Star River Electronics Ltd.

For the case report, first summarize the case in a paragraph. Second, answer the case questions in your case report. Each of the answers should be at least a few sentences long. Make sure to reference the case in your answers when necessary. Some of the questions do not have correct answers but rather ask for your opinion on a topic. Make sure to provide sufficient evidence as to why you answer a certain way. Be sure to make use of the tables included in this document to help answer the questions.

Part 1: Case Report Summary

Summary

Part 2: Case Report Questions

What is Star River?s weighted-average cost of capital (WACC)? What methods can be used to estimate the WACC? What are the key assumptions that especially influence WACC?

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

How well has Star River done in the past? How healthy is it now?

What are the key driver assumptions of the firm?s future financial performance? What are the managerial implications of those key drivers? That is, what aspects of the firm?s activities should Koh focus on especially?

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 River's preside 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 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 CDROMs as a supplier to major software companies. In no time, Star River gained fam the industry for producing high-quality discs. The popularity of optical and multimedia products created rapid growth for CDROM 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 gro 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 compos 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*** See n at the end). 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. Koh's brief discussion with Chin went as f 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 warranted until we get a solid understanding of the firm's 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 can't study these right now. I need you to review the historical performance of Star River for me, and to give me an 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 River's 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 doesn't think we can repay the loan within a reasonable period. I would like you to build a simple financial forecast of our performa 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 River's sales will grow at 15% each year. Also, you should assume capital expenditures of SGD54.6 million (2*** See notes at the end) 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 y 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 we'll have to go back to Star River's owners, New Era Partners and Star River Electronics United Kingdom, for an injection of equity. Of course, New E 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 compa 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 manager's memorandum in Exhibit 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: That's 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 Ri reasonably well established now and shouldn't require such a high-risk premium. I managed to pull together some data on other Singaporean electronics companies w which to estimate the required rate of return on equity [see Exhibit 5]. KOH: Fine. Please estimate Star River's weighted average cost of capital and assess the packaging-machine investment. I would like the results of your analysis tomorrow morning at 7:00. dent er in-box ers. ame in ed, grown at osed 93% of e notes ly s follows: dat least m any mance o n your w Era pany he it 4]. ut River is s with Exhibit 1 STAR RIVER ELECTRONICS LTD. Historical Income Statements Fiscal Year Ended June 30 (SGD 000) 1998 1999 2000 2001 Assumptions 2002 2003 Sales Operating expenses: Production costs and expenses Admin. and selling expenses Depreciation Total operating expenses 71,924 80,115 92,613 106,042 15% /year increase 121,948 140,241 33,703 16,733 8,076 58,512 38,393 17,787 9,028 65,208 46,492 21,301 10,392 78,185 53,445 24,177 11,360 88,983 Average 49% of sales Average 22.5% of sales 1/7 of gross property and equip 59,755 27,438 20,450 107,643 68,718 31,554 20,450 120,722 Operating profit Interest expense Earnings before taxes Income taxes* Net earnings 13,412 5,464 7,949 2,221 5,728 14,908 6,010 8,897 2,322 6,576 14,429 7,938 6,491 1,601 4,889 17,059 7,818 9,241 2,093 7,148 14,305 6,753 7,552 1,850 5,702 19,519 5,791 13,728 3,363 10,364 2,000 3,728 2,000 4,576 2,000 2,889 2,000 5,148 2,000 3,702 2,000 8,364 Dividends to all common shares Retentions of earnings *The expected corporate tax rate was 24.5%. 6.7% of short term borrowings 24.5% of EBT Exhibit 2 STAR RIVER ELECTRONICS LTD. Historical Balance Sheets (Fiscal Year Ended June 30) (SGD 000) Assets: Cash Accounts receivable Inventories Total current assets Gross property, plant & equipment Accumulated depreciation Net property, plant & equipment Total assets Liabilities and Stockholders' Equity: Short-term borrowings (bank)1 Accounts payable Other accrued liabilities Total current liabilities Long-term debt2 Shareholders' equity Total liabilities and stockholders' equity 1 1998 1999 2000 4,816 22,148 23,301 50,265 5,670 25,364 27,662 58,697 6,090 28,078 53,828 87,996 64,611 (4,559) 60,052 110,317 80,153 (13,587) 66,566 125,262 29,002 12,315 24,608 65,926 10,000 34,391 110,317 2002 2003 5,795 Similar to past couple of years 35,486 Average of 32% of sales 63,778 Average of 60% of sales 105,059 6,000 39,023 73,169 118,192 6,000 44,877 84,145 135,022 97,899 (23,979) 73,920 161,916 115,153 New DVD equipment over 2 years (35,339) 1/7 of gross property/equipment 79,814 184,873 143,153 (55,789) 87,364 205,556 143,153 (76,239) 66,914 201,936 37,160 12,806 26,330 76,296 73,089 11,890 25,081 110,060 84,981 13,370 Average 13% of sales 21,318 Assuming 20,000 119,669 100,797 15,853 20,000 136,650 86,435 18,231 20,000 124,666 10,000 38,967 125,263 ### 41,856 161,916 18,200 Same as last year 47,004 Retention of earnings 184,873 18,200 50,706 205,556 ### 59,070 201,936 Short-term debt was borrowed from City Bank at an interest rate equal to Singaporean prime lending rates + 1.5 percent. Current prime lending rates were 5.2 percent. The benchmark 10-year Singapore treasury bond currently yielded 3.6 percent. 2 Two components made up the company's long term debt. One was a SGD10 million loan that had been issued privately in 1996 to New Era Partners and to Star River Electronics Ltd., U.K. This debt was subordinate to any bank debt outstanding. The second component was a SGD8.2 million from a 5-year bond issued on a private placement basis last July 1, 2000 at a price of SGD97 and a coupon of 5.75% paid semi-annually. 2001 Assumptions Exhibit 3 STAR RIVER ELECTRONICS LTD. Ratio Analyses of Historical Financial Statements Fiscal Year Ended June 30 1998 1999 2000 2001 Operating margin (%) Tax rate (%) Return on sales (%) Return on equity (%) Return on assets (%) 18.6% 27.9% 8.0% 16.7% 5.2% 18.6% 26.1% 8.2% 16.9% 5.2% 15.6% 24.7% 5.3% 11.7% 3.0% 16.1% 22.6% 6.7% 15.2% 3.9% Debt/equity ratio Debt/total capital (%) EBIT/interest (x) 1.13 0.53 2.45 1.21 0.55 2.48 1.99 0.67 1.82 2.20 0.69 2.18 65.2% 15.0% 8.0% 112.4 36.5% 69.1% 64.0% 11.4% 13.5% 115.6 33.4% 72.1% 57.2% 15.6% 29.3% 110.7 25.6% 115.8% 57.4% 14.5% 14.2% 122.1 25.0% 119.3% 0.76 0.41 0.77 0.41 0.80 0.31 0.88 0.34 Profitability Leverage Asset Utilization Sales/assets Sales growth rate (%) Assets growth rate (%) Days in receivables Payables to COGS Inventories to COGS Liquidity Current ratio Quick ratio Exhibit 5 STAR RIVER ELECTRONICS LTD. Data on Comparable Companies Name Sing Studios, Inc. Wintronics, Inc. STOR-Max Corp. Digital Media Corp. Wymax, Inc. % of Sales from CD-ROM and/or DVD Production 20% 95% 90% 30% 60% Price/Earnings Ratio 9.0 NMF 18.2 34.6 NMF Beta 1.07 1.56 1.67 1.18 1.52 Book D/E 0.23 1.70 1.30 0.00 0.40 Book Value per Share 1.24 1.46 7.06 17.75 6.95 Note: NMF means not a meaningful figure. This arises when a company's earnings or projected earnings are negative. Market Price per Share 1.37 6.39 27.48 75.22 22.19 Number of Shares Outstanding (millions) 9.3 177.2 89.3 48.3 371.2 Last Annual Dividend 1.82 0.15 none none 1.57 5-Year Earnings Growth Forecast 4.0% 15.7% 21.3% 38.2% 11.3% Analysis of the Packaging Machine Investment 2001 2002 Inflation Rate = 1.50% Years from Now 0 1 If Star River Waits Three Years to Purchase the Machine Maintenance -15,470 Labor -63,700 Overtime -18,200 Depreciation -72,800 Depreciation -72,800 -170,170 -171,631 -41,692 -42,049 -128,478 -129,581 72,800 72,800 Total Cost Tax @ .245 After-tax Cost + Depreciation - Cap. Expenditure Free Cash Flow NPV@11.1% = -1,697,798 If Star River Purchases the New Machine Now Maint. (3,640) Labor (63,700) Depreciation -182,000 -249,340 -250,478 -61,088 -61,367 -188,252 -189,111 182,000 182,000 -1,820,000 53,508 Total Cost Tax After-tax Cost + Depreciation - Cap. Expend. + Tax Shield on Writeoff of Old Machine Free Cash Flow -1,820,000 NPV@11.1% = -1,880,003 Effect of Buying Now vs. Waiting Advantage of Waiting: NPV (Wait) - NPV (Now) = 182,205 Change in FCF 1,820,000 PV Gain from Waiting 182,205 Equiv. Annual Annuity 27,178 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2 3 4 5 6 7 8 9 10 11 12 13 -4,214 -4,424 -66,610 -67,609 0 0 -210,688 -210,688 -210,688 -210,688 -282,721 -283,956 -285,218 -69,267 -69,569 -69,878 -213,454 -214,387 -215,340 210,688 210,688 210,688 -4,646 -68,623 0 -210,688 -210,688 -286,507 -70,194 -216,313 210,688 -4,878 -69,652 0 -210,688 -210,688 -287,823 -70,517 -217,307 210,688 -5,122 -70,697 0 -210,688 -210,688 -289,169 -70,846 -218,322 210,688 -5,378 -71,758 0 -210,688 -210,688 -290,543 -71,183 -219,360 210,688 -5,647 -72,834 0 -210,688 -210,688 -291,949 -71,527 -220,421 210,688 -3,699 -4,652 -5,625 -6,619 -7,634 -15,702 -15,938 -64,656 -65,625 -18,473 -19,031 -72,800 -72,800 -72,800 -72,800 -173,394 -281,511 -42,482 -68,970 -130,913 -212,541 72,800 210,688 -2,106,878 -55,678 -56,781 -2,164,990 -1,853 -2,767 -5,929 -6,226 -6,537 -73,926 -75,035 -76,161 0 0 0 -210,688 -210,688 -210,688 -210,688 -210,688 -210,688 -293,386 -71,879 -221,506 210,688 -8,672 -9,734 (3,822) (4,013) (4,214) (4,424) (4,646) (4,878) (5,122) (5,378) (5,647) (64,656) (65,625) (66,610) (67,609) (68,623) (69,652) (70,697) (71,758) (72,834 -182,000 -182,000 -182,000 -182,000 -182,000 -182,000 -182,000 -182,000 -182,000 0 0 -251,638 -252,823 -254,033 -255,269 -256,530 -257,819 -259,136 -260,481 -79,856 -81,261 -82,698 -61,651 -61,942 -62,238 -62,541 -62,850 -63,166 -63,488 -63,818 -19,565 -19,909 -20,261 -189,987 -190,882 -191,795 -192,728 -193,680 -194,653 -195,647 -196,663 -60,291 -61,352 -62,437 182,000 182,000 182,000 182,000 182,000 182,000 182,000 182,000 0 0 0 -10,818 (5,929) (73,926) 0 (6 (75 47,256 -7,111 -7,987 -8,882 -9,795 -10,728 -11,680 -12,653 -13,647 -14,663 -60,291 -61,352 -62,437 -102,935 -49,671 -2,157,003 7,028 7,028 7,028 7,028 7,028 7,028 7,028 51,618 51,618 51,618 (6,226) 5,035) (6,537) (76,161) Historical and Forecast Sources and Uses of Funds Statement Sources of funds Net income 1999 (Actual) Depreciation 6,576 Increases in debt 9,028 Increases in accounts payable 8,157 Increases in other current liabilities Total sources of cash Dividend payments Increases in cash balance 35,929 11,892 -915 1,722 1,479 -1,250 491 Uses of funds 2000 2001 2002 2003 (Actual) (Actual) (Proj'd) (Proj'd) 4,889 7,148 11,360 5,127 15,260 4,737 19,160 10,392 -3,763 49,045 25,974 28,117 45,429 4,024 47,478 2,000 2,000 1,189 2,132 419 2,000 2,000 -295 4,607 7,408 9,391 27,300 27,300 45,429 47,478 855 3,216 2,714 26,166 17,746 9,950 17,254 Increases in inventories 49,045 Total uses of cash 5,511 17,269 2,287 2,000 Increases in accts. 4,361 15,542 receivable Capital expenditures 17,658 1,874 25,973 36,317 6,014 10,975 Forecasting Assumptions 2000 Assumptions Sales Growth (Actual) (Actual) (Proj'd) 2003 (Proj'd) 15.00% Production Costs/Sales 50.00% 50.00% Admin. and selling expenses/Sales 23.00% 23.00% 27,300 3,900 14.50% 2002 15.00% Capital expenditures Depreciation expense for 15.60% 2001 27,300 3,900 Both Years Dividend Payout Melded Interest Rate Average Tax Rate Cash to Sales Days Sales Outstanding Payables to Cost of Good Inventories to Cost of Go Other Current Liabs. to S 25% 9% 25% 6.50% 120 25% 120% 22% Bank Debt Debt/Equity Base Case $119,908 0% EBIT Cov'g. 2.41 2.39 $106,509 1.62 1.31 5% 2.4 1.42 10% Sales Growth $110,722 $115,189 2.4 1.52 $117,046 2.41 1.57 $119,908 2.41 1.62 $122,861 2.41 1.68 $124,881 2.42 1.72 12% 15% 18% 20% Bank Debt Debt/Equity Base Case EBIT Cov'g. $119,908 2.41 1.62 $93,897 1.83 2.77 $101,329 1.98 2.41 $108,761 2.14 2.08 49% $116,192 2.32 1.77 51% 53% 55% $123,624 2.51 1.48 $131,056 2.72 1.22 $138,488 2.95 0.97 43% 45% Production 47% Costs/Sales Bank Debt Base Case Debt/Equity $119,908 EBIT Cov'g. 2.41 1.62 Days Sales ## $111,141 2.25 1.73 Outstanding ## $115,525 2.33 1.67 ## $117,716 2.37 1.65 ## $119,032 2.39 1.63 ## $119,908 2.41 1.62 ## $120,785 2.43 1.61 ## $122,100 2.45 1.6 ## $124,292 2.49 1.58 Base Case Inventories to COGS Bank Debt Debt/Equity 120% $119,908 130% $127,908 2.56 1.54 140% $135,909 150% $143,909 155% $147,909 2.72 2.88 2.96 3.04 3.21 1.47 160% $151,909 170% $159,909 2.41 EBIT Cov'g. 1.62 1.4 1.37 1.34 1.28