Case 25: Star River Electronics Ltd.

Executive Summary

Ms. Adeline Koh,

The following is a summary of the conclusions I’ve drawn based on the analysis you asked for
by 7am this morning.
Financial Health
While revenues and operating profits continue to grow, operating margins, interest expense, and
short-term debts are hamstringing our bottom line. Operational inefficiencies, specifically on the
production side, are largely to blame. We continue to take on short-term debt—a line item that
has tripled from 2012 to 2015—to fund our operations, but with our outmoded packaging
equipment and our current debt service, we simply cannot profitably produce our product in the
long term. Additionally, our Days Payable Outstanding and Days Sales Outstanding are
completely reversed at 91.3 and 133.4. My recommendation centers on securing a capital
injection from New Era Partners, paying down our debts, bringing our AR and AP back into
balance, and increasing operational efficiency through the purchase of a new packaging machine,
which I’ll discuss in more detail later.
Financial Forecast
My forecast confirms the troubling trend we saw in the historical financials—Star River is
headed in the wrong direction. Sales are projected to grow at a modest 4% over the next two
years, but production costs and expenses—most notably a capital expenditure of SGD54.6
million for DVD and Blu-ray manufacturing equipment—undermine our profitability. Operating
profits are projected to decline from 16,604MM in 2015 to 14,517MM in 2016, and finally to
11,808MM in 2017. Additionally, ROA and ROE predictably suffer in years 2016 and 2017,
signaling further inefficiencies in how Star River utilizes its assets and equity to generate profit.
Given the continuation of the trend I already uncovered in my initial analysis of Star River’s
financial health, my recommendations remain the same.
New Packaging Machine
As mentioned in the above, I believe the purchase of new packaging equipment can greatly
increase our operational efficiency and thus our profitability in the long-term. To better
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understand whether it was an efficient use of our capital in the short-term, however—especially
in light of the challenges we face in servicing our debt—I first completed a cash flow analysis.
Using the average WACC of two comparable firms, Wintronics Inc. and STOR-Max Corp., I
calculated Star River’s WACC to be 10.056%. I then used that value as my discount rate to
determine the NPV of purchasing the equipment now versus 3 years from now. Additional
factors included projected inflation, labor cost, maintenance contracts, and the possibility of
higher labor turnover due to increases in overtime as a result of poor production efficiencies.
Ultimately, the NPV for waiting three years was higher, and in light of all the aforementioned
factors, my recommendation is to wait.
Conclusion
Star River is not in good financial shape, but with an injection of capital from New Era Partners,
a drastic reduction in debt and interest expenses, a reversal of the imbalance between AR and AP,
some adjustment to our operational efficiencies, and the eventual purchase of new packaging
equipment, I believe we can plot a newer more profitable course for the company under your
leadership.
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Financial Health of Star River Electronics Ltd.

Ms. Adeline Koh,

As per your request, I’ve reviewed the financial health of Star River Electronics Ltd. and
provided my analysis below.
General
Despite the decline in physical media, top line sales are actually strong, with revenues growing
from 71,924MM in 2012 to 106,042MM in 2015. Expectations are for this growth to continue at
4% for the next two years, driven in large part by Blu-ray sales to developing countries.
Operating profit continues to grow as well, though modestly, from 13,412MM in 2012 to
16,604MM in 2015. That is, however, where the good news ends I’m afraid.
Profitability
While operating profits are indeed increasing, operating margins have decreased from 18.6% in
2012 to 15.7% in 2015, mostly due to rising production costs and expenses relative to net sales.
In 2012, production costs and expenses accounted for 46.8% of net sales, whereas in 2015 they
accounted for 50.4%. I believe this is due to a lack of operational efficiency, which is validated
by a quick look at Star River’s ROS declining from 10.4% in 2012 to 6.4% in 2015. ROE tells a
similar story with declines from 21.8% to 13.6%. Star River is simply not generating its profits
efficiently. Unsurprisingly, ROA also declined from 6.8% to 3.7% in the same period.
My recommendation is to streamline production by whatever means necessary to better make use
of existing assets. This is one of the few levers we have complete control over, and would not
only bring our ROA back in line, but would also help nudge our ROS back in the right direction.
I would also suggest reining in our debt, which should improve our ROE, but I’ll cover this in
more detail in the following section.
Leverage
Debt and debt service are our two greatest challenges. Short-term borrowing nearly tripled from
29,002MM in 2012 to 82,275MM in 2015. Long-term debt nearly doubled from 10,000MM to
18,200MM. As you might expect, our debt/equity, debt/total capital, and EBIT/Interest ratios
have all suffered at 1.13 to 2.02, 0.53 to 0.67, and 3.85 to 2.18. We’ve taken on too much debt,
and our struggle to service it—which is most easily seen in the decline in our interest coverage
ratio (i.e. 3.85 to 2.18)—is affecting both our short-term profitability and the long-term risk of
investing in our firm.
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Streamlining production should help reduce the need for further debt, but given the exponential
requirement for capital to continue to operate, we won’t be able to solve this problem through
operational efficiency alone. We need to consider alternate methods of securing capital including
an additional stock offering or the sale of equity in the company. At our current rate, our debt
will eventually consume us until we can no longer service it. Action must be taken.
Asset Utilization:
Assets Turnover and Assets Growth Rate Ratios both point to poor efficiency, but our time is
limited so I’d like to focus on the glaringly obvious issues of AR, AP, and Inventory. Days Sales
Outstanding versus Days Payable Outstanding has gone from 112.4 and 133.4 to 122.1 and 91.3.
For a company who is struggling to service its debt, this is backwards. Additionally, days
inventory outstanding has increased from 252.3 to 435.6. That means we’re currently sitting on
over a year’s worth of inventory!
I would recommend to notify vendors that AP will be moving back to the 133-140 days range
and AR will be expecting payment within 90 days to avoid a 10% late fee. As for inventory, we
should reduce production until inventories are back in line with the 252 day figure.
Liquidity:
In light of our mounting debts and capital expenditures on inventory, it should come as no
surprise that our Quick Ratio is an abysmal .35, suggesting that for every dollar in assets we only
have .35 to service our short-term debts. As suggested in the above, we need to get our debt and
inventories under control.
Final Recommendation:
To summarize, we can drastically improve the performance of the company by streamlining
production; raising capital through either an additional stock offering or the sale of equity in the
company; reducing inventory by roughly 40%; and gaining better control over the balance
between AR and AP.
Financial Forecasts
Based on the financial assumptions given, Star River. expects sales to grow by 4%.
Consequently, we can forecast that in 2016 the company will have $110,284 in sales, and in 2017
sales are projected at $114,695. While sales increase, we can also forecast Production and Admin
Expenses to increase. And considering depreciation expenses for new equipment, Total
Operating Expenses increase significantly resulting in a decrease in Operating Profit after 2015.
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Since interest expense is also affected by current loans and new equipment, I believe Net
Earnings are also significantly lower. With the firm still producing positive net earnings there is
no need for external financing, however, in the worst case scenario, if sales do not reach a 4%
increase, the firm may be at risk of not paying its loan within a reasonable period.
ROE for 2016 is projected at 9.1% resulting in a 4.5% drop from 2015 showcasing that the firm
has not utilized its capital investments efficiently. In 2017, ROE continues to decrease resulting
in a projection of 4.1%, further demonstrating poor efficiency of shareholders’ equity. Looking at
ROA, projections continue to gradually decrease in 2016 and 2017. Thus, I can infer that Star
River is not generating enough net income to cover its assets, especially with the new investment
of equipment. Therefore, based on financial assumptions and forecasts, Star River would be at
the risk of further investments from shareholders and paying off its debts within a reasonable
period of time.
Weighted Average Cost of Capital
As part of this analysis I also calculated the weighted average cost of capital of Star River using
comparable firms: Wintronics, Inc, and STOR-Max Corp. Based on Exhibit 5: Data on
Comparable Companies, I was able to calculate Wintronics, Inc.’s WACC to be 9.524% and
STOR-Max Corp.’s WACC to be 10.588%. Therefore, taking the average I concluded Star
River’s weighted average cost of capital to be 10.056% as seen in our Excel attachment.
Analysis of Packaging Equipment Investment
The decision to invest in a new machine involves a careful examination of cash flows associated
with two alternatives. In this case, two options are presented: Option 1, purchasing the machine
now, while Option 2 involves purchasing the machine in three years. The primary difference in
cash flows between these alternatives is based on the timing of the machine purchased and the
costs incurred. Option 1 presents a scenario where the machine is acquired immediately,
resulting in substantial upfront costs. The cash flows in the earlier years are negative, reflecting
the significant investment in labor, maintenance, and depreciation. However, as time progresses,
Option 1 generates positive cash flows, driven by the benefits of depreciation and the machine's
productive capacity.
Option 2 defers the significant upfront costs by delaying the machine purchase for three years.
This decision leads to lower negative cash flows initially. However, as the machine comes into
operation, Option 2 incurs higher costs in later years, including increased maintenance and labor
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expenses. Additionally, the delayed depreciation benefits contribute to higher costs during this
period. The analysis spans the years 2015 to 2029. This time frame allows for a thorough
understanding of the long-term consequences and benefits associated with each option. The time
frame is extended to capture the full lifecycle of the machine, providing insights into its impact
on cash flows over an extended period. Based on our analysis we feel that waiting three years to
buy the equipment would be the best option for cost savings.
Action Plan
We have two distinct areas of priority: Financing Needs and the New Packaging Machine.
Financing Needs
Debt:
Based on my analysis, I believe the extension of our existing loan would do little more than
prolong our predicament. As you can see in the attached forecast, our operational profit is being
hamstrung by growing production costs and expenses along with increasing admin and selling
expenses relative to our modest top line sales growth.
Our situation is made worse by the crippling rise in interest expense associated with our
exponentially growing short term debt.
Operational Efficiency:
This is happening in large part because while our net sales continue their modest growth of 4%
per year, our operational expenses are outpacing them. Much of this can be attributed to our lack
of operational efficiency, specifically on the production side. There will be capital expenditures
of SGD 54.6 million for DVD and Blu-ray manufacturing equipment in the next two years to
address this issue, but even that won’t provide us with the efficiencies necessary to bring our
operating profit back in line. I’m afraid the banker is right—we’re growing beyond our financial
capabilities.
Outside Capital:
For that reason, I suggest we approach New Era Partners for an injection of equity. We simply
cannot afford to take on additional debt. We can barely service the debt we have now. Selling
equity in Star River to New Era Partners will give us the valuable capital we need to pay down
our existing debts while also allowing us the time to restructure the company such that
operational efficiency and profitability are brought back into line.
New Packaging Machine
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One of the ways we can do this is through the purchase of a new packaging machine. As I
mentioned previously, inefficiencies in production have hamstrung our operating profit. This new
machine could solve that. Included in this document is a cash flow analysis I performed to see
whether we would benefit from purchasing this machine now or later. The results indicated a
higher NPV if we waited three years, so that is my suggestion.
Conclusion
In summary, I believe our debt and poor operational efficiency are the two largest impediments
to our success. I suggest we seek a capital injection from New Era Partners to pay down our
debts, reduce our interest expense, and increase our profitability over the next three years. In that
time we can make small changes to increase our operational efficiency, but at the end of those
three years we’ll need to purchase a new packaging machine to ensure continued profitability
into the future.
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Appendix

https://docs.google.com/spreadsheets/d/177FKofi6PJR3znkxmzbXOYntXl7yZoHJ/edit?usp=dri
vesdk&ouid=109612439736685181322&rtpof=true&sd=true

https://docs.google.com/spreadsheets/d/17CT7gDFG_TRA1yGy_Q0GQG1dMwIT9JQg/edit?us
p=drivesdk&ouid=109612439736685181322&rtpof=true&sd=true