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Flash Memory Case Study Final Exam

Rohit Parnerkar

Flash Memory Case Study


Rohit Parnerkar

Flash Memory Case Study Final Exam

Rohit Parnerkar

1. What is Flash Memory weighted average cost of capital? Make sure to clearly
show your calculation of the following as part of your answer?
A: Flash Memory Inc. is a privately held company where the 6 individual hold entire equity of
the firm. Flash competed in a low profit, fast growth, short product lifecycle business which
needs constant investment in Research & Development.
For Calculating Current WACC of the Firm (as of May 2010), I have Considered Following a
Debt to Capital Ratio of 34% i.e. 34% Debt 66% Equity. Please Refer to Exhibit1.
We are given that, the current Cost of Debt is 7.25%, which prime rate of 3.25% + 4% Risk
Premium applicable for 70% funding of accounts receivable. For calculating cost of equity we
need a Beta of comparable listed entity. I have considered Beta of Micron technology which
has a Capital Structure very similar with Flash Memory and competes same category. First we
need to unleveraged the beta to isolate beta of equity which we can further use to estimate
cost of equity.
First, Levered Beta of Micron Technology is 1.25, this represents the sensitivity of the
company at current capital structure towards the industry. I have isolated the beta of equity
which we can use in CAPM model to calculate cost of capital for Flash Memory.
Below is Formula for Leveraging are releveraging this Beat to arrive at Cost of Capital for
Flash Memory:

Using the Above, formula I could determine that Unlevered Beta is 0.965.

Further, I used this Beta to arrive at Cost of Equity using below Formula. Thus, I could
determine that Current Cost of Equity for Flash Memory was 8.75%.
Now we had D/E Ratio and Cost of Debt & Cost of Equity, I could easily calculated out
current WACC. Formula for Weighted Average Cost of Capital is as following:

34/66
Flash Memory
COD
7.25%
D/E+D
34%
COE
8.75%
E/E+D
66%
(1-T)
60%
WACC
7.26%
D/E

Thus, my WACC Comes to 7.26% with a Debt to Capital Ratio 34%.

Flash Memory Case Study Final Exam

Rohit Parnerkar

2. Should Flash Memory accept or reject the proposed investment in the new
product line?
A: As Mentioned in the case study, the Flash Memory in an industry which needs constant
investment in Research & Development. With an investment of $2.2mn company would be
able to access an innovative product line and possibly have a first mover advantage. It is also
mentioned that the new product line has higher margins over sales (COGS is 79% vs 81.10%
of Sales).
Further, we understand that the Company has already reached its Notes Payable limit and
any further borrowing will attract stringent terms and higher, the management is of the view
that company must dilute the equity if need be but must bring the Ratio of Debt in its overall
capital structure to 18%. Thus for evaluating the Project the IRR must be greater than the
WACC. I have used a WACC of 10.03% with Capital Structure as 18:82 Debt to Equity.
Please See Exhibit 2. Based on my Calculations I am of the view that company must accept
project. The Project has an IRR of 21.9%. and has a Positive Net Present Value.
Please not and expenditure of $400,000 is treated as sunk cost and is not included as a part
of calculation.
3. Assuming the company does not invest in the new product line, how much
external funding would Flash Memory require between 2010 and 2012?

A: Please Refer to Exhibit3 Assuming That Flash Memory does not accept the new Product

line we can clearly seen that the Company maintain healthy growth forecast. Our Sales
Figures are based on estimates provided by marketing team. For further clarity I have
mentioned the source of each calculation in the comments column.
I have assumed that company continues to fund its Funding Requirements using Debt
Financing as long as it maintains the 70% of Accounts Receivable threshold.

Notes payable (Additional Funding )


Notes Payable/Accounts Receivable

2010

$13,310

67%

2011

$15,423

64%

2012

$11,435

48%

While calculating there are 2 assumption that I have mare,


1. Company Continuous to Debt Finance it Business as long as the ration of Notes
Payable to Account Receivable remains under 70%.
2. Number of Days is 360 in a year. This is done for Calculation continence and does not
change the outcome.

Flash Memory Case Study Final Exam

Rohit Parnerkar

4. How would accepting the proposed investment in the new product line impact
the amount of external funding that Flash Cards would require between 2010
and 2012? Would you recommend that Flash cards use debt, equity, or a
combination of both debt and equity to raise the necessary funds for its
funding?
A: Please Refer Exhibit4. Assuming Flash Memory accepts the new Investment we see that in
very first year i.e. in 2010. The company needs to invest more than 7 million in the new
project which results in increase in Debt to Capital. The board is of the view that an ideal
Debt Equity ratio is around 22%. While we consistently see that this ratio is breached.
Howere based on the projections of the company we can see that the company forecasts
higher sales and better margins in the future.
According to me, company must continue using debt financing for its Working Capital
Requirements, further, the company has a substantial amount of Retained Earnings which it
can Use for Funding this Project. Flash Memory should avoid issuing additional Capital, as
dilution of equity would result in loss of management discretion.

Exhibit 1
Market Data

Tax Rate
Debt to Equity Ratio
Prime Rate
Risk Premium
US Treasury 10years
Risk Premium (Rm-Rf)

40%
51.52%
3.25%
4.00%
3.70%
6.00%

D/E

33/67
1.25
19/81
1.36
0/100
1

D/E Ratio
Beta for Equity
D/E Ratio
Beta for Equity
D/E Ratio
Beta for Equity

Micron
SanDisk
STEC

Beta when Debt Equity Ratio is '33/67


Micron

Flash

Cost of Equity For Flash

COD
D/E+D
COE
E/E+D
(1-T)
WACC

1.25 =
1.25 =
=

1
0.965

=
=
=

1
1.2631

=
=

3.70%
11.28%

34/66
Flash Memory

7.25%
34%
11.28%
66%
60%
8.92%

60%
1.295522388 X

60%
1.309090909

1.2631 X 6%

33/67 * Beta

52%
0.96486

0.965

Exhibit 2

Flash Memory, Inc.


Net Present Value of Investment in New Product Line ($,000)

18/82
Flash Memory
COD
7.25%
D/E+D
18%
COE
11.28%
E/E+D
82%
(1-T)
60%
WACC
10.03%
2012
2013
2014
D/E

Investment in equipment

2010
-$2,200

2011

Net working capital required to support sales


Investment in Net Working Capital

$5,648
-$5,648

$7,322
-$1,674

$0
$7,322

$2,877
-$2,877

$1,308
$1,569

$21,600
$17,064
$0
$1,806
$300

$28,000
$22,120
$0
$2,341
$0

$0
$0
$0
$0
$0

$11,000
$8,690
$0
$920
$0

Income before Taxes


Taxes

$2,430
$972

$3,539
$1,416

$0
$0

$1,390
$556

Net Income
Depreciation on Straight Line

$1,458
$440

$2,124
$440

$0
$440

$834
$440

Sales
COGS (includes equipment depreciation)
R&D
SG&A
Launch promotion

Cash flow from operations


Total cash flow
NPV @ WACC
IRR

-$7,848
$1,950.23
20.1%

Comments

2015

$1,308 26.15% of Sales as Forcasted by Flash Memory Inc.


$1,308 Addational Working Capital Needed Y-O-Y
$5,000
$3,950
$0
$418
$0

Forcast by Project Sponser


COGS extimated at 79% of Sales
Exibit 3
One time Promotion Expense in '11

$632 EBITA
$253 Income Tax 40%
$379 EAT
$440 Straight Line Depriciation in 5 Years - Given

$1,898

$2,564

$440

$1,274

$819

$225

$9,886

-$2,437

$2,843

$2,127

Flash Memory, Inc.


Assumptions:
All Borrowings at 7.25%
360 Days in a year

Exhibit 3

Income Statement ($000s except earnings per share)


2007

Actual
2008

2009

2010

Forecast
2011

$77,131
$62,519
$14,612

$80,953
$68,382
$12,571

$89,250
$72,424
$16,826

$120,000
$97,320
$22,680

$144,000
$116,784
$27,216

$144,000 Estimates by Marketing Department


$116,784 COGS = 81.10% of sales as per Exibit 3
$27,216

$3,726
$6,594
$4,292

$4,133
$7,536
$902

$4,416
$7,458
$4,952

$6,000
$10,032
$6,648

$7,200
$12,038
$7,978

$7,200 R&D = 5.0% of sales as per Exibit 3


$12,038 SG&A = 8.36% of sales as per Exibit 3
$7,978

$480
-$39

$652
-$27

$735
-$35

$735
-$50

$965
-$50

Income before income taxes

$3,773

$223

$4,182

$5,963

$7,063

$6,909 EBT

Income taxes
Net income

$1,509
$2,264

$89
$134

$1,673
$2,509

$2,385
$3,578

$2,825
$4,238

$2,764 Income taxes = 40% Exibit 1 Foot Note


$4,146 Net Income Part of retained Earnings

$1.52

$0.09

$1.68

$2.40

$2.84

Sales
COGS
Gross margin
R&D
SG&A
Operating income
Interest expense
Other income (expenses)

Earnings per share

Balance Sheet ($000s except shares outstanding and book value per share)

2012

as per Exibit 3

Comments

$1,118 Interest expense = 7.25% of Previous Years Notes Payable


-$50 Other income (expenses) = $50k each year as per Exibit 3

$2.78

Exhibit 3

2007

Actual
2008

2009

2010

Forecast
2011

$2,536
$10,988
$9,592
$309
$23,425

$2,218
$12,864
$11,072
$324
$26,478

$2,934
$14,671
$11,509
$357
$29,471

$3,960
$20,000.00
$14,057.33
$480
$38,497

$4,752
$24,000.00
$16,868.80
$576
$46,197

$5,306
$792
$4,514

$6,116
$1,174
$4,942

$7,282
$1,633
$5,649

$8,182
$2,246.35
$5,936

$9,082
$2,927.50
$6,155

$27,939

$31,420

$35,120

$44,433

$52,351

$52,503

Accounts payable
Notes payable
NotesPayable/Accounts Recivable
Accrued expenses
Income taxes payable
Other current liabilities
Total current liabilities

$3,084
$6,620
60%
$563
$151
$478
$10,897

$4,268
$8,873
69%
$591
$9
$502
$14,244

$3,929
$10,132
69%
$652
$167
$554
$15,435

$6,000
$13,310
67%
$876
$239
$744
$21,170

$7,200
$15,423
64%
$1,051
$283
$893
$24,850

$7,200
$11,435
48%
$1,051
$276
$893
$20,856

Common stock at $0.01 per share par value


Paid in capital in excess of par value
Retained earnings
Total shareholders' equity

$15
$7,980
$9,048
$17,043

$15
$7,980
$9,182
$17,177

$15
$7,980
$11,691
$19,686

$15
$7,980
$15,269
$23,264

$15
$7,980
$19,507
$27,502

$15
$7,980
$23,652 Previous Balance + Net Income for Current year
$31,647

$27,940
1,491,662
$11.43
13.28%
8.9
60.2%
38.8%
63.9%

$31,421
1,491,662
$11.52
0.78%
1.4
69.0%
51.7%
82.9%

$35,121
1,491,662
$13.20
12.75%
6.7
69.1%
51.5%
78.4%

$44,433
1,491,662
$15.60
15.38%
9.1
66.6%
57.2%
91.0%

$52,351
1,491,662
$18.44
15.41%
8.3
64.3%
56.1%
90.4%

Cash
Accounts receivable
Inventories
Prepaid expenses
Total current assets
Property, plant & equipment at cost
Less: Accumulated depreciation
Net property, plant & equipment
Total assets

Total liabilities & shareholders' equity


Number of shares outstanding
Book value per share
Return on equity
Interest coverage ratio (times)
Notes payable / accounts receivable
Notes payable / shareholders' equity
Total liabilities / shareholders' equity

2012 Comments
$4,752
$24,000.00
$16,868.80
$576
$46,197

Cash = 3.3% of sales as per Exibit 3


Accounts receivable = 60 days sales outstanding as per Exibit 3
Inventories = 52 days of cost of good sold as per Exibit 3
Prepaid expenses = 0.4% of sales as per Exibit 3

$9,982 PP&E = Beginning PP&E at cost + CE as per Exibit 3


$3,676.15 Accum.Depri. = Beginning A/D + 7.5% of PP&E at cost per Exibit 3
$6,306

Accounts payable = 30 days of purchases which are 60% of sales


Funding Required (Balancing Number)
Accrued expenses = 0.73% of sales as per Exibit 3
IT payable = 10% of IT expense as per Exibit 3
Other current liabilities = 0.62% of sales as per Exibit 3

$52,503
1,491,662 No Addational Share issue required
$21.22
13.10%
7.1
47.6%
36.1%
65.9%

Flash Memory, Inc.


Assumptions:
Company Accepts New Project
360 Days in a year

Exhibit 4.1

Forecasted of B/S & Income Satements


Income Statement ($000s except earnings per share)
Actual
2007
2008
2009
Sales
COGS
Gross margin

2010

Forecast
2011

$77,131
$62,519
$14,612

$80,953
$68,382
$12,571

$89,250
$72,424
$16,826

$120,000
$97,320
$22,680

$165,600
$133,848
$31,752

$3,726
$6,594
$4,292

$4,133
$7,536
$902

$4,416
$7,458
$4,952

$6,000
$10,032
$6,648

$7,200
$13,844
$10,708

$480
-$39

$652
-$27

$735
-$35

$937
-$50

$1,236
-$350

Income before income taxes

$3,773

$223

$4,182

$5,761

$9,821

Income taxes
Net income

$1,509
$2,264

$89
$134

$1,673
$2,509

$2,304
$3,456

$3,929
$5,893

$1.52

$0.09

$1.68

$2.32

$3.95

R&D
SG&A
Operating Income
Interest expense
Other income (expenses)

Earnings per share

2012

as per Exibit 3

Comments

$172,000 Sales Estimate + Sales of New Business Line


$138,904 COGS includes COGS for new business
$33,096
$7,200 R&D = 5.0% of sales as per Exibit 3
$14,379 SG&A incudes forNew Busniess
$11,517
$1,383
-$50 includes one time promotion Exp & One Time Commission
$10,184 EBT
$4,074 Income taxes = 40% Exibit 1 Foot Note
$6,110 Net Income Part of retained Earnings
$4.10

Exhibit 4.2
Balance Sheet ($000s except shares outstanding and book value per share)

Cash
Accounts receivable
Inventories
Prepaid expenses
Total current assets
Property, plant & equipment at cost
Less: Accumulated depreciation
Net property, plant & equipment
Total assets

2007

Actual
2008

2009

2010

Forecast
2011

$2,536
$10,988
$9,592
$309
$23,425

$2,218
$12,864
$11,072
$324
$26,478

$2,934
$14,671
$11,509
$357
$29,471

$3,960
$20,000.00
$14,057.33
$480
$38,497

$5,465
$27,600.00
$19,333.60
$662
$53,061

$5,306
$792
$4,514

$6,116
$1,174
$4,942

$7,282
$1,633
$5,649

$5,982
$2,081.35
$3,901

$6,882
$2,597.50
$4,285

2012 Comments
$5,676
$28,666.67
$20,063.91
$688
$55,095

Cash = 3.3% of sales as per Exibit 3


Accounts receivable = 60 days sales outstanding as per Exibit 3
Inventories = 52 days of cost of good sold as per Exibit 3
Prepaid expenses = 0.4% of sales as per Exibit 3

$7,782 Includes new plant


$3,181.15 Accum.Depri. = Beginning A/D + 7.5% of PP&E at cost per Exibit 3
$4,601

$27,939

$31,420

$35,120

$42,398

$57,345

$59,695

Accounts payable
Notes payable
NotesPayable/Accounts Recivable
Accrued expenses
Income taxes payable
Other current liabilities
Total current liabilities

$3,084
$6,620
60%
$563
$151
$478
$10,897

$4,268
$8,873
69%
$591
$9
$502
$14,244

$3,929
$10,132
69%
$652
$167
$554
$15,435

$6,000
$17,053
85%
$876
$230
-$4,904
$19,256

$8,280
$19,075
69%
$1,209
$393
-$647
$28,311

$8,600
$5,898
21%
$1,256
$407
$8,388
$24,550

Common stock at $0.01 per share par value


Paid in capital in excess of par value
Retained earnings
Total shareholders' equity

$15
$7,980
$9,048
$17,043

$15
$7,980
$9,182
$17,177

$15
$7,980
$11,691
$19,686

$15
$7,980
$15,147
$23,142

$15
$7,980
$21,040
$29,035

$15
$7,980 No Addational Share issue required
$27,151 Previous Balance + Net Income for Current year
$35,146

Total liabilities & shareholders' equity


Number of shares outstanding
Book value per share
Return on equity
Interest coverage ratio (times)
Notes payable / accounts receivable
Notes payable / shareholders' equity
Total liabilities / shareholders' equity

$27,940

$31,421

$35,121

$42,398

$57,345

1,491,662

1,491,662

1,491,662

1,491,662

1,491,662

$11.43

$11.52

$13.20

$15.51

$19.47

$23.56

13.28%
8.9
60.2%
38.8%
63.9%

0.78%
1.4
69.0%
51.7%
82.9%

12.75%
6.7
69.1%
51.5%
78.4%

14.94%
7.1
85.3%
73.7%
83.2%

20.30%
8.7
69.1%
65.7%
97.5%

17.39%
8.3
20.6%
16.8%
69.9%

Accounts payable = 30 days of purchases as per Exibit 3


*Balancing Number*
Accrued expenses = 0.73% of sales as per Exibit 3
IT payable = 10% of IT expense as per Exibit 3
includes Addational WC Requirement

$59,696
1,491,662 No Addational Share issue required