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This Study Resource Was: Case Study - Flash Memory, Inc
This Study Resource Was: Case Study - Flash Memory, Inc
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Case Study | Flash memory, Inc.
Problem Determination
Management of the computer and electronic divisions - Flash memory
management is facing a challenge: The company needs to invest operating
capital in order to grow its revenue streams, and is considering launching a new
product in the market. An additional $ 2.2 million will be raised to fund the
product, and there are two alternatives:
1. A bank loan, however, has a coefficient at which the bank sets a credit limit
(Notes payable / Accounts reciavable) at 70%. The bank can increase this ratio up
to 90%, but at the expense of increasing the interest rate on the loan.
2. Issuance of ordinary shares (300,000 shares - 23 USD each).
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• The industry is characterized by rapid market growth, constant innovation and
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the need to create new products (research and development costs are quite
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high);
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• Due to technological improvements the product life cycle is short, which often
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results in depreciation of supplies;
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• The industry is characterized by high competition (there are dominant
companies in the industry such as Intel and Samsung), so profitability margins are
low;
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• The SSD market, which accounts for 70% of Flash memory, increased from $
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400 million to $ 2.8 billion in 2009, compared to 2007. By 2013, the market is
expected to grow to $ 5.3 billion.
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• The company responds to the technological challenges of the industry and the
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short viability of products with high research and development costs. They have a
good team in this regard, which can be considered as one of the main factors of
competitive advantage.
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Case Study | Flash memory, Inc.
• New Product Sales Maximum - 70% of product sales in the first year, high sales
growth rates in the second and third years, sales decline in the fourth year and
write-offs in the sixth year.
• The Company extends its operating assets through bank credit, but according to
the agreement with the Bank, the Company's line of credit amounts to 70% of
Receivables, which has already expired. The bank can increase this ratio up to
90% by increasing the loan interest rate from 7.25% to 9.25%. In the view of the
management, if the credit increases, the optimal capital structure will also be
increased (Debt - 18%, Equity - 82%), which is undesirable for them.
• Also, the company is considering stocks and new product releases.
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calculated for the firm (FCFF) we should use the WACC.
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DCF Model: Discount factor Assumptions
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Micron SanDisk
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Technology Corporation STEC, inc.
Book value of equity rs e 5 603 4 157 276
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Market vealue of equity 7 925 9 135 699
Book value of debt 2 760 975 -
Levered beta 1,25 1,36 1,00
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According to the case, management believes that the optimal capital structure for
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the company is Wd - 18% and We - 82%, so we took these weights when
calculating the WACC, although the weighted average capital structure of
comparable companies could also be used (Beta and other Capm components).
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Market data and weights are used when counting because of market weights
commitment may be more accurately show the real value of the company's
capital).
• Calculate the cost-equity based on the CAPM model based on the case data.
Beta Factor Calculate from the average Unlevered beta of comparable publicly
traded companies. To calculate the unlevered beta, we used the market value of
the capital of these comparable companies and weighted them (the market value
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Case Study | Flash memory, Inc.
of the loan cannot be estimated from this data). Finally, the average Unlevered
beta was released at 1.10. When calculating Flash Memory's levered beta, we used
the market value of the company's equity and the levered beta was 1.28 instead
of 1.25, which would be the case if we took Book Value of Equity.
• Risk free rate We took The yield of 10years US treasury obligations. 5 year rate.
• At 18% Leverage the loan cost was set at 7.25% (3.25% + 4%) as the ratio of
Notes payable / Accounts reciavable to this weight does not exceed 70% and
therefore the loan expense does not increase to 9.25% (3.25%). + 6%).
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We: E/(D+E) 82,0%
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Cost of Debt 7,3%
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Wd: D/(D+E) 18,0%
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Profit Tax 40,0%
WACC 10,13%
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table 2. WACC calculations
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As expected in evaluating the project's profitability, the use of Debt and Equity made the
project more attractive as it took advantage of both funding sources, reduced project risk
and weighted average cost of capital (interest tax reduces profit tax).
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Should the company implement the project and what impact will it have
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$7,01
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Operating Income (NOPAT) FCFF
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$3,54 $3,54
$2,43 0 $2,56 0 $2,84
$2,12
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1 4 $1,39 3 7
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$225 $632
We used NPV, IRR, and Profitability Index indicators to measure profitability. Since you
only need to compare one project and not several alternatives, we can each have equal
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Usually, when the NPV of the project is positive, the project should be implemented. But
it is necessary to identify the factors that lead to a positive NPV. According to the case
study, product sales span a five-year period and require $ 2.2 million of initial investment
to purchase a fixed asset and 26.15% of additional sales to fund operating assets. A total
of US $ 7,848 million is needed (US $ 400,000 already spent on the project, which is a
sunk cost and we do not take into account decision making). Calculations show that NPV
does not become positive until the company generates ten years of cash flow. Ie The
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Case Study | Flash memory, Inc.
profitability of the project depends on the overall life cycle of the project, which is quite
long term and quite risky for the given sector. Based on the management's 5-year
forecast NPV = 2 962. However, there is a high likelihood that the product will be listed
after three years. As the company reaches 70% of new product sales in the first year of
product launch, the next two years of high sales growth rates are maintained, however,
as the fourth year declines and the product is already listed for the sixth year, this period
may come earlier and management should consider In such a case what would be the
project Profitability.
For example, if we reduce the number of new project sales years from five to three years,
we find that the NPV value becomes negative (NPV = -152). It has a similar negative
effect on reducing product viability.
Product obsolete after
Normal Case 3 years
NPV 2 962 (152)
IRR 21,9% 8,6%
Profitability index 1,38 0,98
Cost of capital 10,13% 10,13%
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To avoid the undesirable effect described above, management should develop an
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alternative strategy for the sale of the $ 2.2 million unit of equipment. For example, it is
important to consider, in the case of forecast forecasts, whether the company will be
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able to sell the equipment and how it will affect the project's profitability or profitability.
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Debt or Equity?
Sales of the company are growing rapidly and operating capital is not enough to raise
operating capital, so additional funds are needed. If the new project is funded as well, the
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Notes payable / Accounts receivable exceeds the bank's 70% limit, thus increasing the
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loan servicing cost from 7.25% to 9.25% and changing the optimal capital structure
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(Debt 18%, Equity 82%). However, Operating Profit is freely served by the Interest
Coverage Ratio (5.1-times).
It should be noted that with the increase of Leverage, the ROE increases, as the profit
generated by the company is higher than the cost of loan servicing.
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10,0
7,7% 7,6% 7,3% 7,3% 8,8% 9,0% 7,6% 9,6%
ROA %
1 1 2, 2, 1 1 1 1
Financial leverage 1,91 ,92 ,69 00 13 ,83 ,54 ,68 ,48
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2 2 2, 3, 3 1 3 3
EPS 2,28 ,66 ,56 28 55 ,76 ,96 ,24 ,47
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Case Study | Flash memory, Inc.
If the project is financed by issued shares, the ROE and EPS commitments will be reduced
compared to the financing strategy, but the cost of loan servicing will not increase.
Despite the advantages of investing in liabilities, a loan limit is not enough to fund a new
project, while the project is profitable, so it is necessary to issue new shares. Retained
earning is not enough to grow a company quickly and fund a new project. In the case of
new equity investments, the company will have sufficient resources to fund new product
development within the first year. Competition in a given industry is fierce and always
requires new product offerings to market. Failure to launch a new product on time will
lose competitive advantage and reduce market share.
Conclusion
As already mentioned, this industry is characterized by intense competition. At the same
time, large competitors (Samsung and Intel) can put pressure on price and thus create
problems for small companies. Due to competitive pressure in the industry, profitability
margins are reduced. Consequently, costs for research and product development are
significant for a given industry. Competitiveness and effective operation require the
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creation of new products that are associated with a large number of R&D costs. The case
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assumes that this expense does not change and is always 5% of sales, but may require
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more. However, sales of the company are growing rapidly, and the company's revenue is
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not sufficient to fund operating capital, ie. You need to raise additional funds. Therefore,
in such a case, it would be less risky for the new project to be funded by Equity, as a
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reduction in Net Income with Debt financing would have a more significant impact on
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profitability. In case of Debt financing, the Company may not be able to serve its
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increased liabilities due to depreciation or decrease in profit margins and may face
default.
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Additional strategies
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In addition, we can say that based on the results of the existing sales growth, the
company can provide the loan service and since the loan financing is going to be better
profitability, the management of the company should negotiate with the bank. For
example, management may offer the bank a collateralized asset for the production of a
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new product and if forecasts fail and the company becomes insolvent, the bank may
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recover the loss by liquidating the assets acquired to produce the new product.
Management should also consider various scenarios when evaluating the profitability of a
new project, such as whether it will fund a new project or not, in the near future, and
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