Case 26
STAR RIVER
ELECTRONICS LTD.
Group A Team Member
Juthatip Khaovisate 5949005
Phantida Pukpinyo 5949007
Kamonchat Vonglodjanaporn 5949024
Chanjilar Panyakorn 5949038
COMPANY BACKGROUND
Star River Electronics Ltd. was founded as a joint venture between Starlight Electronics
Ltd., United Kingdom, and an Asian venture-capital firm called New Era Partner. The company
was located in Singapore. The company had only one mission which was to manufacturer CD-
ROMs as a supplier to major software companies. However, the company was popular in the
industry for producing high-quality discs. Moreover, the popularity of optical and multimedia
products created rapid growth for CD-ROM manufacturers in the mid-1990s.
CURRENT SITUATION
On July 5, 2001, Adeline Koh was inaugurated as a CEO of Star River Electronics Ltd. The
company survived in the shakeout in the optical-disc manufacturing industry because the
company had a strong volumes in sales in the past two years while other CD-ROMs
manufacturers had floundered. However, the optical-disc-manufacturing industry was
considered as a sunset business especially for CD-ROMs, where the unit prices had decreased
due to a higher competition in the industry and an increase in the substitute products which
was DVDs, where it had 14 times more storage capacity compare to CD-ROMs, and it showed
that the used of CD-ROMs would drop to 41% by 2005 and the used of DVDs would increase by
59%.
Question 1: Assess the current financial health and recent
financial performance of the company. What strengths
and weaknesses would you highlight to Adeline Koh.?
Profitability Ratio
The above bar charted illustrated the profitability ratio of the Star River Electronics Ltd.
from the year 1998 – 2001. The operating margin of the company for the year 1998 – 1999 was
at 18.6% whereas the number dropped to 15.6% in 2000 and had increased a bit to 16.1% in
2001 which showed that the company’s pricing strategy and operating efficiency was slight
dropped, but overall the margin was still fine. Return on sales (ROS) measured the financial
profitability ratio that shows how much the profit is being made per dollar of sales. The ROS for
Star River Electronics Ltd. was quite low in the year 1998, the ROS was only at 8% and it
dropped to 5.35 in the year 2000, which represented a negative signal to the management.
Return on Equity (ROE) represented that out of 100 SGD of share equity that investors invested,
the return that investors would get in 1998 was 16.7SGD and it decreased to 15.20SGD in the
year 2001. Return on Assets (ROA) showed that out of 100SGD of total assets how much net
income the company could generate, in the year 1998 the company could generated only
5.2SGD and it declined to 3.2SGD in the year 2001, which was not a good sign.
LEVERAGE RATIO
Debt to Equity Ratio measured the ability of the company to meet financial obligations,
it showed that the company had an increasing trend in Debt to Equity Ratio from 1998 to 2001
which was 1.13 and 2.20 respectively, moreover, the company had the highest debt to equity
ratio compared to other companies in the same industry (Exhibit 5). However, the EBIT/Interest
ratio was dropped in the year 2000, the reason was because the company paid a higher interest
expense in that year which was 7,938,000 SGD.
ASSETS UTILIZATION
The bar chart above illustrated the asset utilization of the company by showing the sales
growth rate and assets growth rate from the year 1998 – 2001, for sales growth rate, the
company had a growth in sales at 15% in the year 1998 and it dropped to 14.5% in the year
2001, therefore, the sales growth rate did not change much over the four years. On the other
hand, the assets growth rate had gradually increased, the assets growth rate in the year 1998
was at 8% and it hit 29.3% in the year 2000, the reason was because the company had a huge
increase in inventories and it dropped to normal range at 14.2% in the followings year because
the company had an increase in account receivables as well as inventories.
The table above showed the asset utilization of the company, the day in receivables
showed that the number of days that the customers paid for the goods, however, the trend of
the number of days had increased it simply showed that their clients had paid late and it was
more difficult to collect the money from clients or the company had given a longer credit term
to their clients. The payables to COGS of the company had dropped from 36.5% in 1998 to 25%
in 2001, whereas the receivables to COGS increased tremendously from 69.10% in the year
1998 to 119.3% in 2001, it showed that the company had a difficulties dealing with their clients.
LIQUIDITY RATIO
The table above showed the liquidity ratio of the company from the year 1998 to 2001.
Current ratio measured that the company’s ability to pay its short-term and long-term
obligations, it measures total assets and total liabilities of the company, for Stat River Electronics
Ltd. it showed that the range of current ratio fall between 0.76 to 0.88, the company did not
have a good financial health, the company may have a difficulties in paying debt. Quick ratio
measures the company’s ability to meet its short-term debt with its liquidity assets, therefore,
the ratio was too low, it showed that in the year 2001, SGD0.34 of liquidity assets were available
to cover each SGD1 of current liabilities.
STRENGTHS AND WEAKNESSES
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?
We use the following assumptions:
• Sales increases 15% /year
• Production costs and expenses: 49% of sales
• Admin. and selling expenses: 22.5% of sales
• Depreciation: 14% of gross property and equip
• Interest expense: 6.7% of short term borrowings
• Tax Rate 24.5%
Then, we will get the forecasted Income Statements as below:
We use the following assumptions:
• Similar to past couple of years
• Accounts receivable: 32% of sales
• Inventories: 60% of sales
• Gross property, plant & equipment: Add New DVD equipment over 2 years
• Accumulated depreciation: 14% of gross property/equipment
• Accounts payable: 13% of sales
• Other accrued liabilities: Assuming 20,000
• Long-term debt: Same as last year
• Shareholders' equity: Add Retention of earnings
Then, we will get the forecasted Balance Sheets as below:
These were forecast using the percent-of-sales method, averaging the most recent two
years to provide the primary ratios, with a few exceptions. This forecast shows that while
maintaining the current levels of operating efficiency, depreciation of existing equipment, and
purchasing the new DVD equipment will require additional funds on the order of SGD 11M for
2002 and a further 25M in 2003. This means that Star River cannot pay off its loan in a
reasonable period. Sensitivity analysis shows that, while maintaining the current sales growth
rate of 15%, the need for additional funds in 2002 is 2003 are relatively insensitive to operating
expenses, requiring that operating expenses, as a percentage of sales, be reduced from 50% to
below 40% in 2002, and reduced further in 2003, in order to avoid the need for additional
financing. It is understandable now why Star River was seen as “growing beyond its financial
capabilities”. The company needs an infusion of capital in order to maintain the actual growth
rate. It is unlikely the firm would recover unless inventories are reduced, especially in the
context of weakened demand for CD-ROMs and the associated risk of having to deeply discount
or even write them off. Another item to correct is the Production costs and expenses, currently
running at 50% of the revenue. The management has expressed concerns with outdated
packaging equipment and the use of the more expensive second and third shift to catch up with
production. An investment here would probably turn profitable in the context of healthy sale numbers.
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?
Sales is one of the major key driver assumptions but as sales increases, so do production costs,
admin and selling expenses, accounts receivable and inventories. According to the case Koh
expected growth rate to be at 15%. Despite the risky assumption of Koh, Star River has little
capacity to support future demand.
Therefore according to the case the key driver assumptions of the Star River’s required an
additional manufacturing investments to increase production and lower the leverage level of
the firm as currently company has high level of debt outstanding.
Firstly, the company aims to increase production efficiency and reduce production costs. In
order to complete this goal, the company needs to replace the old machine that cost production
sunk cost with a new effective machine. Due to the fact that the existing machines required high
maintenance cost and also costed a delay to the whole production process. As the existing
machines frequently broken and needed to be shut down for repairs. From this incident, the
company required its employees to work overtime in order to compensate as the machine is not
function. Additionally, not only that the new machine will help reduce the production time as
well as the maintenance cost but will also has extra capacity to cover the production needed in
the foreseeable future.
Moreover the company need to maintain inventory at minimal level as the portion of inventory
level to sales double over the past few years meaning that the company has to bear higher
inventory holding expense Inventories are a staggering 60% of sales and are full of soon to
obsolete inventory. It is possible that some product such as CDs in the inventory will not be able
to be sold at full retail value. Perhaps more important to the current financial outlook, as
inventories increase, so does the amount the company is required to borrow increases.
Secondly, in order to reduce the leverage level the company has to restructuring debt provides
another way to increase capital and reduce the debt to capital ratio and stop issuing dividends
to its shareholders and repay the outstanding debt first. Begin with the highest cost loan (short-
term) to ensure efficiency future financial performance.
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?
Since Star River is privately held, determining the WACC requires making assumptions. For
cost of equity, we decided to use CAPM method. As the CAPM method help investors calculate
risk and what type of return that should expect on their investment. On the other hand, the
cost of debt is calculate based on the average of short-term and long-terms loans.
Firstly, cost of equity. According to the case that is privately own company consequently Star
River’s beta was not publically available therefore we had to use the average beta from
company that belong in the same industry instead. As the case already provided data on
Singaporean electronics as shown below. We decided to use beta from Wintronices, Inc. as 95%
of its sales portion generate from CD-ROM and/or DVD production same as Star River and has a
similar expected growth rate.
However the given beta is leveraged beta therefore we have to find the unlevered beta first
and the given debt to equity ratio is in term of book value therefore we need to find market
debt to equity ratio first. Then use this unlevered beta of the average industry and market D/E
to find the leverage beta for the Star River’s by using Hamada equation.
In order to find market D/E, we need to find both market value of debt and equity.
Market value of Debt = (Book D/E)*(Book Val per share)*(# of shares outs)
We can obtain market value of debt at 439.
Market value of Equity = (Market Price per Share)*(# of shares outs)
We can obtain market value of equity t at 1,132. Therefore the market D/E of Wintronics, Inc. is
at 0.39.
Next we have to find an unleveraged beta of the firm by using Wintronies, Inc. as a comparable
company therefore we plugged in beta leverage at 1.56 and market D/E of the firm at 0.39. As a
result we get unleveraged beta at 1.21. Moreover we as in Exhibition 2 given value of debt and
equity, short term debt at 84,981 and long term debt at 18,200 thus total value of debt as of
2001 was at 103,181 and market equity value at 206,231. We can obtained market equity
market value of the firm by using Market/Book of Wintronics, Inc. as a peer average therefore
total firm value was 309,412. And so we can obtain weighted of debt (Wd) at 33%, weighted of
equity (We) at 67%, and debt to equity ratio at 0.50.
Moreover in order to find the Star River beta, we plugged in the data into the Hamada formula
again. Using unleveraged beta at 1.21 and debt to equity ratio of firm at 0.5 as a resulted we can
obtained firm leverage beta at 1.66.
Once we have the all of the information we used the benchmark 10-year Singapore Treasury
bond yield at 3.6%, and the Singapore’s equity market risk premium could be assumed to be
close to global equity market premium of 6% as Singapore’s high rate of integration into global
market. Therefore the cost of equity of the Star River is at 13.6%.
Furthermore for the cost of debt, the market value of debt was calculated using the yield to
maturity on the existing privately placed bond of June 1, 2000. The bond has face value at
1,000 with the 5.75% semi-annual coupon and the discount price of 97, the YTM on this bond is
6.6%. Star River’s tax rate is at 24.5% therefore the after tax cost of debt is at 5.0%
To conclude after we got all of the information we plugged in cost of capital formula. Cost of
equity at 13.6%, cost of debt at 6.6%, weight of equity at 67%, weight of debt at 33%, and tax
rate at 24.5%.
As a result we got cost of capital of Star River’s company at 11%.
5. What are the free cash flows of the packaging machine
investment? Should Koh approve the investment?
According to the case, Ms. Koh received a memorandum from Mr. Esmond Lim
proposing to buy new packaging equipment immediately in order to save both operating
expense and capital expenditure. To decide whether the company should use existing machine
and replace with new machine in the next three years or the company should replace with new
machine now, capital budgeting analysis for these two options is necessary.
Key assumptions as per below table:
Capital budgeting analysis for Option 1: Replace New Machine in 3 Years' Times as per below:
Capital budgeting analysis for Option 1: Replace New Machine in 3 Years' Times as per below:
Recommendation: Star River should use existing machine and replace with new machine in the next three years, by comparing NPV.
Conclusion
According to the financial ratios analysis of the company we think that there financial
ratios are moderate however the company should lower the leverage level of the firm as they
have higher growth than the capacity of capital. The New Packaging Equipment should replace
in next 3 years and should use existing machine by comparing NPV. As the world and The
technology change so that the company does not exist anymore.
