Case Overview
Star River Electronics Ltd. Star River Electronics Ltd. is a large manufacturer and supplier of CD-ROMS based in Singapore. It was founded as a joint venture between an Asian venture capital firm, New Era Partners and Starlight Electronics Ltd, UK. It has enjoyed a great deal of success in the past, due in large part to their excellent reputation for producing high-quality discs. But due to recent emerge of Digital Video Disks (DVDs) Star River Electronics does need to face some problems. The conditions got worsen with the recent resignation of their former CEO.
The new CEO Adeline Koh needs to face these problems. Digital Video Disks (DVDs) are expected to cut into the CD-ROM market in the very near future, but with 5% of their sales coming from this area. Star River needs capital expenditures to increase their capacity in this sector. To finance this expenditure, they can use either debt or equity. Also, a new packaging machine which would cut down on labor and overhead costs has been proposed, and Star River needs to know whether to approve the purchase now, or wait three years, where new equipment would have to be purchased to handle the projected growth rates.
Finally, a weighted average cost of capital needs to be estimated for the firm, which will help to answer this question of whether to wait or buy this equipment at the present time. In order to ensure the continuation and financial stability of Star River Electronics Ltd. chief executive officer Adeline Koh must convince the Company’s banker, to grant an extension on the Company’s loan as the Company stands to improve its performance through DVD production (and possibly, the purchase of new packaging equipment). Here is the summary of financial questions facing Koh:
Historical performance of Star River Electronics Ltd. and provide some positive or negative insight on them. Financial Forecast of Star River Electronics Ltd. ’s performance for next 2 years. Estimate Return on Book Asset and Equity and identify key assumptions of those returns. Estimate Star River Electronics Ltd. ’s Weighted Average Cost of Capital and assess the Packing machine investment. Recommend about financial and operating changes.
Historical Analysis
Ratio analysis
For historical analysis we have provided a ratio analysis of 4 years and showed a trend for next 2 years on the basis of these ratios.
Profitability Ratios
Return on Equity Return on Equity measures the rate of return on the ownership interest (shareholders’ equity) of the common stock owners.
It measures a firm’s efficiency at generating profits from every unit of shareholders’ equity (also known as net assets or assets minus liabilities). ROE shows how well a company uses investment funds to generate earnings growth. Star River has had a decent return on equity ranging from 11. 7% to 16. 7%.
Return on Assets
The return on assets (ROA) percentage shows how profitable a company’s assets are in generating revenue. This tells us what the company can do with what it has, i. e. how many dollars of earnings they derive from each dollar of assets they control.
Return on assets gives an indication of the capital intensity of the company, which will depend on the industry; As Star River requires large initial investments it generally has lower return on assets.
Leverage Ratio
The Debt-To-Equity Ratio The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders’ equity and debt used to finance a company’s assets. Star River’s last year (2001) standing D/E ratio was 2. 2 which is higher than its industry practice. A high debt/equity ratio generally means that the company has been aggressive in financing its growth with debt.
This can result in volatile earnings as a result of the additional interest expense.
Debt-To-Capital Ratio
The debt-to-capital ratio gives users an idea of a company’s financial structure, or how it is financing its operations, along with some insight into its financial strength. The higher the debt-to-capital ratio, the more debt the company has compared to its equity. Star River has always depended much on debt for its financing and the trend shows this ratio may get higher in future. Star River, with high debt-to-capital ratios, compared to a eneral or industry average, may show weak financial strength because the cost of these debts may weigh on the company and increase its default risk.
Asset utilization Ratio
Sales/Assets: Asset turnover is a financial ratio that measures the efficiency of a company’s use of its assets in generating sales revenue or sales income to the company. The higher the number the better. Star rivers asset turnover has been decent over the years. Inventories to COGS: Inventories to COGS ratio is the Percentage of cost of sales attributable to average inventory.
A decreasing number indicates higher efficiency in use of resources; an increasing number suggests potential cash flow problems due to greater sums tied up in inventory. In our analysis, we found that there is a significant inventory problem. Star River’s inventory to COGS was as high as 119. 30% in the last year. What it shows is that the inventory that they are creating is becoming outdated before they are able to sell it. Payable to COGS The ratio analysis of Star River shows that they have been able to decrease their payables account, meaning they are paying more of their obligations at the current time.
The Days in Accounts Receivable Ratio: The days in accounts receivable ratio is, as the name implies, the calculation of how many days of cash are locked up in receivables. Receivables are the money is that is owed the company. This calculation shows the average number of days it takes to collect your accounts receivable. Another problem we found with their ratios is that they are having problems collecting on their receivables. What this will ultimately lead to is a cash inflow problem. Liquidity ratio: Current ratio: The current ratio is a financial ratio that measures whether or not a firm as enough resources to pay its debts over the next 12 months. It compares a firm’s current assets to its current liabilities. Star River’s current ratio indicates that it cannot cover its current obligations totally with its current assets. Low values (less than 1), however, do not indicate a critical problem. If an organization has good long-term prospects, it may be able to borrow against those prospects to meet current obligations. ? Financial Forecast: The second task that needed to be finished was to forecast the income statement and the balance sheet for the next two years.
We grew sales at a 15% rate, which is the stated rate from Koh. Also, in forecasting the balance sheet, we only showed debt financing for the capital expenditure of the DVD manufacturing equipment, which was the requested structure. Other relevant facts and assumptions for preparing the financial forecast are stated below- Assume that sales will increase at 15% per year Operating expenses and operating profit will increase by the same percentage Assume that cash will increase at 15% per year Accounts receivable and inventories will also increase by the same percentage
Assume accounts payable and other accrued liabilities will increase by 15% per year Interest expense is weighted for short-term debt and long-term debt: 6. 53% The new DVD manufacturing equipment will cost SGD54. 6 million The new equipment costs are paid throughout the next two years. The new equipment is depreciated over seven years in straight line method. Long term debt calculation includes private placement of 10mill loan, SGD8. 2 mill 5 year bond and the new bank loan for SGD54. 6 million. Short term bank loan is calculated in consistent with previous years’ trend.
Analysis of Financial Forecast
Current Ratio Analysis
The forecasted balance sheet shows that there is a problem with current assets covering current liabilities.
The Current Ratio stands 0. 82 and 0. 79 for 2002 and 2003. This means, if Star River continues with their current borrowing structure, they will not be able to cover all of their current obligations.
Debt Equity Ratio
With the proposed structure of debt structure Star River will face a serious default risk threat as they are already heavily levered. The D/E ratio for 2002 and 2003 stands 6. 30 and 6. 71 which is quiet extreme in the industry standard. Debt Service Coverage Ratio The debt service coverage ratio (DSCR) is the ratio of cash available for debt servicing to interest, principal and lease payments.
A DSCR of less than 1 would mean a negative cash flow. From the above statements projected DSCR for year 2002 and 2003 is 4. 097% and 4. 013%. This would mean that there is only enough net operating income to cover only about 4% of annual debt payments. This is a serious problem for Star River. Banks will be very unlikely to provide any loan in this situation. Furthermore they face an acute default risk. NPV Analysis: We calculated the Net Present Value of the new DVD manufacturing project assuming 6. 36% cost of capital (calculation shown later). We assumed cash flow increases at the same percentage of sales (15%).
It gives us a positive NPV of SDG66808. 57 for a 5 year run of the project and an Internal Rate of Return of 28%. If we deem our estimations are correct then the project is quite a profitable one.
Net Earnings
With the increase of 15% sales and increased interest expense for additional debt requirements, the net earnings for 2002 and 2003 in comparison to other years have increased.
It shows that though sales are increasing at a substantial rate, increase in interest payment slows the growth of Net Earnings.
Forecasting Book Value Return on Equity (ROE) and Return on Assets (ROA)
The next request was to come up with reasonable forecasts of book value Return on Equity and Return on Assets. The main driver assumptions in these forecasts are: The growth assumption of 15% increase in Sales. Net Income after Tax, as well as the 15% growth assumption of cash flows to the firm. The calculated Weighted Average Cost of Capital (rWACC) of Star River Electronics Ltd.
Assuming that Operating expenses and operating profit & Accounts receivable and inventories will increase by 15% Return on Equity (ROE) measures the rate of return on the ownership interest (shareholders’ equity) of the common stock owners. It measures a firm’s efficiency at generating profits from every unit of shareholders’ equity. ROE shows how well a company uses investment funds to generate earnings growth. ROE is expressed as a percentage and calculated as: ROE = (Net Income After Tax)/(Equity Capital) The calculated ROE for Star River Electronics Ltd. for the next 2 years are: Year20022003
ROE25. 80%26. 92% ? Return on Assets is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company’s annual earnings by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as “return on investment”. The formula for return on assets is: ROA = (Net Income After Tax)/(Total Assets) The assets of the company are comprised of both debt and equity. Both of these types of financing are used to fund the operations of the company.
The ROA figure gives investors an idea of how effectively the company is converting the money it has to invest into net income. The higher the ROA number, the better, because the company is earning more money on less investment. The calculated ROA for Star River Electronics Ltd. for the next 2 years are: Year20022003 ROA3. 54%3. 49% ? Decision Regarding New Packing Equipment: The last request we addressed was to determine if the cost of waiting 3 years in investing in the new packaging equipment outweighed purchasing now. To help compare these two scenarios, we had to determine an appropriate WACC.
In calculating our WACC, we took a weighted cost of our short-term debt and long-term debt to determine the appropriate borrowing rate. To determine the appropriate cost of equity, we unlevered the industry’s beta, which consisted of Wintronics and STOR-Max Corp. , and re-levered that beta with our debt structure.
Once we determined the appropriate WACC, we looked at the price difference of the new equipment waiting three years and the costs associated with the old equipment; then we looked at the costs associated with purchasing the new equipment at the current time. We discounted the appropriate cash flows to the current time and compare the two outcomes.
The underlying assumptions & Facts were: The new packaging machine will cost SGD1. 82 million.
We can see from the above calculation that by purchasing the new packaging machine now instead of waiting three years, they will cut costs by SGD15558 and add value to the firm.
Findings & Recommendation
Positive Aspects of Historical Analysis
Star River has had a decent Return On Equity Star rivers Asset Turnover has been decent over the years. Star River shows that they have been able to decrease their payables account Negative Aspects of Historical Analysis Star River’s D/E ratio is higher than its industry practice.
This can result in volatile earnings as a result of the additional interest expense. Star River, with high Debt-To-Capital Ratios, compared to a general or industry average, may show weak financial strength because the cost of these debts may weigh on the company and increase its default risk. Inventories to COGS ratio shows Star River Electronics Ltd. has had a significant inventory problem. The inventory that they are creating is becoming outdated before they are able to sell it. The Days in Accounts Receivable Ratio shows that they are having problems collecting on their receivables.
What this will ultimately lead to is a cash inflow problem. Star River’s Current Ratio indicates that it cannot cover its current obligations totally with its current assets. Positive Aspects of Financial Forecast: The NPV analysis gives us high positive NPV and high IRR for Star River Electronics Ltd. ’s DVD manufacturing project. With the new DVD manufacturing project sales increases by 15% the Net Earnings for Star River Electronics Ltd. will also increase from previous years. Negative Aspects of Financial Forecast The forecasted balance sheet shows that there is a problem with current assets covering current liabilities.
If Star River continues with their current borrowing structure, they will not be able to cover all of their current obligations. With the proposed structure of debt structure Star River will face a serious default risk threat as the D/E ratio is quiet extreme in the industry standard. The Debt Service Coverage Ratio (DSCR) shows that there is enough net operating income to cover only about 4% of annual debt payments. Any Bank will be very unlikely to provide any loan in this situation. Because of debt financing Star River Electronics Ltd. incurs higher interest expense which results in lower than expected Net earnings and cash flow shortage.
The current structure of debt shows that 82% of financing comes from short term bank loans which we think is one of the main reasons behind Star River Electronics Ltd. ’s liquidity problems. Findings Regarding New Packing Equipment: Purchasing the new packaging machine now instead of waiting three years, will save costs by SGD15558 and add value to the firm. It will certainly increase efficiency and add speed, capacity and reliability in production process. Findings Regarding ROE and ROA Return on Equity (ROE) measures a firm’s efficiency at generating profits from every unit of shareholders’ equity.
It shows how well a company uses investment funds to generate earnings growth. The ROE has increased from 2000 to 2001 for Star River Electronics Ltd. which may be due in part to the decreasing equity from the increased debt in that time period. For the projected years of 2002 & 2003 the ROE is 25. 8% and 26. 92%. This high ROE will help the manager’s to persuade the shareholder’s to inject more capital to the company. Return on Assets is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings.
The ROA of Star River Electronics Ltd. for the next 2 years are projected to be 3. 54% & 3. 49%. Though the numbers are declining from previous years it’s not yet a matter of high concern, but the managers should give a look at it. ? Recommendations: Financial Changes: Equity Financing: We suggest that Star River Electronics Ltd. shift their financing towards equity as opposed to debt financing. This is because they cannot go on increasing debt financing at the cost of high default risk and face bankruptcy. At the current rate very few if any banks will be interested to lend them.
As we have estimated high Return on Equity from the current project, the Star River Electronics Ltd. shareholders/investors will be interested in financing the attractive project. Solve Current Liquidity Problem: To mitigate the current liquidity problem one thing Star River Electronics Ltd. can do is reduce the amount of short term borrowings by leaning more heavily toward equity and the use of more long-term debt as opposed to short-term debt. This will reduce their interest expenses as well as short term obligations. Operating Changes: Reduce Inventories
The days in receivables has been substantially increasing throughout the past few years, which adds to holding costs. Star River Electronics Ltd. needs to address their increasing inventories by increasing managerial efficiency. Collection of Account Receivable: Star River Electronics Ltd. needs to increase its efficiency in collecting receivables timely if they want to avoid cash inflow problems. New Packing Equipment: As the costs of waiting 3 years in investing in the new packaging equipment outweighs purchasing now, Star River Electronics Ltd. should buy it now rather than waiting. This would also help them increase efficiency.
