Star River Electronics Ltd.

Team 14 Constantine Brocoum Courtney Delia Stephanie Doherty David Dubois Radu Oprea December 19th, 2009
Star River Electronics Ltd. Page i

Contents
Objectives................................................................................................................................................ 1 Management Summary ........................................................................................................................... 1 Financial Health ....................................................................................................................................... 1 Financial Forecast for 2002 and 2003 ....................................................................................................... 3 Key Driver Assumptions ........................................................................................................................... 5 Star River WACC ...................................................................................................................................... 5 Free Cash Flows of the Packaging Machine Investment............................................................................ 7 Appendices ................................................................................................. Error! Bookmark not defined.

Star River Electronics Ltd.

Page ii

Objectives
This report seeks to answer the following five questions about Star River Electronics Ltd.: 1. Assess the current financial health and recent financial performance of the company. What strengths and/or weaknesses would you highlight to Adeline Koh? 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? 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? 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? 5. What are the free cash flows of the packaging machine investment? Should Koh approve the investment?

Management Summary Financial Health

The financial health or strength of a company is measured by its ability to service its financial obligations senior to the common shareholders. These obligations include debt payments, preferred stock payments, the funding of any pension plans and rental and lease expenses. Below I have highlighted many of the weaknesses of the company. A common metric investors use to evaluate the ability of a company to service its debt is the interest coverage ratio or times interest earned. Star River can only cover its interest by a little more than 2 times. This is a worrisome finding. This ratio has steadily decreased since 1999. The debt to equity ratios are consistently rising year over year at a compounding at a rate of 18.1%. There was a 64% jump from 1999 to 2000. This is a worrisome trend. Inventories to COGS ratios are increasing dramatically. Operating margin % has decreased since 1998 both of which are not a good signs. ROA is a measures how well the firm is using its assets to generate earnings. The ROA has in general decreased by 6.9% since 1998 compounded annually. This indicates that the firm is not using its assets efficiently.

Star River Electronics Ltd.

Page 1

The ROE has increased from 2000 to 2001 which may be due in part to the decreasing equity from the increased debt in that time period. Debt/total capital ratio is increasing steadily which is secondary to the increasing amounts of debt. Accounts receivable is increasing as is accounts payable. As time in AR increases the monthly flow of cash slows producing short term shortages of cash. This may be one reason for the increased short term borrowing. Shortages of cash can also cause problems for Star River paying their suppliers. This is seen in increasing accounts payable. A significant weakness of the company lies in the fact that it needs to borrow money for current operations. This when combined with the need for capital expenditure (new packaging equipment) may be too much for the company to handle. If one evaluates the Balance sheet you will see that short term borrowing from the bank has increased dramatically since 1998. This indicates that current cash flows are unable to handle the daily financial needs of the company. Overall the company s financial position is precarious. They are taking on too much debt while making large capital expenditures. This in combination with delays in payments to the company by their customers (increasing AR) and increasing account payable is producing a precarious financial position. Star River s financial health is weak and will become weaker if it decides to borrow money to acquire new equipment.

Star River Electronics Ltd.

Page 2

Financial Forecast for 2002 and 2003

Balance Sheets (Fiscal Year Ended June 30) (SGD 000) Assets: Cash Accounts receivable Inventories Total current assets Gross property, plant & equipment Accumulated depreciation Net property, plant & equipment Total assets Liabilities and Stockholders' Equity: Short-term borrowings (bank)1 Accounts payable Other accrued liabilities Total current liabilities 1998 1999 2000 2001 Assumptions 2002 2003

4,816 22,148 23,301 50,265 64,611 (4,559) 60,052 110,317

5,670 25,364 27,662 58,697 80,153 (42,952) 37,201 95,897

6,090 28,078 53,828 87,996 97,899 (89,444) 8,455 96,451

5,795 Similar to past few years 35,486 Average of 32% of sales 63,778 Average of 60% of sales 105,059 115,153 New DVD equipment over 2 years (142,889) 1/7 of gross property/equipment (27,736) 77,323

6,000 39,023 73,169 118,192

6,000 44,877 84,145 135,022

143,153 143,153 (55,789) (103,539) 87,364 39,614 205,556 174,636

29,002 12,315 24,608 65,926

37,160 12,806 26,330 76,296 10,000 36,712 123,008

73,089 11,890 25,081 110,060 10,000 38,314 158,374

84,981 13,370 Average 13% of sales 21,318 Assuming 20,000 119,669 18,200 Same as last year 40,406 Retention of earnings 178,275

107,394 15,853 20,000 143,247 18,200 44,108 205,556

64,684 18,231 20,000 102,915 18,200 53,520 174,636

Long-term debt2 10,000 Shareholders' equity 34,391 Total liabilities and stockholders' equity 110,317
1

Short-term debt was borrowed from City Bank at an interest rate equal to Singaporean prime lending rates + 1.5 percent. Current prime lending rates were 5.2 percent. The benchmark 10-year Singapore treasury bond currently yielded 3.6 percent. 2 Two components made up the company's long term debt. One was a SGD10 million loan that had been issued privately in 1996 to New Era Partners and to Star River Electronics Ltd., U.K. This debt was subordinate to any bank debt outstanding. The second component was a SGD8.2 million from a 5-year bond issued on a private placement basis last July 1, 2000 at a price of SGD97 and a coupon of 5.75% paid semi-annually.

Star River Electronics Ltd.

Page 3

Exhibit 1 STAR RIVER ELECTRONICS LTD. Historical Income Statements Fiscal Year Ended June 30

(SGD 000) Sales Operating expenses: Production costs and expenses Admin. and selling expenses Depreciation Total operating expenses Operating profit Interest expense Earnings before taxes Income taxes* Net earnings Dividends to all common shares Retentions of earnings *The expected corporate tax rate was 24.5%.

1998 71,924 33,703 16,733 8,076 58,512 13,412 5,464 7,949 2,221 5,728 2,000 3,728

1999 80,115 38,393 17,787 9,028 65,208 14,908 6,010 8,897 2,322 6,576 2,000 4,576

2000 92,613 46,492 21,301 10,392 78,185 14,429 7,938 6,491 1,601 4,889 2,000 2,889

2001 106,042 53,445 24,177 11,360 88,983 17,059 7,818 9,241 2,093 7,148 2,000 5,148

Assumptions 15% /year increase Average 49% of sales Average 22.5% of sales 1/7 of gross p and e

2002 121,948 59,755 27,438 20,450 107,643 14,305 6,753 7,552 1,850 5,702 2,000 3,702

2003 140,241 68,718 31,554 20,450 120,722 19,519 4,404 15,115 3,703 11,412 2,000 9,412

6.7% of short term borrowings 24.5% of EBT

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.

Star River Electronics Ltd.

Page 4

Key Driver Assumptions

Sales is one of the major key driver assumptions because so many assumptions are based on a percentage of sales. As sales increases, so do production costs, admin and selling expenses, accounts receivable and inventories. Koh assumes that a 15% year over year growth is expected. This is a risky assumption since the market is moving away from cd technology to dvd technology. Star River has little capacity to support future dvd demand without taking on additional manufacturing investments. Inventories are a staggering 60% of sales and are full of soon to obsolete inventory. It is possible that this inventory of cds will not be able to be sold at full retail value with the growth of the dvd market. Perhaps more important to the current financial outlook, as inventories increase, so does the amount the company is required to borrow increases. The company is borrowing money just to maintain their inventories.

Star River WACC

STOR-Max is the closest competitor to Star River, also being a good match relative to product portfolio, sale percentages and growth rate. The Equity Beta and Book D/E are provided in Exhibit 3, also Book/Market equity ratio can be determine from book share price versus market share price as being 0.26. This will help determine the Market D/E ratio at 0.33. Using
Equity Beta = Asset Beta * (1 + D/E)

we determine STOR-Max Asset Beta to be 1.25.

Star River Electronics Ltd.

Page 5

WACC Calculation STOR-MAX Corp used as comparison Equity Beta Stor-max Book Debt/Equity Market share price Book share price Book/market ratio Market Debt/Equity Asset Beta Stor-max

1.67 1.3 27.48 7.06 0.26 0.33 1.25

Star River
Book Debt/Equity Market Debt/Equity Equity Beta StarRiver Risk free rate (tr) Expected return on market Corporate tax rate (tc) Cost of equity (re) Cost of debt (rd) Wdebt Wequity WACC 2.2 0.57 1.96 3.60% 9.60% 22.6% 15.36% 5.75% 0.36 0.64 11.418%

Star River Electronics Ltd.

Page 6

Another key assumption is made on (Book D/E) / Market D/E) ratio as being the same for the two companies. Being provided with the Book D/E ratio for Star River, we determine the Market D/E for Star River as being 0.57. The Cost of Debt would be the interest rate for one of the issued bonds, 5.75%. This is a key assumption, neglecting the other components of Star River s debt. The Risk free rate is similar with the 10-year treasury bond yield at 3.6%, and the market premium would be close to the global equity market premium of 6%. With all ingredients provided, the Cost of Equity is calculated through CAPM, rendering it at 15.36%, far lower than the 40% mentioned as customary when dealing with risky companies. Further on, WACC would be determined as being 11.418%.

Free Cash Flows of the Packaging Machine Investment

Star River Electronics Ltd.

Page 7