QUESTION: What are the free cash flows of the packaging-machine investment? Should Koh approve the investment?

STAR RIVER ELECTRONICS LTD.

On July 5, 2001, her first day as CEO of Star River Electronics Ltd., Adeline Koh confronted a host of management problems. One week earlier, Star Rivers president and CEO had suddenly resigned to accept a CEO position with another firm. Koh had been appointed to fill the positionstarting immediately. Several items in her in-box that first day were financial in nature, either requiring a financial decision or with outcomes that would have major financial implications for the firm. That evening, Koh asked to meet with her assistant, Andy Chin, to begin addressing the most prominent issues.

Star River Electronics and the Optical-Disc-Manufacturing Industry

Star River Electronics had been founded as a joint venture between Starlight Electronics Ltd., United Kingdom, and an Asian venture-capital firm, New Era Partners. Based in Singapore, Star River had a single business mission: to manufacture CD-ROMs as a supplier to major software companies. In no time, Star River gained fame in the industry for producing high-quality discs.

The popularity of optical and multimedia products created rapid growth for CD-ROM manufacturers in the mid-1990s. Accordingly, small manufacturers proliferated, creating an oversupply that pushed prices down by as much as 40%. Consolidation followed as less efficient producers began to feel the pinch.

Star River Electronics survived the shakeout, thanks to its sterling reputation. While other CD-ROM manufacturers floundered, volume sales at the company had grown at a robust rate in the past two years. Unit prices, however, had declined because of price competition and the growing popularity of substitute storage devices, particularly digital video discs (DVDs). The latter had 14 times more storage capacity and threatened to displace CD-ROMs. Although CD- ROM disc drives composed 93% of all optical-disc-drive shipments in 1999, a study predicted that this number would fall to 41% by 2005, while the share of DVD drives would rise to 59%.1 Star River had begun to experiment with DVD manufacturing, but DVDs still accounted for less than 5% of its sales at fiscal year-end 2001. With newly installed capacity, however, the company hoped to increase the proportion of revenue from DVDs.

Financial Questions Facing Adeline Koh

That evening, Koh met with Andy Chin, a promising new associate whom she had brought along from New Era Partners. Kohs brief discussion with Chin went as follows:

Koh: Back at New Era, we looked at Star River as one of our most promising venture- capital investments. Now it seems that such optimism may not be warrantedat least until we get a solid understanding of the firms past performance and its forecast performance. Did you have any success on this?

Chin: Yes, the bookkeeper gave me these: the historical income statements [Exhibit 1] and balance sheets [Exhibit 2] for the last four years. The accounting system here is still pretty primitive. However, I checked a number of the accounts, and they look orderly. So I suspect that we can work with these figures. From these statements, I calculated a set of diagnostic ratios [Exhibit 3].

Koh: I see you have been busy. Unfortunately, I cant study these right now. I need you to review the historical performance of Star River for me, and to give me any positive or negative insights that you think are significant.

Chin: When do you need this?

Koh: At 7:00 a.m. tomorrow. I want to call on our banker tomorrow morning and get an extension on Star Rivers loan.

Chin: The banker, Mr. Tan, said that Star River was growing beyond its financial capabilities. What does that mean?

Koh: It probably means that he doesnt think we can repay the loan within a reasonable period. I would like you to build a simple financial forecast of our performance for the next two years (ignore seasonal effects), and show me what our debt requirements will be at the fiscal years ending 2002 and 2003. I think it is reasonable to expect that Star Rivers sales will grow at 15% each year. Also, you should assume capital expenditures of SGD54.6 million2 for DVD manufacturing equipment, spread out over the next two years and depreciated over seven years. Use whatever other assumptions seem appropriate to you, based on your historical analysis of results. For this forecast, you should assume that any external funding is in the form of debt.

Chin: But what if the forecasts show that Star River cannot repay the loan?

Koh: Then well have to go back to Star Rivers owners, New Era Partners and Star River Electronics United Kingdom, for an injection of equity. Of course, New Era Partners would rather not invest more funds unless we can show that the returns on such an investment would be very attractive and/or that the survival of the company depends on it. Thus, my third request is for you to examine what returns on book assets and book equity Star River will offer in the next two years and to identify the key-driver assumptions of those returns. Finally, let me have your recommendations about operating and financial changes I should make based on the historical analysis and the forecasts.

Chin: The plant manager revised his request for a new packaging machine and thinks these are the right numbers [see the plant managers memorandum in Exhibit 4]. Essentially, the issue is whether to invest now or wait three years to buy the new packaging equipment. The new equipment can save significantly on labor costs but carries a price tag of SGD1.82 million. My hunch is that our preference between investing now versus waiting three years will hinge on the discount rate.

Koh: [laughing] The joke in business school was that the discount rate was always 10%.

Chin: Thats not what my business school taught me! New Era always uses a 40% discount rate to value equity investments in risky start-up companies. But Star River is reasonably well established now and shouldnt require such a high-risk premium. I managed to pull together some data on other Singaporean electronics companies with which to estimate the required rate of return on equity [see Exhibit 5].

Koh: Fine. Please estimate Star Rivers weighted average cost of capital and assess the packaging-machine investment. I would like the results of your analysis tomorrow morning at 7:00.

2 SGD = Singaporean dollars.