STAR RIVER ELECTRONICS LTD.
You are Andy Chin. Prepare the first part of the report due at 7 a.m. tomorrow to the new CEO of
Star River Electronics, Ltd., Adeline Koh. This first part should detail the external funding needs
required by Star River. Develop a memo (plus exhibits) to inform Ms. Koh before
her conversation with the banker, Mr. Tan, tomorrow morning. Your memo should include:
?
A brief discussion on why Star River needs additional funding even though it is a
profitable business.
?
Financial projections for the years 2002, 2003 and 2004 indicating Star River's
need for funds. Use the sales projections given for 2002 and 2003 and generate
your own revenue projections for 2004.
?
Size of the loan you think Star River should request from Mr. Tan. Assume that
your short-term bank borrowings are currently capped at SGD100 million and that
your long-term borrowings will require no principal payments until July 2005.
?
Results of sensitivity analysis on key parameters indicating why changes in their
values may occur and how those changes will affect Star River's need for funds.
?
Specific talking points for Ms. Koh's conversation with Mr. Tan. Is his concern
that Star River is growing beyond its financial capabilities accurate?
STAR RIVER ELECTRONICS LTD. Historical Income Statements Fiscal Year Ended June 30 (SGD 000) 1998 1999 2000 2001 Forecast 2002 2003 2004 Sales 71,924 80,115 92,613 106,042 15.0% Operating expenses: 121,948.45 140,240.71 161,276.82 Production costs and expenses 33,703 38,393 46,492 53,445 50.0% Admin. and selling expenses 60,974.22 70, 120.36 16,733 80,638.41 17,787 21,301 24,177 23.0% Depreciation 28,048.14 32,255.36 37,093.67 8,076 9,028 10,392 11,360 15,260.46 Total operating expenses 19,160.46 58,512 23,060.46 65,208 78, 185 88,983 104,282.83 121,536.18 140,792.54 Operating profit 13,412 14,908 14,429 17,059 17,665.62 18,704.53 20,484.28 Interest expense 5.464 6,010 7,938 7,818 Earnings before taxes 6,835.22 7,949 6,835.22 6,835.22 8,897 6.491 9,241 10,830.40 11,869.31 Income taxes* 13,649.06 2,221 2,322 1,601 2,093 24.5% 2,653.45 Net earnings 2,907.98 3,344.02 5,728 6,576 4,889 7,148 8,176.95 8,961.33 10,305.04 Dividends to all common shares 2,000 2,000 2,000 2,000 2,000.00 Retentions of earnings 2,000.00 2,000.00 3,728 4,576 2,889 5,148 6,176.95 6,961.33 8,305.04Historical Balance Sheets (Fiscal Year Ended June 30) (SGD 000) 1998 1999 2000 2001 2002 2003 2004 Assets: Cash 4,816 5,670 6,090 5,795 5% 5,487.68 6,310.83 7,257.46 Accounts receivable 22,148 25,364 28,078 35,486 31.0% 37,804.02 43,474.62 49,995.81 Inventories 23,301 27,662 53,828 63,778 60.0% 73,169.07 84,144.43 96,766.09 Total current assets 50,265 58,697 87,996 105,059 116,460.77 133,929.88 154,019.36 Gross property, plant & equipment 64,611 80,153 97,899 115,153 142,452.90 169,752.90 169,752.90 Accumulated depreciation (4,559) (13,587) (23,979) (35,339 (50,599.61) (69,760.08) (92,820.54) Net property, plant & equipment 60,052 66,566 73,920 79,814 91,853.29 99,992.82 76,932.36 Total assets 110,317 125,262 161,916 184,873 208,314.05 233,922.71 230,951.73 Liabilities and Stockholders' Equity: Short-term borrowings (bank) 29,002 37,160 73,089 84,981 84,980.88 84,980.88 84,980.88 Accounts payable 12,315 12,806 11,890 13,370 14% 17,072.78 19,633.70 22,578.75 Other accrued liabilities 24,608 26,330 25,081 21,318 23% 28,048.14 32,255.36 37,093.67 Total current liabilities 65,926 76,296 110,060 119,669 130,101.81 136,869.94 144,653.30 Long-term debt- 10,000 10,000 10,000 18,200 18,200.00 18,200.00 18,200.00 Shareholders' equity 34,391 38,967 41,856 47,004 53,181.07 60,142.40 68,447.44 Total liabilities and stockholders' equity 110,317 125,263 161,916 184,873 201,482.88 215,212.35 231,300.75 Cumulative Need for Funds 6,831.17 18,710.36 (349.02) Annual Need for For Funds 11,879.18 (12,228.21)Exhibit 3 STAR RIVER ELECTRONICS LTD. Ratio Analyses of Historical Financial Statements Fiscal Year Ended June 30 1998 1999 2000 2001 Profitability Operating margin (%) 18.6% 18.6% 15.6% 16.1% 0.14 0.13 0.13 Tax rate (%) 27.9% 26.1% 24.7% 22.6% 0.25 0.25 Return on sales (%) (PM) 0.25 8.0% 8.2% 5.3% 6.7% 0.07 0.06 Return on equity (%) ROE 0.06 16.7% 16.9% 11.7% 15.2% 0.15 0.15 0.15 Return on assets (%) ROA 5.2% 5.2% 3.0% 3.9% 0.04 0.04 0.04 Leverage Debt/equity ratio 1.13 1.21 1.99 2.20 1.94 1.72 1.51 Total Debt/total capital (%)( LT Debt Ratio) 0.53% 0.55% 0.67% 0.69% 0.66 0.63 EBIT/ Interest 0.60 2.45% 2.48% 1.82% 2.18% 2.58 2.74 3.00 Asset Utilization Sales/assets 65.2 64 57.2 57.4 0.59 0.60 0.70 Sales growth rate (%) 15.0% 11.4% 15.6% 14.5% 0.15 0.15 Assets growth rate (%) 0.15 8.0% 13.5% 29.3% 14.2% 0.09 0.07 0.07 Days in receivables 112.40 115.56 110.66 122.14 Payables to COGS 36.5% 33.4% 25.6% 25.0% Inventories to COGS 69.1% 72.1% 115.8% 119.3% Liquidity Liquidity ratios are less than 1, but both have been increasing steadily Current ratio 76.2% 76.9% 80.0% 87.8% 89.5% 97.9% 106.5% Quick ratio 40.9% 40.7% 31.0% 34.5% 33.3% 36.4% 39.6%STAR RIVER ELECTRONICS LTD. On July 5, 2001, her first day as CEO of Star River Electronics Lid., Adeline Koh confronted a host of management problems. One week earlier, Star River's president and CEO had suddenly resigned to accept a CEO position with another firm. Koh had been appointed to fill the position-starting 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 Lid., 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--2- UVA-F-1361 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%.' 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 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 warranted at least 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 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 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 performance for the next two years (ignore seasonal effects), and show me what our debtrequirements 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' 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 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 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 manager's 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: 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 River is 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 with 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.Exhibit 1 STAR RIVER ELECTRONICS LTD. Historical Income Statements for Fiscal Year Ended June 30 (SGD 000) 1998 1999 2000 2001 Sales 71,924 80,115 92,613 106,042 Operating expenses: Production costs and expenses 33,703 38,393 46,492 53,445 Admin. and selling expenses 16,733 17,787 21,301 24,177 Depreciation 8,076 9,028 10,392 11,360 Total operating expenses 58,512 65,208 78, 185 88,983 Operating profit 13,412 14,908 14,429 17,059 Interest expense 5,464 6,010 7,938 7,818 Earnings before taxes 7,949 8,897 6,491 9,241 Income taxes 2,221 2,322 1,601 2,093 Net earnings 5,728 6,576 4,889 7,148 Dividends to all common shares 2,000 2,000 2,000 2,000 Retentions of earnings 3,728 4,576 2,889 5,148 "The expected corporate tax rate was 24.5%.Exhibit 2 STAR RIVER ELECTRONICS LTD. Historical Balance Sheets for Fiscal Year Ended June 30 (SGD 000) 1998 1999 2000 2001 Assets: Cash 4,816 5,670 6,090 5,795 Accounts receivable 22,148 25,364 28,078 35,486 Inventories 23,301 27,662 53,828 63,778 Total current assets 50,265 58,697 87,996 105,059 Gross property, plant & equipment 64,611 80,153 97,899 115,153 Accumulated depreciation (4,559) (13,587) (23,979) (35,339) Net property, plant & equipment 60,052 66,566 73,920 79,814 Total assets 110,317 125,262 161,916 184,873 Liabilities and Stockholders' Equity: Short-term borrowings (bank)" 29,002 37,160 73,089 84,981 Accounts payable 12,315 12,806 11,890 13,370 Other accrued liabilities 24,608 26,330 25,081 21,318 Total current liabilities 65,926 76,296 1 10,060 119,669 Long-term debt 10,000 10,000 10,000 18,200 Shareholders' equity 34,391 38,967 41,856 47,004 Total liabilities and stockholders' equity 110,317 125,263 161,916 184,873 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. "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 Lid., U.K. This debt was subordinate to any bank debt outstanding. The second component was a SGDS.2 million from a 5-year bond issued on a private placement basis last July 1, 2000 at a price of SOD97 and a coupon of 5.75% paid semi-annually
