Flash Memory , Inc.

FM2 case Study Assignment , XLRI

Abhimanyu Kumar Singh

MP15002

BME 2015-18

Case: Flash Memory, Inc.

Executive Summary
The report presents a case about Flash Memory Inc., which was
established in San Jose, California. Flash Memory Inc. has a sensational
history since its creation but with the passage of time and with the
innovation of new electronics and computers devices, the industry was
facing new challenges, which threatened the profits of the company and
made the company to worry about its future.
Industry consists of giants like Intel, Samsung and smaller firms like
Micron Technology, SanDisk Corporation, STEC Inc., and Flash Memory Inc.
The demand for high performance devices and components was growing,
particularly memory devices. Flash Memory Inc. had focused on Solid
State Drives (SSDs), which is the fastest growing division in the overall
memory industry. Industry statistics illustrated that the SSD market
expanded from about $400 million in 2007 to $1.1 billion in 2009, and it
was further forecasted to grow to $2.8 billion in 2011 and $5.3 billion in
2013. By 2010, the Flash Memory Inc.s board of directors consisted of six
members, and they had possession of the entire equity in the firm.
Due to changes in technology, Flash Memory Inc.s memory and other
products have short product life cycles. The companys new products
normally realized 70% of their maximum sales level in their first year, and
maximum sales were achieved that were maintained in the second and
third year. The fourth year and the proceeding years saw rapid decaying
sales, and by the sixth year, the products were out of date. This normal
sales life cycle for the companys products, however, could be significantly
shortened by technologically superior new products released by
competitors.
Flash Memory Inc. had used notes payable obtained from the companys
commercial bank, and secured by the pledge of accounts receivable so as
to fund this growth of working capital. Although, these notes payable were
technically short-term loans, but in actuality they represented permanent
financing as the company continually relied on these loans to finance both
its existing operations and new investments.
Problem Statement:
The problem in the case is that, Flash Memory Inc. is considering
expanding its business operations but for that the company is in need of
the financing. Hathaway Browne, the Chief Financial Officer of Flash
Memory Inc. wanted to analyze the future aspect of the investment and
financing requirements for the expansion as the company was not growing
with stable pace. The high market competition and rapid growth attracted
the big giant of the other market to enter into this market segment, which
created problems for Flash Memory Inc. in terms of reducing its profit
margins and it also affected its working capital requirements, which
lowered its investment capacity and also worsen Flash Memory Inc.s
financial position in the market.
Question 1

In order to evaluate the future project, it is important to calculate the

weighted average cost of capital. This would need the calculation of other
variables as well such as the cost of equity and debt. However, for the
purpose of calculation of cost of equity, we need to have the risk-free rate
and
the
market
premium.
The risk-free rate is estimated by looking at the current yields to maturity
on debt securities. Over here, the risk-free rate 10-year Treasury bonds
are considered and the market premium is 6%. That represents the
expected return of the overall stock market versus the Treasury bonds.
The tax rate of 40% is used to calculate the beta equity. Beta equity is
assumed to be 1 as the company with 100% equity finance shows the
beta coefficient of 1 (STEC INC.).
Beta equity represents the risk that is attached to the particular industry.
As Flash Memory Incorporation was the small private company, beta
equity was of no use to them but when it comes to investment, the risk
factor was necessary to take into consideration. Therefore, the beta equity
is calculated that represents the risk of the company or industry after
incorporating the beta assets and beta debt into it.
After this, the weighted average cost of capital is calculated. The weighted
average cost of capital for Flash Memory Inc. is 9.96%. This WACC would
be used to evaluate the future investments. This weighted average cost of
capital represents the risk as well as the discount rate from calculating the
present value of future cash flows. On the other hand, it is the average
rate of return for the companys investor to compensate them. It
incorporates the capital structure of company within it.
Question 2
The free cash flow forecast is calculated to estimate the future cash flow
stream that would derive from the project. However, the figures calculated
such as sales, cost of goods sold, sales, admin and general expense might
not be exactly as accurate as the forecast but it did generate the ideas for
the management of Flash Memory Incorporation to the critical variables
for the success of the project.
The forecasted free cash flow is based on several assumptions due to
uncertainties in the future. Sales are estimated by the management as
the sales and marketing team is quite excited about this investment and
believes that this would be one of the healthy investments. Cost of goods
sold is assumed to be 79% of the sales. This might be based on the
previous years COGS margin against the sales.
However, the management is just concerned about the margin, whereas,
other costs may also arise in the future. Flash Memory Incorporation is
going through advancement in the global environment. Technology is
changing day by day along with the demands of the customers; therefore,
Flash Memory Incorporation might have to introduce innovative
techniques in the future that would affect its cost of sales.
Same case goes with the sales, general and administrative expenses as
they are expresses in same percentage of sales as in 2009. However, the
management cannot rely that these expenses would be the same during
the planning horizon as well as in the actual future time. The management

needs to consider alternatives that could lead to the increment of such

costs. Flash Memory Incorporation is considering expanding its operations
in the future and therefore, it would need to be more conscious about
administration expenses.
In 2011, the management estimated that due to the new project there
would be direct advertisement and campaign, but still the management
cannot be sure that this type of expense will only rise in 2011. The
number of competitors might increase as this industry has been
developing very fast. This market of solid state drives (SSD) is
continuously boosting as it reached to $1.1 billion in 2009 from $400
million in 2007, as it increased to $2.8 billion in 2011 to $5.3 billion in
2013

Overview of Case Solution

The CFO of Flash Memory, Inc. is organizing the companys future
financing and investing goals for the coming three years. Flash Memory is
a mediocre sized firm that has developed expertise in the construction
and production of Solid state drives (SSDs) and memory units for the
computer and automated industries. The organization determinedly funds
the research and development (R&D) of innovative goods in order to
maintain its competitive edge in the industry over other key players.
Higher needs for the working capital have compelled the CFO to take into
consideration other means for further funding. Additionally, he must also
think about an investment o in a novice product line that has the
capability of turning extremely lucrative. Students will be required to
construct financial predictions and forecasts, compute the weighted
average cost of capital (WACC), approximate cash flows, and assess
financing options available. This case is specifically suggested to be given
a sa final exam in an MBA-level corporate finance course. Key concepts
and learning include: Capital Budgeting, Cash Flows, Financial Forecasting,
Long Term Financing, Net Present Value (NPV), and Weighted Average Cost
of Capital (WACC)
Analysis:
The analysis was performed to solve the given requirements below:
Financial statement forecast from 2010 to 2012 as if the new product line
project will not be approved with an assumption that company will borrow
from bank:
Flash Memory Inc. was preparing the companys financing and
investing plan for three years. Due to strong industry and company
growth, Flash Memory Inc. needed to restructure its capital structure for
increasing its sales revenue. Flash Memory Inc.s bank is reluctant to
extend additional loan to the company as it has reached at its limit
because its bank note payable almost reached at 70% of the face value of
its receivable amount. However, the factoring group would lend up to 90%

of the companys existing accounts receivable balances, but this group

would also monitor Flash Memory Inc.s credit extension policies and
accounts receivable collection activities more rigorously than the
commercial loan department that currently managed the companys loan
agreement. Bank will also charge an extra 2% interest rate of 9.25%
instead of 7.25%. In order to evaluate whether the company needed
addition funds, we have made forecasted income statement and balance
sheet for next three years i.e. 2010, 2011 and 2012. Forecasted income
statement and balance have been prepared by using the assumption that
Flash Memory Inc. has provided.
Forecasted financial statement is based on assumptions; however, many
of these assumptions do not seem reasonable. One of the most
unreasonable assumptions is that purchase should be 60% of the cost of
goods sold in each year; therefore, inventory value should fall from 2010
to 2012 instead of growing to the net sale. It is unreasonable because by
using this assumption, inventory value will drop dramatically instead of
growing proportionally, as inventory outflow will increase due to small
purchase. Moreover, property, plant and equipment (PP&E) as percentage
of total sales were 5.85%, 6.1% and 6.33% of the sales respectively in
2007 to 2009. But net PP&E as a percentage to net sales is assumed to be
4.95% in 2010. As sales are continuously increasing; therefore, more
investment is required in non-current assets as compared to past.
Investment in non-current assets is assumed fixed of $900,000. Therefore,
this assumption also seems to be unreasonable.
1. Actual and Forecasted Financial Statements Assuming No
Investment in New Product Line, No Sale of New Common
Stock, and All Borrowings at 9.25%

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

per share)

2. Calculation of Cost of Capital

Step 1 - Calculation of asset Beta for the industry using market
value weights:
Micron Technology
D = book value of debt (4-30-2010)
BVE = book value of equity (4-30-2010)
MVE = market value of equity (4-30-2010)
E = equity or levered beta

$2,760
$5,603
$7,925

25.8%
74.2%
1.25

A = asset or unlevered beta

SanDisk Corporation
D = book value of debt (4-30-2010)
BVE = book value of equity (4-30-2010)
MVE = market value of equity (4-30-2010)

1.03

$975
$4,157
$9,135

E = equity or levered beta

A = asset or unlevered beta
STEC, Inc.
D = book value of debt (4-30-2010)
BVE = book value of equity (4-30-2010)
MVE = market value of equity (4-30-2010)

9.6%
90.4%
1.36
1.28

$0
$276
$699

E = equity or levered beta

A = asset or unlevered beta

0.0%
100.0%
1.00
1.00

Average A for the industry

1.10

Step 2 - Calculation of cost of equity capital for Flash Memory,

Inc.:
Current weights of debt and equity
D = value of bank debt from 2009 balance sheet
E = value of equity at $25 per share

$10,132
$37,292

21.4%
78.6%

Since Flash is at the limit of its current loan agreement, management believes this is a
higher proportion of debt finance than optimal. As stated in the case, management has
set target capital structure weights equal to 18% debt and 82% equity.
Flash Memory, Inc.
D = target value of debt
18.0%
E = target value of equity
82.0%
A = average asset beta for the industry
E = equity or levered beta

1.10
1.25

Cost of equity capital for Flash

Ke = Rf + E x Market Risk Premium
Rf = risk-free rate of return
E = Flash's equity or levered beta
Assumed market risk premium
Ke = Flash's cost of equity capital

3.70%
1.25
6.00%
11.20%

Step 3 - Calculation of cost of capital for Flash Memory, Inc.:

K = Wd x Kd x (1 - T) + We x Ke
Wd = weight of debt in Flash's capital structure
Kd = Flash's cost of debt capital (a)
T = Flash's income tax rate
We = weight of equity in Flash's capital structure
Ke = Flash' cost of equity capital
K = Flash's cost of capital

18.00%
7.25%
40.00%
82.00%
11.20%
9.96%

(a) at 18% weight of debt Flash will be within the 70% of accounts receivable limit of
the existing loan agreement, thus the 7.25% cost of debt capital. If Flash was over
this limit and changed to factoring, the cost of debt capital would increase to 9.25%,
and the equity beta and cost of equity capital would also increase.

3. Net Present Value of Investment in New Product Line

($000s)

Investment in
equipment

Net working capital

required to support
sales
- % of sales
Investment in net
working capital (the
year-on-year
change)

Sales
Cost of goods sold
(includes
equipment
depreciation)
- % of sales
Research &
development
Selling, general &
administrative

2010
$2,200

2011

2012

2013

2014

2015

$5,648
26.15
%

$7,322

$7,322

$2,877

$1,308

26.15%

26.15%

26.15%

26.15%

$0
26.15
%

$5,648

-$1,674

$0

$4,446

$1,569

$1,308

$21,60
0

$28,00
0

$28,00
0

$11,00
0

$5,000

$17,06
4

$22,12
0

$22,12
0

$8,690

79.00%

79.00%

79.00%

79.00%

$3,950
79.00
%

$0

$0

$0

$0

$0

$1,806

$2,341

$2,341

$920

$418

Total

$0

- % of slaes
Launch promotion
Income before
income taxes
Income taxes @
40%
Net income
Depreciation of
equipment @ 20%
SLM
Cash flow from
operations

Total cash flow

$7,848

8.36%
$300

8.36%
$0

8.36%
$0

8.36%
$0

8.36%
$0

$2,430

$3,539

$3,539

$1,390

$632

$972

$1,416

$1,416

$556

$253

$1,458

$2,124

$2,124

$834

$379

$440

$440

$440

$440

$440

$1,898

$2,564

$2,564

$1,274

$819

$225

$2,564

$7,009

$2,843

$2,127

$2,200

NPV @ cost of capital

IRR
MIRR

$3,014
21.9%
17.3%

Cost of capital

9.96%

4. Change in Forecasted Financial Statements

Acceptance of Investment in New Product Line

due

to

5. Actual and Forecasted Financial Statements Assuming

Acceptance of Investment in New Product Line, No Sale of
New Common Stock, and All Borrowings at 9.25%

6. Actual and Forecasted Financial Statements Assuming

Acceptance of Investment in New Product Line, Sale of
300,000 Shares of Common Stock Receiving Net Proceeds of
$23 per share, and All Borrowings at 7.25%

Conclusion
The Chief Executive Officer of Flash Memory was considering the financing
opportunities regarding the companys current product line as well as all
other new investments that are being approved by the board. The CFO,
Browne, was worried about whether to take the project or not. He was also
worried about the ways to finance the new project. Uncertainties resulted
in clear foresight. Summary of case Analysis would help us to take
decision better.
Summary case Flash memory Inc.
No Investment in New Product Line; Sell No New Stock; Borrow at 9.25%
2010
2011
2012
Earnings per share
$2.28
$2.66
Interest coverage ratio (times)
7.1
6.0
Return on equity
14.7%
14.7%
Notes payable / accounts receivable
72.5%
71.5%
Notes payable / shareholders' equity
62.0%
62.5%
Total liabilities / shareholders' equity
90.8%
92.0%
Notes payable (000s)
$14,306
$16,914
Invest in the New Product Line; Borrowings @9.25%
2010
2011

$2.56
5.1
12.4%
56.3%
43.2%
69.0%
$13,325
2012

Earnings per share

$2.28
$3.55
$3.76
Interest coverage ratio (times)
7.1
6.8
5.4
Return on equity
14.7%
18.7%
16.5%
Notes payable / accounts receivable
83.7%
84.1%
66.2%
Notes payable / shareholders' equity
71.5%
80.7%
55.1%
Total liabilities / shareholders' equity
100.3%
113.1%
83.2%
Notes payable (000s)
$16,506
$22,897
$18,719
Invest in the New Product Line sale of 300000 shares; [email protected]%
2010
2011
2012
Earnings per share
Interest coverage ratio (times)
Return on equity
Notes payable / accounts receivable
Notes payable / shareholders' equity
Total liabilities / shareholders' equity
Notes payable (000s)

$1.96
9.1
11.7%
48.0%
31.5%
53.6%
$9,476

$3.24
15.1
16.2%
56.3%
42.7%
68.4%
$15,338

$3.47
10.4
14.8%
37.3%
25.0%
47.8%
$10,550

Taking the average of given values of Beta, I have arrived at an NPV of

$3014k. The NPV value is very sensitive to beta and our decision of
investing or not investing in the project would be incidental to this.

Currently the smallest Company in the exhibits (STEC Inc) has a beta of 1
which I feel is the true reflector of Flash business. At that level of Beta
investing in the project seems more profitable.
Now coming to all the assumptions, I have assumed that the level of
receivables to calculate the borrowing base is same as that in 2009
because the Company is using Debt/Equity to fund the project in 2010. In
addition, the level of interest would increase to 9.25% because of
additional debt borrowings of $1.2Mn. This debt borrowing is required to
fund the initial capital of $2.2Mn for equipment and $5.4Mn for working
capital. I have assumed the working capital required and one time ad
expense of $300,000 in 2010 and it will be funded using the Debt
borrowing/Equity issuance.
Based on the RFR of 3.7% and Market risk premium of 6% and Beta of 1.1,
I calculated the WACC to be about 9.96%.
The alternative of using businesss own cash flows is not possible because
the parent business itself is facing operational issues and a significant
working capital build up resulting in short term liquidity concerns.
The business can rather sell its receivables to the factoring agent and I
believe it would receive a consideration that is significantly below 90% of
receivables. In order to calculate the requirement of debt/equity after the
cash inflows from factoring, we need to have information regarding the
actual values that the factor would be willing to provide for Cos
receivables.
With all three alternatives I would go with Invest in the New Product Line sale of
300000 shares; [email protected]%

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