the CFO of Flash Memory, Inc was preparing the companys investing and financing plans for the next three years. As a small firm operating in the computer and electronic device memory market, Flash competed in product markets that reflected fast growth, continuous technological change, short product life cycles, changing customer wants and needs, a large number of competitors, and a high level of rivalry within the industry. These factors combined to produce low profit margins and a continual need for additional working capital, which adversely impacted Flashs financial position and its ability to finance important investment opportunities. Flash had intense competition between product offerings, high rivalry, and low profit margins as a percent of sales.

Background

In spring of 2010, Flash specialized in the design and manufacture of SSDs and memory modules that were sold to original equipment manufacturers (OEMs), distributors, and retailers and ended up in computers, computing systems, and other electronic devices. Flashs memory components, which constituted 80% of company revenue, utilized flash memory technologya non- volatile memory that is faster, uses less power, is more resistant to failure when compared with traditional hard disk drives, and continues to store information even after an electronic device is turned off. The remaining 20% of Flashs sales came from other high performance electronic components sold through the same channels, for the same end products.

Due to changes in technology, Flashs memory and other products experienced short product life cycles. The companys new products typically realized 70% of their maximum sales level in their first year, and maximum sales were reached and maintained in the second and third years. Years four and beyond saw rapidly decaying sales, and by year six the products were obsolete. This normal sales life cycle for the companys products, however, could be significantly shortened by technologically superior new products released by competitors. In a few instances Flashs products quickly became worthless, forcing significant inventory write-downs and reductions in profit.

Flash responded to the risk of technological changes in the industry by aggressive spending on research and development to improve its existing product lines and add new ones. The company had successfully recruited and retained a highly skilled group of research engineers and scientists, and the activities of this group had been supported by substantial budgetary allocations. This combination of ample funding of an exceptional staff had resulted in high quality products which were well-respected by customers and competitors alike. Top management believed the reputation of Flashs products was one of its key competitive advantages, and they were determined to maintain this reputation through continued research and development expenditures.

The success of Flashs memory components had resulted in compounded average annual sales growth of 7.6% per year since 2007 (Exhibit 1), and its investment in current assets had grown even faster, at a 12.2% compounded average annual rate over the same period (Exhibit 2). Flash had used notes payable obtained from the companys commercial bank, and secured by the pledge of accounts receivable, to fund this growth of working capital. Although these notes payable were technically short-term loans, in actuality they represented permanent financing, as the company continually relied on these loans to finance both existing operations and new investments. The bank was willing to lend up to 70% of the face value of receivables, and this funding arrangement had been satisfactory until recently, when the companys bank note payable balances had reached this 70% limit. The bank loan officer had made it clear to Browne that Flash had reached the limit of the banks ability to extend credit under the terms of the current loan agreement.

As general economic conditions improved in the first few months of 2010, Flashs sales increased rapidly, and the company continued to generate profits in approximately the same percentage of sales as in 2009. Unfortunately this rapid sales growth had also required a large increase in working capital, and internal cash flow had not been sufficient to fund this increase in receivables and inventories. The banks position on extending additional financing remained the same, and when approached in May about extending additional credit to the company, the loan officer had been unwilling to do so.

The loan officer did, however, discuss the factoring division of the bank with Browne, which serviced higher-risk customers with more aggressive accounts receivable financing. The factoring group would lend up to 90% of a companys existing accounts receivable balances, but this group would also monitor Flashs credit extension policies and accounts receivable collection activities more rigorously than the commercial loan department that currently managed the companys loan agreement. Because of the additional risk and greater cost associated with closer monitoring of the loan, the interest rate charged by the bank would increase from prime + 4% to prime plus 6% on the total outstanding loan balance to Flash, based off the May 2010 prime rate of 3.25%. In its forecasting process, Flash calculated interest expense as the beginning of year debt balance multiplied by the appropriate interest rate. Although this would not produce a precise number for forecasted notes payable and interest expense, Browne preferred to start with a simpler calculation, and this produced a reasonable first estimate.

Growth Projections

Based on the overall economic recovery and recent reports of robust sales of smart phones and net books, in early May the company was forecasting full-year 2010 sales of $120 million, with a corresponding cost of goods sold number of $97.32 million. Flashs projected year-end 2010 current asset investment necessary to support this level of sales and cost of goods sold was also prepared to assess the companys immediate financing needs.

These forecasts of working capital requirements were based on sales in recent months, projected demand from OEMs, distributors, and retailers during the remainder of the year, and expected relationships between the income statement and these working capital accounts. Cash had been estimated at 3.3% of sales, accounts receivable were calculated based on an estimated 60 days sales outstanding, and the inventory forecast assumed the company would improve its inventory turnover, holding only 52 days of cost of goods sold in inventory.

Beyond 2010, the marketing manager had estimated that sales of the companys existing products would reach $144 million in 2011. It was expected that sales would be maintained at that level in 2012, but after that sales would decline to $128 million in 2013 and $105 million in 2014. In spite of the expected growth in the overall industry, Flashs product line would be less competitive absent new products which were significant improvements over previous offerings.

In addition to these income statement and working capital forecasts, there were other important items which would impact the companys forecasts and financing requirements. Purchases typically made up 60% of cost of goods sold, and the year-end 2009 accounts payable balance represented 33 days of purchases. This wasnt much greater than the 30-day payment period that Flash tried to maintain, but in 2010 and beyond the company was committed to achieve and maintain this number. The second of these items was research and development, which was planned to increase in 2010 to drive new product innovation. Research and development expenditures had been approximately 5% of sales in recent years, and in 2010 and beyond management was committed to maintaining expenditures at this percent of sales. Selling, general and administrative expenses were driven by sales volume and were expected to maintain their 2009 relationship with sales. Capital expenditures necessary to support existing product lines and sales growth were projected at $900,000 per year in 2010 through 2012. The final item was yearly depreciation expense, which was calculated as 7.5% of the beginning of year balance of property, plant & equipment at cost. A summary of these important forecast assumptions is included (Exhibit 3).

Investment Opportunity

Browne had recently been given a proposal for a major new product line, which was expected to have a significant impact on the companys sales, profits, and cash flows. This new product line had been in development for the past nine months, and $400,000 had already been spent taking the product from the concept stage to the point where working prototypes had been built and were currently being tested. Flashs design and marketing people were very excited about this new product line, believing its combination of speed, size, density, reliability, and power consumption, would make it a winner in the fastest growing segment of the memory industry.

Customer acceptance and competitor reaction to the new product line was uncertain, but the projects sponsors were confident it would generate sales of at least $21.6 million in 2011 and $28 million in 2012 and 2013, before falling off to $11 million in 2014 and $5 million in 2015. The product was also believed to be superior to existing memory products, and would therefore command gross margins of 21% throughout its life.

Implementing this new product line would also require large investments and expenditures by the company. New plant and equipment costing $2.2 million must be purchased, and this specific equipment would be depreciated straight-line to zero salvage value over its five-year life. This depreciation expense all flowed to cost of goods sold expense, and was already included in the estimate that cost of goods sold would be 79% of sales. Flash also expected net working capital would be 26.15% of sales. This initial investment in equipment and net working capital would occur in 2010, and in subsequent years the net working capital would increase and then decrease, as sales of the new product line rose and then fell. SG&A expenses were expected to be the same percent of sales as the company experienced in 2009, but in addition the marketing manager also planned a one- time $300,000 advertising and promotion campaign simultaneous with the launch of the product in 2011.

Should they invest in a new product/project and why?