FIN42080 Star River Electronics Sample Assignment

FIN 42080

Star River Electronics Ltd. Case

1. Assess the current financial health and recent financial performance of the company. What strengths and/or weaknesses would you highlight to Adeline Koh?

Advantages

For the positives, there are six things to highlight for Adeline Koh: the increase in ROA and ROE, the continued high growth rate for sales and assets, and the high current and quick ratios.

The ROE increased from 11.7% in 2000 to 15.2% in 2001.
Additionally, the ROA increased from 3.0% to 3.9%.
However, this is still below its 1999 and 1998 level.
Sales did grow 15%, 11.4%, 15.6%, and 14.5%, however earnings did not grow with sales.
Company managed to stay profitable over the past five years.
Company issued dividends to shareholders on a consistent basis.

Disadvantages

For the disadvantages, I would highlight the increase in debt and interest expense. These two things are particularly concerning given the forecast for declining CD-ROM sales. Investors are also heavily concerned with how well a company can cover its debt obligations. Star River is only able to cover its interest expense by slightly more than two times its equity and this could lead to future problems regarding liquidity. Operating margin percentage has been decreasing since 1998, which shows lack of efficiency. Debt to equity ratios have been trending upwards and compounding at a rate of 18%. Especially notable is the jump from 1999 to 2000, which was an increasing rate of 64%. The shortage of cash that the company is experiencing is most likely from accounts receivable increasing and account payable increasing as well. This tight short-term cash position could potentially explain the company’s short-term borrowing. Their current cash flows are unable to fund the daily financial needs of operations, such as paying suppliers. The cash shortage problem could stem from the fact that the company is having a hard time collecting payments from customers, which would help lower interest expenses if collected more efficiently. The company also have old packaging equipment that needed frequent repairs and shutdowns, which stalled or stopped production. This caused employees to have to work overtime and thus increased the company’s expenses even more. Overall, the company has a large amount of capital expenditure while also taking on too much debt, which has resulted in a relatively weak financial position.

2. Forecast the firm’s financial statements for 2002 and 2003. What will be the external financing requirements of the firm in those years? Can the firm repay its loan within a reasonable period?

Pro Forma Income Statement

(SGD 000)	1998	1999	2000	2001	2002	2003
Sales	71,924	80,115	92,613	106,042	121,948	140,241
Operating expenses:
Production costs and expenses	33,703	38,393	46,492	53,445	61,462	70,681
Admin. and selling expenses	16,733	17,787	21,301	24,177	27,804	31,975
Depreciation	8,076	9,028	10,392	11,360	15,260	23,060
Total operating expenses	58,512	65,208	78,185	88,983	104,526	125,716
Operating profit	13,412	14,908	14,429	17,059	17,422	14,524
Interest expense	5,464	6,010	7,938	7,818	7,818	7,818
Earnings before taxes	7,949	8,897	6,491	9,241	9,604	6,706
Income taxes*	2,221	2,322	1,601	2,093	2,353	1,643
Net earnings	5,728	6,576	4,889	7,148	7,251	5,063
Dividends to all common shares	2,000	2,000	2,000	2,000	2,000	2,000
Retentions of earnings	3,728	4,576	2,889	5,148	5,251	3,063

(SGD 000)	1998	1999	2000	2001	2002	2003
Cash	4,816	5,670	6,090	5,795	6,664	7,663.73
Accounts receivable	22,148	25,364	28,078	35,486	40,809	46,930.25
Inventories	23,301	27,662	53,828	63,778	73,345	84,346.41
Total current assets	50,265	58,697	87,996	105,059	120,818	138,940.39
Gross property, plant & equipment	64,611	80,153	97,899	115,153	142,453	169,752.90
Accumulated depreciation	(4,559)	(13,587)	(23,979)	(35,339)	(50,600)	(73,660.08)
Net property, plant & equipment	60,052	66,566	73,920	79,814	91,853	96,092.82
Total assets	110,317	125,262	161,916	184,873	212,671	235,033.21
Liabilities and Stockholders' Equity:
Short-term borrowings (bank)¹	29,002	37,160	73,089	84,981	84,981	84,981
Accounts payable	12,315	12,806	11,890	13,370	15,375	17,682
Other accrued liabilities	24,608	26,330	25,081	21,318	24,516	28,193
Total current liabilities	65,926	76,296	110,060	119,669	124,872	130,855.60
Long-term debt²	10,000	10,000	10,000	18,200	18,200	18,200.00
Shareholders' equity	34,391	38,967	41,856	47,004	52,255	55,318.49
Total liabilities and stockholders' equity	110,317	125,263	161,916	184,873	195,327	204,374.10
					EFN
					17,344	30,659

Pro Forma Balance Sheet

		1998	1999	2000	2001	2002	2003
Profitability
	Operating margin (%)	18.6%	18.6%	15.6%	16.1%	14.3%	10.4%
	Tax rate (%)	27.9%	26.1%	24.7%	22.6%	24.5%	24.5%
	Return on sales (%)	8.0%	8.2%	5.3%	6.7%	5.9%	3.6%
	Return on equity (%)	16.7%	16.9%	11.7%	15.2%	13.9%	9.2%
	Return on assets (%)	5.2%	5.2%	3.0%	3.9%	3.4%	2.2%
Leverage
	Debt/equity ratio	1.13	1.21	1.99	2.20	1.97	1.87
	Debt/total capital (%)	0.53	0.55	0.67	0.69	0.66	0.65
	EBIT/interest (x)	2.45	2.48	1.82	2.18	2.23	1.86
Asset Utilization
	Sales/assets	65.2%	64.0%	57.2%	57.4%	57.3%	59.7%
	Sales growth rate (%)	15.0%	11.4%	15.6%	14.5%	15.0%	15.0%
	Assets growth rate (%)	8.0%	13.5%	29.3%	14.2%	15.0%	10.5%
	Days in receivables	112.4	115.6	110.7	122.1	122.1	122.1
	Payables to COGS	36.5%	33.4%	25.6%	25.0%	25.0%	25.0%
	Inventories to COGS	69.1%	72.1%	115.8%	119.3%	119.3%	119.3%
Liquidity
	Current ratio	0.76	0.77	0.80	0.88	0.97	1.06
	Quick ratio	0.41	0.41	0.31	0.34	0.38	0.42

Pro Forma Ratios for 2002 and 2003

Firm payment of loan

No, the firm would not be able to pay its loan because to achieve the 15% sales growth rate and all the changes which that would bring, Star River will require 17. 344 million SGD in 2002 and 30.659 million SGD in 2003. This amount of external financing needed does not seem to indicate that the company would be able to pay off any loans that it will be signing in the near future due to its requiring of financing, most likely more debt, to reach its maximum growth rate.

3. 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?

The core assumption for this model is the growth rate of the company. Because the expenses are almost entirely varied with the growth rate in the model, should the growth rate fall short of the projected 15%, Star River Electronics would be in big trouble. This is also highly possible since the market is moving away from CD-rom’s and now even moving away from DVD’s and there is a chance they may suffer from technology obsolescence. Additionally, the interest expense is assumed to remain constant. Therefore, it is assumed that no new debt in incurred. This is important because if the growth rate is less than the projected 15% and the company still sends more, as if sales went up dramatically, the increase in interest expense would be a very big deal. Additionally, the dividend payout (2,000SGD per annum) is assumed to be fixed. Should the net income be less than projected, again due to a sales projection miss, the retained earnings portion of the balance sheet would miss its projection and hurt some of the projected ratios.

Other key drivers and assumptions of the company’s financial health are that there must be a reduction in production costs and debt, which includes replacing the old production machines with newer ones. The company should use comparative analysis to help determine when they should buy the new equipment since it will be a hefty purchase. To reduce the company’s debt, they will need to stop issuing dividends for a while. Although this seems like a positive, it is hurting the company because that money could be better used to pay off debt. The company should also collect its account receivables that customers owe of about $5,486. The company must also reduce inventory by stopping production for a short time so that the company can reduces its short-term loans which were being using for holding inventory. The company should also focus on equity financing instead of debt financing to help reduce interest payments and loans.

4. What is Star River’s weighted-average cost of capital (WACC)? What methods did you use to estimate WACC? What are the key assumptions that especially influence WACC?

The weighted average cost of capital for Star River Electronics was 10.64%%. We arrived at this by using a MV/BV multiplier as a proxy for the market capitalization, since this is a private company. Additionally, we assumed that the book value of debt is also equal to the book value. The multiple for MV/BV was calculated by taking the average of the premium that Star River’s closest peers were trading at relative to their book values. For the closest peers, we used Wintronics, Inc, STOR-Max Corp, and Wymax, Inc. We used these because they were the three companies that had the majority of their business in CD-ROMs and DVD Production, making them the closest peers. We calculated their market capitalization by taking the shares outstanding and multiplying it by the share price. We calculated the book value the same way. The math is summarized in the chart below. MV/BV Multiple = 3.41x = $3941/$1156.

Company	Book Value per Share	Market Price per Share	Number of Shares Outstanding (millions)	Total BV	Total MV
Wintronics, Inc.	1.46	6.39	177.2	258	1,132
STOR-Max Corp.	7.06	27.48	89.3	631	2,454
Wymax, Inc.	6.95	22.19	371.2	2,581	8,235
			Average	1,156	3,941
				MV/BV Multiplier
				3.41x

Weights of Debt vs. Equity

Using the multiple calculated above, the MV of equity was calculated. MV of Equity = BV of Stockholder’s Equity * MV/BV Multiple. In 2001, that would be 47,004 * 3.41 = 160,284. The BV of Debt was assumed to be the same as MV of Debt. Therefore, the MV of debt in 2001 was 103,181 (Long-term debt + Short-term borrowing). Therefore, the weights of the market values of debt and equity were 60.8% equity and 39.2% debt, respectively.

Cost of Equity

The cost of equity was calculated using the average of the betas from the three closest competitors as a proxy for this company’s beta, then the CAPM formula was used. The average beta from the same three companies that were used to calculate the MV/BV multiple were used for this calculation as well. The average beta ended up being 1.58. Therefore, that was the beta used for this company. The 5-year bond from Singapore’s central bank in January 2001 was yielding 3.14%[1]. In the spreadsheet, it said to assume the Singapore market risk premium was in line with the global average of 6%, so we used a risk premium of 6%. Therefore, the formula used to calculate the cost of equity for this company was 3.14 + (1.58 * 6), which is 12.62%.

Cost of Debt

For this calculation, we simply divided the interest expense by the total amount of debt outstanding (Long-term debt + short term borrowing). This formula was…

7.58% = 7,818 / 103,181.

WACC Calculation

WACC = (Weight of Debt * Cost of Debt) + (Weight of Equity * Cost of Equity)

10.64% = (0.392 * 7.58) + (0.608 * 12.62)

Critical Assumptions

The biggest assumptions for the WACC calculation in the MV/BV multiplier and the use of those three particular companies as the proxy for the market information of this company, since Star River is private. However, these assumptions were made to create a more accurate market-based WACC as opposed to a book value based WACC. From these two assumptions, all the other assumptions were derived, namely the beta value for the CAPM equation and the weights of both debt and equity. These are major parts of the WACC calculation so their being derived for two assumptions is worth noting. However, our assumptions are grounded in logic and follow two consistent themes, that market based WACC are superior to book value based WACCs and that Star River should be compared with its peers and only closest peers.

[1] https://www.investing.com/rates-bonds/singapore-5-year-bond-yield-historical-data