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Star River Electronic Ltd.

1. What are the issues of this case?

Adeline Koh who is the new CEO of star river electronic ltd faced new issues regarding on the management from the first day of being
appointed itself. Star River produces compact disc (CD) but has to change their production from CD to DVD and Blu-ray disc. Star
River managed to survive few shakeouts which were caused by the technology innovations. This has made the sales volume of the
company to grown a robust rate. Besides, the unit prices for the star river products start to decline due to the price competition and the
increasing popularity in streaming. This has made the Star river management to grow the Blu-ray revenue to cover up the decline in
profit for the DVD and CD for upcoming 5 years. Other than that, there were also issues on purchasing the new machine or not. As the
plant manager suggest immediate implementation on plant upgrade as the old machine requires the workers to put in overtime to keep
in running and has high maintenance cost and purchasing the new machine will solve all this problems. However, the new machine
cost SGD1.82 million and obviously not supporting star river cash flow for current time.

2. How well has Star River done in the past? How healthy is it now?

Financial Ratio Analysis

Profitability Ratio

Year 2012 2013 2014 2015


Operating Margin 18.6% 18.6% 15.6% 15.7%
Tax Rate 24.5% 24.6% 23.5% 24.7%
Return on Sales 10.4% 10.3% 6.8% 6.4%
Return on Equity 21.8% 20.3% 14.0% 13.6%
Return on Asset 6.8% 6.6% 3.9% 3.7%
Leverage

Year 2012 2013 2014 2015


Debt/Equity 1.13 1.12 1.76 2.02
Debt/total capital 0.53 0.53 0.64 0.67
EBIT/interest 3.85 3.79 2.32 2.18

Asset Utilization

Year 2012 2013 2014 2015


Sales/assets 65.2% 64.0% 57.6% 57.4%
Sales growth rate 15.0% 11.4% 15.6% 14.5%
Assets growth 8.0% 13.5% 28.5% 14.9%
rate
Days sales 112.4 115.6 110.7 122.1
outstanding
Days payable 133.4 121.7 93.3 91.3
outstanding
Days inventory 252.3 263.0 422.6 435.6
outstanding

Liquidity

Year 2012 2013 2014 2015


Current ratio 0.76 0.79 0.82 0.90
Quick ratio 0.41 0.42 0.31 0.35
Star River did well in the mid-1990 due to the rise in popularity of optical and multimedia products created high demand for
CD-ROMs. Eventually, with the introduction of DVD and its slowly replacement of CD-ROM, the sale of DVD is only made up of 5%
of their sales at fiscal year-end 2001. Star River is aiming to increase their revenue from DVD. Star River’s current financial position
isn’t healthy since they are taking too much debt.

First of all, in terms of profitability of the company we are concerning on several ratios where it could measure the company’s
performance. By using the profitability ratio, it can evaluated whether the company has the capacity to create profit from what is left
over from income earned after deducting all costs and expenses related to earning the income. Based on the financial statements of the
Star River Electronics Ltd, show that the company had been facing a decreasing operating margin from the year 2012 to 2015. The
decreasing of operating profit margin indicate that the company’s profit after pay all the variable costs of production like wages, raw
materials and some other expenses is reducing year by year. In other words, operating margin is a margin ratio where it measure the
company’s pricing strategy and operating efficiency. In this case, since the company had been facing a decrease in its operating
margin, it shows that the company is not capable in managing their variable costs and also the raw materials which shows that the
company is not capable in earning the maximum profit.

The return on sales of the company had been in a declining trend for the five years from 2012 to 2015. In addition to that, as
can be seen in the company’s historical financial statements, the return on equity and return on assets have also in the declining trend
for the same five years period. The falling rate of return indicates that the company does not have the ability to generate profit without
much need of capital.

In terms of company’s leverage, it is very crucial to identify and evaluate how much a company is dependent on debt in order
to finance its day-to-day activities and also it helps to estimate the risk level to a company’s shareholders. Apart from that, it will also
measure the creditworthiness of a firm to meet its liabilities in the form of interest expenses and other payments. As it is generally
known that the leverage level of a company shouldn’t be at its highest neither at its lowest. This is because in general, a high level of
leverage indicates that the company may not be able to generate enough profit to satisfy its debt obligations. On the other hand, low
level of leverage might also indicate that a company is not taking advantage of the increased profits that financial leverage may benefit.
In the case of the Star River Electronics Ltd, it shows that the company has a rising trend of leverage throughout the five years of
accounting period. This somehow shows that the company was not able to generate sufficient cash or income in order to compensate
their debt obligations by also considering their falling trend of profitability ratios.

Next elements that is very essential to indicate a company’s financial health is asset utilization. The asset utilization ratio
measures the total revenue earned by a company for every dollar of assets a company owns. Star River Electronics Ltd did not use or
utilized its assets well in order to earn revenue for the company. This can be seen where sales to assets ratio, sales growth rate, assets
growth rate had been in the declining fashion from the year 2012 to 2015. Indirectly it shows that the company did not have the
capability and efficiency to manage their assets well that resulted in higher leverage need. Apart from that, number of days sales
outstanding had been increasing from year to year which indicate that the company was not efficient in receiving back their credit
from sales operations. Increase in number of days inventory outstanding was also did not indicate good inventory management
operations. A declining ratio over time however indicates that a company is able to sell inventory at a quicker leap.

Last but not least is the liquidity ratio which has been one of the major parts in deciding whether the company is financially
healthy or not. One of the critical strategy that each firm need to think about is the ability to meet financial obligations when it comes
due and it can be done by measuring the liquidity ratio. In average, as can be seen in the Star River Ltd historical financial statements,
the company has a high liquidity ratio for the past five year’s period. For an example is the current ratio where it has been in a rising
trend for that period of time. Since the company’s current ratio was below than 1, it indicates that the company might not be able to
pay off their short-term liabilities with cash. The same indicator goes for the low quick ratio resulted in the same years. Quick ratio
measures the amount of liquid assets available to offset current debt. Generally, a healthy enterprise will always tend to keep their
quick ratio at 1.0 or higher and a ratio of 2.0 or higher is considered as a comfortable financial position.
However, liquidity ratio is very subjective and it also varies according to the specific industry average. The reason behind it is
that when a company has a high liquidity ratio, it indicates that there are too much cash been hold and reserved instead of utilize them
in other areas that could be profited of. On the other hand, low liquidity ratio as mentioned earlier could cause the business to struggle
from paying short-term obligations. In a nutshell, based on the overall performance of Star River Electronics Ltd for the past five
years period, it can be concluded that the company did not have a growing or good achievement throughout the years. Even though,
there might be some capabilities to manage the company’s assets wisely and efficiently but the execution is what matters the most.
The financial ratio analysis had proven that the company didn’t do well in the past five years.
3. Can Star River repay the bank loan within a reasonable period? Construct a forecast of the firm's financial statements for
2016 and 2017. What will be the external financing requirements of the firm in those years.

Historical and Forecasted Income Statement For Fiscal Years Ended June 30

(SGD 000) 2012 2013 2014 2015 Assumptions 2016 2017

Sales 71,924 80,115 92,613 106,042 4% /year increase 110,284 114,695


Operating expenses:
Production costs and expenses 33,703 38,393 46,492 53,445 SGD15,470 53,460 53,475
Admin. and selling expenses 16,733 17,787 21,301 24,633 average 81,900per year 24,715 24,797
Depreciation 8,076 9,028 10,392 11,360 SGD218,400 11,433 11,506
Total operating expenses 58,512 65,208 78,185 89,439 89,608 89,778

Operating profit 13,412 14,907 14,428 16,604 20,676 24,917


Interest expense 3,487 3,929 6,227 7,614 6.9% of short term borrowings 5,853 6,066
Earnings before taxes 9,925 10,978 8,201 8,990 14,823 18,852
Income taxes* 2,430 2,705 1,925 2,220 24.5% of EBT 3,632 4,619
Net earnings 7,495 8,273 6,276 6,770 11,191 14,233

Dividends to all common shares 2,000 2,000 2,000 2,000 2,000 2,000
Retentions of earnings 5,495 6,273 4,276 4,770 9,191 12,233

*The expected corporate tax rate was 24.5%.


Historical and Forecasted Balance Sheets For Fiscal Years Ended June 30

(SGD 000) 2012 2013 2014 2015 Assumptions 2016 2017

Assets:
Cash 4,816 5,670 6,090 5,795 average 6% from sales 6,617 6,882
Accounts receivable 22,148 25,364 28,078 35,486 Average of 32% of sales 35,291 36,702
Inventories 23,301 27,662 53,828 63,778 assume raise to 70% 77,199 91,756
Total current assets 50,265 58,697 87,996 105,059 119,107 135,340

New DVD equipment over


Gross property, plant & equipment 64,611 80,153 97,899 115,153 2 years 116,973 116,973
Depreciation of new
Accumulated depreciation (4,559) (13,587) (23,979) (35,339) equipment (35,521) (35,703)
Net property, plant & equipment 60,052 66,566 73,920 79,814 81,452 81,270
Total assets 110,317 125,262 160,916 184,873 200,559 216,610

Liabilities and Stockholders' Equity:


Short-term borrowings (bank)1 29,002 36,462 69,005 82,275 87,356 90,530
Accounts payable 12,315 12,806 11,890 13,370 Average 14.6% of sales 16,101 16,745
Assuming 20,000 on
Other accrued liabilities 24,608 26,330 25,081 21,318 average 20,000 20,000
Total current liabilities 65,925 75,598 105,976 116,963 123,457 127,275

Long-term debt2 10,000 10,000 10,000 18,200 Same as last year 18,200 18,200
Shareholders' equity 34,391 40,664 44,940 49,710 Retention of earnings 58,901 71,135
Total liabilities and stockholders' equity 110,316 126,262 160,916 184,873 200,559 216,610
If the company expected their sales would increase to 4% for each year for the next 2 years, their sales will increase to SGD
110284 Million in 2016 and SGD 114 695 Million for 2017. Their production cost and expenses also would be increase by SGD
15470 for each year in forecasting statement. Their production cost is keep increasing as the sales increase. If Star River cannot cater
this increment in production cost and operating expenses, they cannot generate the efficient profit since they need to spend more to
generate more as their operating margin for the previous 4 years shows the downward pattern. We also assumes that their inventories
will be increase by 70% percent for forecasted year, it is because for the early two years of historical years, their inventories are in
range of 30% of the sales, while for the next two years which in 2014 and 2015 their inventories are increase in range of 50% to 60%
of sales. So for forecasted year in 2016 and 2017 we assume that the inventories level will keep increasing as the sales increase in the
range of 70% in 2016 and 2017. The ideas of Esmond Lim, Plant Manager is a good things since it can increase the Star River sales,
but it could be difficult for them to executed the idea with the current financial problem that the faced. If they can increase the sales in
the forecasted year, Star River need to bear additional cost of liabilities to balance their asset and liabilities, which required them to
have extra funds at SGD5,081 in 2016 and SGD 8,255 in 2017 which would increase in their short term borrowing. By this their short
term borrowing might be increase from year to year shows that they are facing difficulties to repay their loans in the reasonable period.
Moreover, their leverage also keep increase from year to year then additional financial needed in 2016 and 2017 to finance new
equipment may worsen their financial condition. To buy a new equipment, they really need to have a lot of funds to cover their
inventories and other production cost. However, Star River still have the other choice such as, they can reduce payout which allow
them to have more capital or raising new equity. By doing this, Star River will be able to maintain or lower their debt equity ratio and
slowly recover their financial problem.
4) Should Koh approve the packaging-machine investment?

The plant manager has expressed his concern about the unreliability of the current packaging machine. He recommended to purchase
of a replacement. Due to the limitation on production using the current equipment, Star River will have to purchase the new equipment
within three years in order to keep up with forecast production levels. This analysis requires in forecasting the two projects for 13
years whether want to purchase now or waiting three years more. For these issue are include with unexpected changes in the inflation
and interest rates, the required rate of return on equity and labor cost.

The relevant assumptions are include the inflation rate, associated maintenance contract and the increasing price of the new machine,
the differential labor cost associated with operating the current machine and the new machine. The financial of the cash flows below
indicate that, the expected inflation and the increased price of the machine in the future will bring the decision to his wait on this
purchase until 2005.

Year 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
FCF (buy now) (1,661,360) (7,111) (79,870) (8,882) (9,795) (10,728) (11,680) (12,653) (13,648) (14,663) (60,291) (61,352) (62,437)
FCF(buy later) (55,678) (56,781) (57,900) (2,110,736) 11,801 12,735 13,688 14,662 15,658 16,674 62,303 63,365 64,451

NPV (buy now) (1,539,148)


NPV (buy later) (1,397,480)
Difference (141,668)
decision : buy later

In addition to the cash flow aspect of decision, there are other aspects which financial implications are difficult to forecast but should
be considered. In particular, being unethical in the production department cause of the expected high over time requirements for the
next three years could increase the turnover rate in the department. If the company were to lose key people in the department, they
may find themselves facing an outdated and unreliable packaging machine and lack of people experienced in repairing the machine.
By recreate this experience while maintaining the necessary output from the machine, is likely to cause missed shipments to customers
and damage to the reputation in the industry. So, the net present value of purchasing the machine now is SGD141,668 greater than
waiting the purchase. (further information can see appendix 1)
APPENDIX 1

Assumption

Inflation 1.50%
Tax Rate 24.50%
Cost of Capital 13.99%

Current Machine
Annual Maintanence (15,470)
Op. Labor (regular time) (63,700)
Op. Labor (overtime) (81,900)
Book Value (at start 2002) 218,400
Dep. Year Remaining 3
Book Value 218,400

New Machine
Price (2002) 1,820,000
Dep. Years Remaining 10
Maintanence Contract (2002) 3,640
Price & Maintanence growth 5%
Rate
Buy Now
Year 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
New Machine
Purchase (1,820,000)

Maintanence exp. (3,640) (3,833) (4,013) (4,214) (4,424) (4,646) (4,878) (5,122) (5,378) (5,647) (5,929) (6,226) (6,537)
Op. Labor (63,700) (64,656) (65,625) (66,610) (67,609) (68,623) (69,652) (70,697) (71,758) (72,834) (73,926) (75,035) (76,161)
Depreciation Exp. (182,000) (182,000) (182,000) (182,000) (182,000) (182,000) (182,000) (182,000) (182,000) (182,000) - - -
Total Exp. (249,340) (250,478) (251,638) (252,824) (254,033) (255,269) (256,530) (257,819) (259,136) (260,481) (79,855) (81,261) (82,698)
Total Exp. After Tax 188,252 189,111 189,987 190,882 191,795 192,728 193,680 194,653 195,648 196,663 60,291 61,352 62,437
Sell Old Machine 164,892
Add Back Depreciation 182,000 182,000 182,000 182,000 182,000 182,000 182,000 182,000 182,000 182,000 0 0 0
Op. Cash Flow (158,640) 7,111 7,987 8,882 9,795 10,728 11,680 12,653 13,648 14,663 60,291 61,352 62,437

Free Cash Flow (1,661,360) 7,111 7,987 8,882 9,795 10,728 11,680 12,653 13,648 14,663 60,291 61,352 62,437
NPV (1,539,148)
Buy in Three Years 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Year
Current Machine
Maintanence exp. (15,470) (15,702) (15,938)
Op. Labor (81,900) (83,129) (84,375)
Depreciation Exp. (72,800) (72,800) (72,800)
Total Exp. (170,170) (171,631) (173,113)
Total Exp. After Tax 128,478 129,581 130,700
Add Back Depreciation 72,800 72,800 72,800
Cash Flow 55,678 56,781 57,900

New Machine
Purchase (2,106,878)

Maintanence exp. (4,214) (4,424) (4,646) (4,878) (5,122) (5,378) (5,647) (5,929) (6,226) (6,537)
Op. Labor (66,610) (67,609) (68,623) (69,652) (70,697) (71,758) (72,834) (73,926) (75,035) (76,161)
Depreciation Exp. (210,688) (210,688) (210,688) (210,688) (210,688) (210,688) (210,688) (210,688) (210,688) (210,688)
Total Exp. (281,512) (282,721) (283,957) (285,218) (286,507) (287,824) (289,169) (290,543) (291,949) (293,386)
Total Exp. After Tax 212,541 213,454 214,387 215,339 216,313 217,307 218,322 219,360 220,421 221,506
Add Back Depreciation 210,688 210,688 210,688 210,688 210,688 210,688 210,688 210,688 210,688 210,688
Op. Cash Flow 1,853 2,766 3,699 4,651 5,625 6,619 7,634 8,672 9,733 10,818

Free Cash Flow (55,678) (56,781) (57,900) (2,108,731) 2,766 3,699 4,651 5,625 6,619 7,634 8,672 9,733 10,818
NPV (1,397,480)