a decline in sales due to a lack in demand. The demand has decreased because of increase in popularity of substitute storage devices and technology that is outdated (CD-ROMs to DVDs). The inventory can cause a large write-down in a future financial statement. An excess and obsolescence costs analysis should be performed on the inventory. Any inventory that does not have demand in the next year should be written-off and more efficient inventory practices. Strength:Strength of Star River is its ability to control operating and administrative expenses. The chart below shows only a minimal increase in cost of sales as a percentage of Sales, and a decline in SG&A expenses as a percentage of sales. This shows obedience in spending, and efficient manufacturing.

Year sales COS as a % of sales

SG&A costs as a % of sales

199871,924 46.9% 23.3%

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1999 80,11547.9% 22.2%

2000 92,61350.2% 23.0%

2001 106,042

50.4% 22.8%

Other strength of Star Rivers is: its ability to increase sales year over year ,shown on exhibit 1 i.e.

(1998,1999,2000,2001) sales were 71924 ,80115, 92613,106,0420 respectively.

Star river had gained fame in the industry for producing high quality DISCS

The popularity of optical and multimedia products created rapid growth of the CD ROMS.

(2) Differences the ownership structure make to the financing of the company.

Star River Electronics has been formed by a joint venture of two companies, Starlight Electronics Limited UK and an Asian venture capital firm known as New Era Partners in mid 1990. The table below shows the financing structure of the company which is partly financed by debts and equity financing.But no new equity contributions from investors in recent time period

Year 1998 1999 2000 2001

Long Debt (SGD 000) 10,000

10,000

10,000

18,200

Shareholders equity (SGD 000)

34,391

38,967

41,856

47,004

Total 44,391

48,967

51,856

65,204

Debt financing % 23% 20% 19% 28%

Equity financing % 77% 80% 81% 72%

Total financing 100% 100% 100% 100%

From the table we can observe that Star River Co Ltd is fully financed by equity and partial financed by debt. The trend shows equity has been increasing in 1998-2000 and 2001 has fallen down due to acquisition of second component which cost SGD 8.2 million from a 5 year bond. There has been no new equity contribution from investors in recent time period, the dividends declared to shareholders has been retained and used in company liquidity operations.

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Return on equity1998 1999 2000 200116.65% 16.87% 11.68%

15.21%

Overall ROE has been increasing but due to increase in operating expenses in the year 2000 and 2001 they have outgrow the revenue.Interest cover has been increasing due to increase in borrowing which results to business risk as it appear in exhibit 3.

(3) -Forecasted financial statements for the firm for 2002 and 2003

Star River Ltd Forecasted balance sheet for 2002 and 2003

(SGD 000) 1998 1999 2000 2001 2002 2003

% sales

Sales 71,

924 80,11

5 92,61

3 106,04

2 121,94

8 140,24

1 15.00%

Operating expenses: Production costs and expenses 33,703 38,393 46,492 53,445 61,462 70,681 50.40% Admin. and selling expenses 16,733 17,787 21,301 24,177 27,804 31,975 22.80%

Depreciation 8,076 9,028 10,392 11,360 13,614 14,394

Total operating expenses 58,512 65,208 78,185 88,983 102,880 117,050

Operating profit 13,412 14,908 14,429 17,059 19,068 23,191 16.09%

Interest expense 5,464 6,010 7,938 7,818 9,998 14,143 6.62%

Earnings before taxes 7,949 8,897 6,491 9,241 9,071 9,047 8.71%

Income taxes* 2,221 2,322 1,601 2,093 2,222 2,217 24.50%

Net earnings 5,728 6,576 4,889 7,148 6,848 6,831

Dividends to all common shares 2,000 2,000 2,000 2,000 2,000 2,000

Retentions of earnings 3,

728 4,57

6 2,88

9 5,14

8 4,84

8 4,83

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Star River Ltd Forecasted balance sheet for 2003 and 2003

(SGD 000) 2001 2002 2003

Assets:

Cash 5,795 6.5% 6,168.85 6,566.94

Accounts receivable 35,486 31.6% 46,684.97 61,418.18

Inventories 63,778 43.9% 91,796.23 132,123.11

Total current assets 105,059 144,650.04 200,108.23

Gross property, plant & equipment 115,153 27,300 142,452.90 169,752.90

Accumulated depreciation -35,339 -48,953.10 -63,347.21

Net property, plant & equipment 79,814 93,499.80 106,405.69

Total assets 184,873 238,149.84 306,513.93

Liabilities and Stockholders' Equity:

Short-term borrowings (bank)1 84,981 10.97% 94,304.12 104,650.20

Accounts payable 13,370 14.64% 15,327.01 17,570.62

Other accrued liabilities 21,318 -6.94% 19,838.89 18,462.41

Total current liabilities 119,669 129,470.02 140,683.24

Long-term debt2 18,200 56,827.50 109,147.53

Shareholders' equity 47,004 51,852.32 56,683.16

Total liabilities and stockholders' equity

184,873 14% 238,149.84 306,513.93

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(ii)Financing requirements over the period and the repayment terms that should be accepted.In our forecast we assume the following

Sales will grow by 15% in each year Operating expenses will increase by 10% Administration and selling expenses will grow to 5% Depreciation will base on the value of assets computed on straight line

method. Retention will remain constant from 1998 to 2003 Dividend to all common shares will remain constant to year 2003 Account receivable will increase by 15% Account payable will increase by 105% Inventories will increase by 10% Long term debt has grown to 27.3m % in 2000 and 2001 Cash at hand will grow by 5.5% Interest on long-term borrowing 3.6% The new packaging machine will not be bought now but after three years, this

is based on the information provided and we have achieved positive NPV Short term borrowing will grow by 5% Further outside funding is required if new equipment for the project is

undertaken refer Balance Sheet. If no additional projects are assumed, Star Rivers can fund its operations without any additional funding with just its internal cash flows. Based on the forecasted income statement, 15% revenue growth will yield a net income of SGD 6.8 million in 2002 and SGD 6.8 million in 2003.

The total financing requirement from 2001 to 2003 is SGD 90.947 million refer balance sheet. This is based on the forecasted balance sheet which forecasts each account based on the condition of the company and run rates. Star River will need to obtain long-term debt for the SGD 90.947 million. Star River is operating in the black, and can payback the loan.

Assuming Star River can continue growing at a similar pace to its run rate, they can payback the loan in 9 years. If they needed to speed up the time to pay the loan back, they can cut the dividend and payback the loan in 8 years (refer payback) period calculations.

Star River’s financing requirement is in respect of long term borrowing of SGD 54.6m to facilitate capital expenditures for year 2002 and 2003.

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Funds available to payback loan w/o dividend

2003 6,831

2004 8,308

2005

10,104

2006 12,288

2007 14,944

2008 18,175

2009 22,104

2010 26,883

Funds available to payback loan w dividend

2003 4,831

2004 5,875

2005 7,145

2006 8,690

2007 10,569

2008 12,854

2009 15,633

2010 19,012

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2011 23,122

4) Key driver’s assumptions of the firm’s future financial performance.• Sales growth, as the trend shows sales has been increasing hence the new CEO

(Adeline Koh) should maintain and ensure she strive so as to compete with the new technology.

• New system of controlling inventory must be introduced instantly (Just in Time,

• Investors should be requested to put more funds to operate the business instead of borrowing and use loans into the capital expenditure. Debt financing has been increasing with less return which business is on the riskier side.

• CD-ROM technology has been outdated hence CEO should think of acquiring new machines and change products which can go hand in hand with the new technology changes

• Operating profit (selling & administrative expenses) has also contributed to reduction of the bottom line (profit) there should be a certain way of minimizing these costs. Interest rate will be minimized if the policy of loan used to finance the capital expenditure.

• Working capital (current assets less current liabilities) is also one of the areas Adeline Koh should consider so as to keep the business sustainable. Reduce the receivable days period to be as minimum as possible, or extend the days to pay their suppliers.

• Corporate tax rate is high in regard to the performance of the business, if there is a possibility of requesting for consideration (looking at the poor performance of the business) the new CEO should go for.

• Koh may not need to focus on all of these key driver’s, but a decision needs to be made for each. Sales growth is a major issue, top line will drive most of the financial decisions of the company. As long as it can grow at the 15% forecasted rate, no real issues will arise. But major issues will develop from any growth under 15%.

The inventory issue is a relatively easy decision, but has a huge financial impact. The international accounting standards board (IASB) was not implemented in Singapore until after this case. IASB implemented standards similar to GAAP. Assuming that they do not need to perform an E&O analysis each quarter, they will not have to write-down the inventory. But in reality, this is an issue that they should address, but it will destroy their P&L the month they decide to write-down their inflated inventory.

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Koh should make the decision on writing-down the inventory voluntarily now, or being forced to by an auditor or IASB at a later date. Capital funding is important because they will need to decide whether or not to fund the new packaging equipment project. Since this cannot be funded using internal cash flows, they will need to obtain debt (an equity offering has already been expressed as not being an option). Koh will need to review the NPV analysis below and either recommend or reject this project.

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2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Inflation rate 1.50% 1.50% 1.50% 1.50% 1.50% 1.50% 1.50% 1.50% 1.50% 1.50% 1.50%

Year from now0 1 2 3 4 5 6 7 8 9 10 11 12 13

If star River waits three years to purchase the machine

Maintenance (15470) (15702) (15938) (4424) (4646) (4878) (5122) (5378) (5647) (5929) (6226) (6537)

Labor (63700) (64656) (65625) (66610) (67609) (68623) (69652) (70697) (71758) (72834) (73926) (75035)

Overtime (18200) (18473) (18750) 0 0 0 0 0 0 0 0 0 Depreciation (72800) (72800) (72800) (182000) (182000) (182000) (182000) (182000) (182000) (182000) (182000) (182000)

Total Cost (170170) (171631) (173113) (253034) (254255) (255501) (256774) (258075) (259404) (260763) (262152) (263572)Tax @ 24.5% (41692) (42049) (42413) (61993) (62292) (62598) (62910) (63228) (63554) (63887) (64227) (64575)After-tax Cost (128478.35) (129581.07) (130700.32) (191040.79) (191962.16) (192903.21) (193864.51) (194846.67) (195850.33) (196876.15) (197924.82) (198997.06)+ Depreciation 72800.00 72800.00 72800.00 182000.00 182000.00 182000.00 182000.00 182000.00 182000.00 182000.00 182000.00 182000.00

- Cap. Expenditure 0.00 0.00 (2106877.50) 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Free Cash Flow

- (55678.35) (56781.07) (2164777.82) (9040.79) (9962.16) (10903.21) (11864.51) (12846.67) (13850.33) (14876.15) (15924.82) (16997.06)

npv 11% (1,561,552)

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Maint. (3822) (4013) (4214) (4424) (4646) (4878) (5122) (5378) (5647) (5929) (6226) (6537) (6864)

Labor (63700) (64656) (65625) (66610) (67609) (68623) (69652) (70697) (71758) (72834) (73926) (75035) (76161)

Depreciation (182000) (182000) (182000) (182000) (182000) (182000) (182000) (182000) (182000) (182000) 0 0 0

Total Cost (249522) (250669) (251839) (253034) (254255) (255501) (256774) (258075) (259404) (260763) (80152) (81572) (83025)

Tax (61133) (61414) (61701) (61993) (62292) (62598) (62910) (63228) (63554) (63887) (19637) (19985) (20341)

After-tax Cost (188389) (189255) (190139) (191041) (191962) (192903) (193865) (194847) (195850) (196876) (60515) (61587) (62684)

+ Depreciation 182000 182000 182000 182000 182000 182000 182000 182000 182000 182000 0 0 (0)

- Cap. Expend. -1,820,000.00 0 0 0 0 0 0 0 0 0 0 0 0 0

+ Tax Shield on Writeoff of Old Machine 53508 0 0 0 0 0 0 0 0 0 0 0 0Free Cash Flow -1,820,000 47119 (7255) (8139) (9041) (9962) (10903) (11865) (12847) (13850) (14876) (60515) (61587) (62684)

npv 11%

(1,695,473)

Effect of Buying Now vs. Waiting

Advantage of Waiting: NPV (Wait) - NPV (Now) =133, 922 Star river Electronics should wait to buy the machine because the cost of keeping

The old machine is lower than if they buy the new machine now.

Change in FCF

(355,193)

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5) (i) Weighted Average Cost of CapitalThe weighted average cost of capital (WACC) is used in finance to measure a firm's cost of capital. This is used by many firms as a discount rate for financed projects, as the cost of financing. WACC is the return a firm must earn on existing assets to keep its stock price constant and satisfy its creditors and owners.The weight of debt and equity was derived from the 2001 balance sheet. The tax rate was given at 24.5%. Return on debt is 6.62%. The cost of equity was derived from the capital asset pricing model (CAPM). The CAPM formula takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. Current data was used for the risk free rate which is 5%. Historical data was needed to calculate the return on the market at 15%. Beta was derived from exhibit 5. Similar firms have a beta of 1.07 to 1.67. Star Rivers is in the middle of these companies, so a beta of 1.4 was assigned to Star Rivers which is an average of the given Betas. CAPM calculates to 12% based on the following formula

WACC is then calculated at 11% based on the following information.

Weighted Average Cost of Capital

Appendix E

WACC = wd (1-T) rd + we re

wd = D/(D+E), debt portion of value of corporationT = tax rate

rd = cost of debt (rate)we = E/(D+E), equity portion of value of corporation

re = rf + β (rm -

rf)

Risk Free Rate of Return 3.60%

Return on Market 9.60%Beta 1.4

CAPM or Return on Equity 12.000%

Tax 24.5%Kd 6.62%

rf 3.60%

β 1.40Market risk premium 6%CAPM(Ke) 12%

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re = cost of internal equity (rate)

WACC = 11.01%

wd = 14.06%T = 24.50%

rd = 6.62%

we = 85.94%

re = 12.00%

(ii) The free cash flow of the new packaging machine is SGD -2,056 million. But after this is discounted back at the discount rate of 11 %, the net present value (NPV) is SGD -1,695 million. Based on the financials, Koh should not approve this project because of its negative NPV. Another analysis based on waiting three years was also performed, and it also had negative cash flows (see NPV analysis). Based on the analysis of the industry, Koh should not approve this project either because the longer they can wait to implement this, the better. They can wait until 2004 if they have to, and the wait and see approach is better because the sustainability of selling the CD-ROMs could change. And the packaging equipment may not be sufficient for the next product being manufactured by Star Rivers.

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