Good Flash Memory Inc. Case Case Study Example
The case deals with the projections made by the Flash Company for the upcoming three years and the dilemma of whether to accept the new proposal or not.
The problem that is clearly reflected in the case is that the Company, Flash Memory Inc. is trying to expand its operations of the business, but it does not have the required financing. Since there are doubt issues on the growth stability of the Company, the Chief Financial Officer of the Company, Hathaway Browne, was interested in analyzing the aspects of investing and financing requirements for the extension of the business in the future. The high growth rate despite high competition in the market has attracted many other new players including big players of other markets. It has been a problem for Flash Memory Inc. since the Company has seen a decline in profit margins and periodic effects on its requirements for working capital. The investment ability of the Company has been hampered, leading to a declined financial position for the Company in its own market.
Financial statement estimate from year 2010 to year 2012, as if the fresh product line venture will not be permitted on a postulation that the company will borrow from bank.
It had been three years since the Company was planning its activities on investing and financing. The restructure in the Company’s capital was a must to revive the revenues given the growing competition in the industry. The loan limit for the bank has been reached with the note payable being up to 70% of the nominal value of the total amount to be received. The lending from factoring group would be as high as 90% of the amount that the Company maintains as receivable balances, but still there would be added restrictions of monitoring on Company’s credit terms, as compared to the loan department regulations. The charge by the bank will also be additional 2%, increasing the interest rate from 9.25%, rather than 7.25%. The forecast of the financial statements, including the balance sheet and income statement has been made to assess the need for additional funds for the Company. The preparation of these statements is based on the assumptions that have been provided in the case.
There are many assumptions made in the case for the ease of forecasting the financial statements for the three years. However, the assumptions are not devoid of flaws. An instance of this may be that the purchase portion included in the cost of goods sold is 60% in each year. This means that the value of inventory should be decreased from 2010 to 2012, rather than increasing as per the net sales. This will result in inventory value dramatically dropping instead of proportional growth. This is also because the outflow in inventory will increase even when a small purchase is made. Another illogical assumption is that the net property plant and equipment to net sales ratio has been taken at 4.95% in the year 2010, when in the past the ratio was maintained at 5.85%, 6.1% and 6.33% of sales in the years 2007, 2008 and 2009 respectively. With the increase in sales, there should be added investments in the non-current assets in comparison to past. But it has been assumed to be fixed at $900,000. There are other illogical assumptions as well, but they had to be taken into consideration during financial statement preparation.
The first set of financial statements in the Excel file has been made with the following three main assumptions:
There is no investment in Product line
There is no sale of new common stock
All borrowings are made at 9.25%.
The other assumptions made at various points in the calculations are as follows:
- Given that the Company stands at the limit for the current agreement on the loan, there is a trust in the management that the proportion of debt is higher than what is required for optimal financing. The case clearly states that the target setting of management in terms of capital structure proportions is 82% for equity and 18% for debt.
- The cost of debt capital for the Company will be 7.25% if the weight of debt is at 18%, meaning that the Company will fall within the 70% accounts receivable range of the current loan agreement.
- If the Company goes above this limit, by changing into factoring, the increased costs of capital for the Company will be 9.25%. Simultaneously, the value of equity beta and cost of capital for the equity share would also rise.
Assuming the company does not invest in the new product line; prepare forecasted income statements and balance sheets at year-end 2010, 2011 and 2012. Based on these forecasts, provide an estimate of Flash's required external financing for each year.
The forecasted income statement and the balance sheet is shown in exhibit 1 of the excel sheet.
Estimate the incremental cash flows associated with the proposed investment in the new product line.
The calculations are shown in the excel sheet. Ex 4.
What discount rate would you recommend that the company use to estimate the value of the investment decision in the new product line?
So, the firm will have the discount rate of 9.96% to value its investment.
If the company decides to proceed with the investment, how much do you estimate the company will need for the investment and how would you recommend that the company obtain those funds?
For this question, the detail forecasted detail is shown in exhibit 5 and exhibit 6 of the excel sheet. Exhibit 5 shows the forecast when the company finance its new investment from the bank loan at the rate of 9.25% without issuance of new common stock. Exhibit 6 shows financing forecast by issuance of new common stock and the debt at the interest rate of 7.25%. The comparative analysis of these two alternative shows that it is beneficial for the company to finance the new investment by taking loan with interest rate of 9.25%.
If the company finances its new operation with the loan, then the EPS for coming next three years will be higher than the EPS coming from common stock financing. The debt financed EPS is higher every year than equity financed EPS. The ROE of debt-financed venture is also more favorable, which is higher than the ROE of equity financed venture. The other ratios seems to be more favorable for debt-financed project than equity financed. The returns for investor will be good when the debt financing is done. Even though this might increase the riskiness of the company, the risk is not that high as compared to benefit. Even though the company have borrowing ceiling of 70% of accounts receivable, debt financing does not seem feasible, as the Notes payable to accounts receivable ratio will exceed the limit of 70%. However, at 9.25% interest i.e. 2% more than current rate, the bank can give the loan up to 90% of accounts receivable. Since, the company shows the promising results on the debt financing, it is better to borrow loan at 9.25% interest rate to finance its venture.
In your opinion, should the company accept or reject the investment opportunity. Briefly explain why.
The analysis part involves looking at the various decisions the Company has to make and whether the Company should invest or not.
If we look at the above analysis, then we can see that the company will earn the NPV of 3,014,000 by investing in the new project. This will add the shareholders’ wealth. The IRR of 21.9% and MIRR of 17.3% is higher than the cost of capital. So, the company must accept the investment.
Looking at all the cases, the profitable would be to invest in the new product line since it gives higher earnings per share and return on equity; the ability to pay interest on debt is also significantly increased.
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