Star River Electronics Ltd.

Case Analysis
Case Breakdown
Star River Electronics Ltd., a prominent CD-ROM manufacturer and distributor based in
Singapore, was established through a partnership between Asian venture capital firm New
Era Partners and UK-based Starlight Electronics Ltd. The company has enjoyed past success
due to their superior disc quality. However, the rise of Digital Video Disks (DVDs) presents
challenges, which are exacerbated by the departure of their previous CEO.

New CEO Adeline Koh must confront these issues. As DVDs are anticipated to impact the CD-
ROM market soon, and 5% of Star River's sales derive from this area, the company requires
capital investments to expand capacity in this sector. To fund this expenditure, they can opt
for debt or equity. Additionally, a new packaging machine that could reduce labor and
overhead expenses has been proposed. Star River must decide whether to approve the
purchase now or delay it for three years, when new equipment would be needed to
accommodate expected growth rates.

A weighted average cost of capital must be calculated for the company, which will inform the
decision to purchase the equipment now or later. CEO Adeline Koh must persuade the
company's banker to extend Star River's loan, as the company aims to enhance performance
through DVD production (and possibly, the acquisition of new packaging equipment). Koh
must address these financial questions:

1. Analyze Star River Electronics Ltd.'s historical performance and highlight positive
or negative aspects.
2. Forecast the company's performance for the next two years.
3. Estimate Return on Book Asset and Equity and identify the key assumptions of those
returns.
4. Calculate Star River Electronics Ltd.'s Weighted Average Cost of Capital and evaluate
the packaging machine investment.
5. Offer recommendations on financial and operational changes.

Historical Analysis
Ratio analysis
We conducted a ratio analysis of four years and projected trends for the next two years based
on these ratios.

Profitability Ratios
Return on Equity (ROE) measures a company's efficiency in generating profits from
shareholders' equity (net assets or assets minus liabilities). Star River's ROE ranged from
11.7% to 16.7%, indicating a decent return.
Return on Assets (ROA) shows how effectively a company's assets generate revenue. As
Star River requires substantial initial investments, it generally has a lower ROA.

Leverage Ratio
The Debt-To-Equity (D/E) ratio indicates the proportion of shareholders' equity and debt used
to finance a company's assets. Star River's D/E ratio in 2001 was 2.2, which is higher than
industry standards. A high D/E ratio suggests that a company has been aggressive in
financing growth with debt, which may result in fluctuating earnings due to increased interest
expenses.

Debt-To-Capital Ratio
The debt-to-capital ratio offers insight into a company's financial structure and strength. A
higher ratio means the company has more debt relative to its equity. Star River has
consistently relied on debt for financing, and this ratio may increase in the future. Compared
to industry averages, Star River's high debt-to-capital ratios may indicate weak financial
strength and increased default risk.

Asset Utilization Ratio

Sales/Assets: The asset turnover metric gauges a firm's effectiveness in employing its
assets to produce sales income. Over the years, Star River has demonstrated satisfactory
asset turnover.

Inventories to COGS: In the previous year, Star River's inventory to COGS reached a
staggering 119.30%. This high percentage signifies that the company's inventory is becoming
obsolete before it can be sold, indicating a significant inventory issue.

Payables to COGS: Star River's ratio analysis reveals a decrease in their payables account,
suggesting that they are currently meeting more of their financial obligations.

Days in Accounts Receivable Ratio: This calculation represents the average number of days
it takes for a company to collect its accounts receivable. Star River appears to be
experiencing difficulties in collecting its receivables, which could ultimately result in a cash
inflow problem.

In conclusion, the case analysis of Star River Electronics Ltd. highlights several financial
challenges the company must address, including adapting to the emerging DVD market,
deciding on the best financing method for capital expenditures, and determining whether to
invest in new packaging equipment. Additionally, CEO Adeline Koh must persuade the
company's banker to extend their loan to ensure continued financial stability. By analyzing
historical performance and financial forecasts, Koh can make informed decisions about the
company's future direction and financial health.

Liquidity Indicator
Current ratio: This financial metric evaluates a company's capacity to settle its debts within
the next 12 months by contrasting its current assets with its current liabilities. Star River's
current ratio reveals that it cannot entirely meet its immediate obligations using its current
assets. Values below 1, however, do not necessarily signal a dire issue, as an organization
with promising long-term prospects may obtain loans based on those prospects to address
short-term obligations.
Financial Forecast: Our secondary objective was to project the income statement and
balance sheet for the subsequent two years. We anticipated a 15% sales growth rate, as
indicated by Koh. In addition, our balance sheet forecast only included debt financing for the
DVD manufacturing equipment's capital expenditure, per the requested structure. The
financial forecast relies on the following key assumptions and relevant details: sales will
grow by 15% annually; operating expenses and operating profit will increase by the same
percentage; cash, accounts receivable, and inventories will all rise by 15% per year; accounts
payable and other accrued liabilities will also grow by 15% per year; the interest expense is
weighted for short-term and long-term debt at 6.53%. The new DVD manufacturing
equipment will cost SGD 54.6 million, with payments spread over the next two years. The
equipment will be depreciated using the straight-line method over seven years. Long-term
debt calculations include a private placement of a 10 million loan, an SGD 8.2 million 5-year
bond, and a new bank loan for SGD 54.6 million. The short-term bank loan is determined in
line with historical trends.

Analysis of Financial Forecast

Current Ratio Analysis
The projected balance sheet reveals a challenge with current assets covering current
liabilities. The Current Ratio stands at 0.82 and 0.79 for 2002 and 2003, respectively. This
implies that if Star River maintains its existing borrowing structure, it will be unable to fulfill
all its current obligations.

Debt Equity Ratio

With the suggested debt structure, Star River confronts a significant default risk, as it is
already heavily leveraged. The D/E ratio for 2002 and 2003 is 6.30 and 6.71, respectively, which
is quite high compared to industry standards.

Debt Service Coverage Ratio: The debt service coverage ratio (DSCR) represents the
proportion of available cash for debt servicing to interest, principal, and lease payments. A
DSCR below 1 indicates negative cash flow. The projected DSCR for 2002 and 2003 is 4.097%
and 4.013%, respectively. This means that there is only sufficient net operating income to
cover roughly 4% of annual debt payments. This presents a serious issue for Star River, as
banks are unlikely to grant loans in this situation, and the company faces a heightened risk
of default.

NPV Analysis: We calculated the Net Present Value of the new DVD manufacturing project,
assuming a 6.36% cost of capital (with calculations provided later). We presumed cash flow
would increase at the same percentage as sales (15%). This resulted in a positive NPV of SGD
66,808.57 for a 5-year duration of the project and an Internal Rate of Return of 28%. Assuming
our estimates are accurate, the project appears to be quite profitable.
Findings & Recommendations
Positive Elements of Historical Analysis
Star River has achieved a respectable Return On Equity over the years, and its Asset
Turnover has been reasonably good. Star River has been successful in reducing its payables
account. Negative Elements of Historical Analysis include Star River's D/E ratio being higher
than industry norms, which could lead to unstable earnings due to additional interest
expenses. With high Debt-to-Capital Ratios compared to the industry average, Star River
may exhibit weak financial strength as the cost of these debts could burden the company and
increase its risk of default. The Inventories to COGS ratio indicates that Star River Electronics
Ltd. has faced a considerable inventory issue, with their inventory becoming obsolete before
being sold. The Days in Accounts Receivable Ratio reveals difficulties in collecting on
receivables, potentially leading to cash inflow problems. Star River's Current Ratio shows
that it cannot fully cover its current obligations with its current assets.

Positive Elements of Financial Forecast: The NPV analysis results in a high positive NPV and
high IRR for Star River Electronics Ltd.'s DVD manufacturing project. With the new DVD
manufacturing project, sales increase by 15%, leading to higher Net Earnings for Star River
Electronics Ltd. compared to previous years. Negative Elements of Financial Forecast
include the projected balance sheet indicating an issue with current assets covering current
liabilities. If Star River maintains its current borrowing structure, it will be unable to cover
all its current obligations. With the suggested debt structure, Star River faces a severe
default risk threat, as the D/E ratio is quite extreme by industry standards. The Debt Service
Coverage Ratio (DSCR) demonstrates that there is only enough net operating income to cover
approximately 4% of annual debt payments. Banks are unlikely to provide loans in this
situation. Due to debt financing, Star River Electronics Ltd. incurs higher interest expenses,
resulting in lower-than-expected Net earnings and a cash flow shortage. The current debt
structure reveals that 82% of financing comes from short-term bank loans, which we believe
is one of the primary causes behind Star River Electronics Ltd.'s liquidity problems.

Findings Regarding New Packing Equipment: Acquiring the new packaging machine now,
rather than waiting three years, will save SGD 15,558 in costs and add value to the company.
It will undoubtedly enhance efficiency and boost speed, capacity, and reliability in the
production process.

Findings Regarding ROE and ROA: Return on Equity (ROE) measures a firm's efficiency at
generating profits from each unit of shareholders' equity, indicating how effectively a
company uses investment funds to achieve earnings growth. The ROE for Star River
Electronics Ltd. has increased from 2000 to 2001, possibly due to the decreased equity
resulting from increased debt during that period. For the projected years of 2002 & 2003, the
ROE is 25.8% and 26.92%, respectively. This high ROE will assist managers in persuading
shareholders to invest more capital in the company. Return on Assets (ROA) is an indicator
of how profitable a company is relative to its total assets, showing how efficiently
management uses its assets to generate earnings. The projected ROA of Star River
Electronics Ltd. for the next two years is 3.54% and 3.49%. While these numbers are declining
compared to previous years, they are not yet a significant concern, but management should
monitor the situation.
Financial Changes:
Equity Financing: We recommend that Star River Electronics Ltd. shift their financing focus
towards equity instead of debt financing. The reason for this is that they cannot continue to
increase debt financing at the risk of high default and potentially facing bankruptcy. With the
current situation, very few, if any, banks will be interested in lending to them. Given the high
Return on Equity we have estimated from the current project, shareholders and investors in
Star River Electronics Ltd. might be interested in financing this promising project.

Solve Current Liquidity Problem: To address the current liquidity problem, one option for Star
River Electronics Ltd. is to reduce the amount of short-term borrowings by relying more on
equity and using more long-term debt instead of short-term debt. This will help decrease
their interest expenses and short-term obligations.

Operating Changes:
Reduce Inventories: The days in receivables have been steadily increasing over the past few
years, leading to higher holding costs. Star River Electronics Ltd. needs to tackle their
growing inventories by improving managerial efficiency.

Collection of Account Receivable: Star River Electronics Ltd. must increase its efficiency in
collecting receivables in a timely manner if they want to avoid cash inflow issues.

New Packaging Machine: Since the costs of waiting three years to invest in new packaging
equipment are higher than purchasing it now, Star River Electronics Ltd. should buy it
immediately rather than waiting. This would also help them enhance efficiency.