Star River Electronics Ltd. is a large manufacturer and supplier of CD-ROMS. It was founded as a joint venture between New Era Partners and Starlight Electronics Ltd. It has enjoyed a great deal of success in the past decade, due in large part to their excellent reputation.
Star River does need to address several issues with the recent resignation of their former CEO. Digital Video Disks are expected to cut into the CD-ROM market in the very near future, and with only 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 our analysis, after looking at Star River’s ratio analysis, we found that there is a significant inventory problem. It seems that Star River’s operations consist of taking out short-term debt to finance creating inventory. What this shows is that the inventory that they are creating is becoming outdated before they are able to sell it. 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. With the lack of cash coming in and the increase in inventories, Star River will not be able to cover their current obligations, therefore find themselves in a very high default risk. Star River also has the highest debt ratios compared to their industry. This, also, shows that they are over leveraging themselves and creating excessive default risk. On the upside of their financial ratios, they have been able to decrease their payables account, meaning they are paying more of their obligations at the current time. Another good note is that they are able to create a decent return on equity and have a coverage ratio of over 2.
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. The forecasted balance sheet shows that there is a problem with current assets covering current liabilities. The way we showed the financing of the capital expenditure was to keep the current weights of short-term borrowings and long-term borrowings consistent with 2001. If Star River continues with their current borrowing structure, they will not be able to cover all of their current obligations.
The third request was to come up with reasonable forecasts of book value return on equity and return on assets. The main drivers in these forecasts are the growth assumption in sales and the hurdle rate we calculated, as well as the cash flows to the firm.
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 relevered 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.
We suggest Star River should take on the expenditures required for the DVD equipment and the new packaging machine at the current time. The DVD equipment will better position them in this up coming market. By purchasing the new packaging machine now instead of waiting three years, they will cut costs and add value to the firm.
When financing these expenditures, we feel they should lean more heavily toward equity and the use of more long-term debt as opposed to short-term debt. This will help address their current liquidity and solvency problems. Also, they need to address their increasing inventories. The days in receivables has been substantially increasing throughout the past few years, which adds to holding costs. If Star River implements these changes, we feel they will be in a good position in the CD-ROM and DVD market in the future and will be able to maximize shareholder value.
This case has several areas presenting the possibility of future error. First of all, we did go ahead and use the 15% growth assumption presented in the case. However, assuming a relatively large growth rate in sales in such a volatile industry as this could present inflated numbers and expectations.
Also, it is hard to forecast how much growth in DVDs will actually occur. Technology is a very volatile industry, and to make the assumption that we need to incur large expenditures on a relatively new product in the industry could put the company in a bad position if the DVD market does not flourish as much as is expected.
Finally, we do not know if we will be able to borrow the additional debt requirements at the same rate we have previously borrowed at. In reality, we probably will not be able to do so. Also, we have to take into consideration the reaction of shareholders to possible dilution of shares by using equity to finance the new expenditures.
Overall we feel group four did a fairly decent job of covering the major issues in the case. We agree with them in their recommendations on these issues, but found some significantly different numbers in our calculations on several of them.
In their calculation of the cost of debt, they assumed a rate of 7.5% on a 20-year note with annual interest payments. We feel they should have provided justifications for using this rate. We used a weighted average of the short and long term debt outstanding to come up with a rate of 6.53%. We do not think they should have ignored short-term debt, especially with it comprising such a large percentage of their leverage structure.
In calculating the cost of equity, we agree with their recommendation to use only Wintronics and STOR-Max as comparison companies to find the equity beta for Star River, as they most closely mirror it in the aspects of their current and future core operations, and in their debt structures. However, after unlevering to find the asset beta for the industry and relevering it into Star Rivers’ structure, we found an equity beta of 1.93. Group four found it to equal 2.14, and we do not understand what is causing this discrepancy.
Lastly, in one of their balance sheet predictions, their total assets did not equal liabilities plus shareholder’s equity, which is obviously a problem. If they had properly reviewed their handouts before they submitted them, they would have noticed this problem.
Again, we do think group four did a good job of addressing the main problems this course presents, we just think they should have spent more time verifying some of their calculations.