After completing Case 2, students will:

1. Develop a financial forecast for a company, considering different growth scenarios

and investments, to determine if the company can meet its future financial needs.
2. Analyse the effects of investment decisions on a company’s financial health,
focusing on cost savings, efficiency, and return on investment.
3. Evaluate strategic financial recommendations on whether to invest in new
technology now or later, based on cost, depreciation, and long-term financial impact

2
On July 5, 2001, her first day as CEO of Star River Electronics Ltd., Adeline Koh con- fronted a host of
management problems. One week earlier, Star River’s president and CEO had suddenly resigned to accept
a CEO position with another firm. Koh had been appointed to fill the position—starting immediately.
Several items in her in-box that first day were financial in nature, either requiring a financial decision or
with outcomes that would have major financial implications for the firm. That evening, Koh asked to meet
with her assistant, Andy Chin, to begin addressing the most prominent issues.

Star River Electronics and the Optical-Disc- Manufacturing

Industry
Star River Electronics had been founded as a joint venture between Starlight Elec- tronics Ltd., United
Kingdom, and an Asian venture-capital firm, New Era Partners. Based in Singapore, Star River had a single
business mission: to manufacture CD- ROMs as a supplier to major software companies. In no time, Star
River gained fame in the industry for producing high-quality discs.

The popularity of optical and multimedia products created rapid growth for CD- ROM manufacturers in
the mid-1990s. Accordingly, small manufacturers proliferated, creating an oversupply that pushed prices
down by as much as 40%. Consolidation followed as less efficient producers began to feel the pinch.

Star River Electronics survived the shakeout, thanks to its sterling reputation. While other CD-ROM
manufacturers floundered, volume sales at the company had grown at a robust rate in the past two years.
Unit prices, however, had declined because of price competition and the growing popularity of substitute
storage devices, particu- larly digital video discs (DVDs). The latter had 14 times more storage capacity
and threatened to displace CD-ROMs. Although CD-ROM disc drives composed 93% of

This case is derived from materials originally prepared by Robert F. Bruner, Dean and Charles C. Abbott Professor of
Business Administration, Robert Conroy, Paul M. Hammaker Research Professor of Business Administration, and Kenneth
Eades, Professor of Business Administration. The firms and individuals in the case are fictitious. The financial support of the
Batten Institute is gratefully acknowledged. It was written as a basis for class discussion rather than to illustrate effective or
ineffective handling of an administrative situation. Copyright © 2001 by the University of Virginia Darden School
Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
[email protected]. No part of this publication may be reproduced, stored in a retrieval system, used in
a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or
otherwise—without the permission of the Darden School Foundation. Rev. 12/05.

365
 Case 2 Star River Electronics Ltd. 366

all optical-disc-drive shipments in 1999, a study predicted that this number would fall to 41% by 2005,
while the share of DVD drives would rise to 59%. 1 Star River had begun to experiment with DVD
manufacturing, but DVDs still accounted for less than 5% of its sales at fiscal year-end 2001. With
newly installed capacity, however, the company hoped to increase the proportion of revenue from
DVDs.

Financial Questions Facing Adeline Koh

That evening, Koh met with Andy Chin, a promising new associate whom she had brought along from
New Era Partners. Koh’s brief discussion with Chin went as follows:
KOH: Back at New Era, we looked at Star River as one of our most promising venture-capital
investments. Now it seems that such optimism may not be warranted—at least until we get a solid
understanding of the firm’s past perform- ance and its forecast performance. Did you have any
success on this?
CHIN: Yes, the bookkeeper gave me these: the historical income statements [Exhibit 1] and balance
sheets [Exhibit 2] for the last four years. The accounting system here is still pretty primitive.
However, I checked a number of the accounts, and they look orderly. So I suspect that we can work
with these figures. From these statements, I calculated a set of diagnostic ratios [Exhibit 3].
KOH: I see you have been busy. Unfortunately, I can’t study these right now. I need you to review the
historical performance of Star River for me, and to give me any positive or negative insights that you
think are significant.
CHIN: When do you need this?
KOH: At 7:00 a.m. tomorrow. I want to call on our banker tomorrow morning and get an extension on
Star River’s loan.
CHIN: The banker, Mr. Tan, said that Star River was “growing beyond its financial capabilities.” What does
that mean?
KOH: It probably means that he doesn’t think we can repay the loan within a reasonable period. I
would like you to build a simple financial forecast of our performance for the next two years (ignore
seasonal effects) and show me what our debt requirements will be at the fiscal years ending 2002 and
2003. I think it is reasonable to expect that Star River’s sales will grow at 15% each year. Also, you
should assume capital expenditures of SGD54.6 million2 for DVD manufacturing equipment, spread
out over the next two years and depreciated over seven years. Use whatever other assumptions seem
appropriate to you, based on your historical analysis of results. For this forecast, you should assume
that any external funding is in the form of debt.
CHIN: But what if the forecasts show that Star River cannot repay the loan?

1
Global Industry Analysts, Inc., “TEAC—Facts, Figures and Forecasts,” 5.
2
SGD = Singaporean dollars.
 Case 2 Star River Electronics Ltd. 367

KOH: Then we’ll have to go back to Star River’s owners, New Era Partners and Star River Electronics
United Kingdom, for an injection of equity. Of course, New Era Partners would rather not invest more
funds unless we can show that the returns on such an investment would be very attractive and/or that the
survival of the company depends on it. Thus, my third request is for you to examine what returns on book
assets and book equity Star River will offer in the next two years and to identify the “key-driver”
assumptions of those returns. Finally, let me have your recommendations about operating and financial
changes I should make based on the historical analysis and the forecasts.
CHIN: The plant manager revised his request for a new packaging machine and thinks these are the right
numbers [see the plant manager’s memorandum in Exhibit 4]. Essentially, the issue is whether to invest
now or wait three years to buy the new packaging equipment. The new equipment can save
significantly on labor costs but carries a price tag of SGD1.82 million. My hunch is that our preference
between investing now versus waiting three years will hinge on the discount rate.
KOH: [laughing] The joke in business school was that the discount rate was always 10%.
CHIN: That’s not what my business school taught me! New Era always uses a 40% discount rate to value
equity investments in risky start-up companies. But Star River is reasonably well established now and
shouldn’t require such a high-risk premium. I managed to pull together some data on other Singaporean
electronics companies with which to estimate the required rate of return on equity [see Exhibit 5].
KOH:Fine. Please estimate Star River’s weighted average cost of capital and assess the packaging-
machine investment. I would like the results of your analysis tomorrow morning at 7:00.
 Case 2 Star River Electronics Ltd. 368

EXHIBIT 1 | Historical Income Statements for Fiscal Year Ended June 30 (SGD 000)

1998 1999 2000 2001

Sales 71,924 80,115 92,613 106,042

Operating expenses:
Production costs and expenses 33,703 38,393 46,492 53,445
Admin. and selling expenses 16,733 17,787 21,301 24,177
Depreciation 8,076 9,028 10,392 11,360
Total operating expenses 58,512 65,208 78,185 88,983
Operating profit 13,412 14,908 14,429 17,059
Interest expense 5,464 6,010 7,938 7,818
Earnings before taxes 7,949 8,897 6,491 9,241
Income taxes* 2,221 2,322 1,601 2,093
Net earnings 5,728 6,576 4,889 7,148
Dividends to all common shares 2,000 2,000 2,000 2,000
Retentions of earnings 3,728 4,576 2,889 5,148

*The expected corporate tax rate was 24.5%.

 Case 2 Star River Electronics Ltd. 369

EXHIBIT 2 | Historical Balance Sheets for Fiscal Year Ended June 30 (SGD 000)

1998 1999 2000 2001

Assets:
Cash 4,816 5,670 6,090 5,795
Accounts receivable 22,148 25,364 28,078 35,486
Inventories 23,301 27,662 53,828 63,778
Total current assets 50,265 58,697 87,996 105,059
Gross property, plant & equipment 64,611 80,153 97,899 115,153
Accumulated depreciation (4,559) (13,587) (23,979) (35,339)
Net property, plant & equipment 60,052 66,566 73,920 79,814
Total assets 110,317 125,262 161,916 184,873
Liabilities and Stockholders’ Equity:
Short-term borrowings (bank)1 29,002 37,160 73,089 84,981
Accounts payable 12,315 12,806 11,890 13,370
Other accrued liabilities 24,608 26,330 25,081 21,318
Total current liabilities 65,926 76,296 110,060 119,669
2
Long-term debt 10,000 10,000 10,000 18,200
Shareholders’ equity 34,391 38,967 41,856 47,004
Total liabilities and stockholders’ equity 110,317 125,263 161,916 184,873
1
Short-term debt was borrowed from City Bank at an interest rate equal to Singaporean prime lending rates + 1.5%. Current prime
lending rates were 5.2%. The benchmark 10-year Singapore treasury bond currently yielded 3.6%.

2
Two components made up the company’s long term debt. One was a SGD10 million loan that had been issued privately in 1996 to New
Era Partners and to Star River Electronics Ltd., U.K. This debt was subordinate to any bank debt outstanding. The second component was
a SGD8.2 million from a 5-year bond issued on a private placement basis last July 1, 2000, at a price of SGD97 and a coupon of 5.75%
paid semiannually.
 Case 2 Star River Electronics Ltd. 370

EXHIBIT 3 | Ratio Analyses of Historical Financial Statements

1998 1999 2000 2001

Profitability
Operating margin (%) 18.6% 18.6% 15.6% 16.1%
Tax rate (%) 27.9% 26.1% 24.7% 22.6%
Return on sales (%) 8.0% 8.2% 5.3% 6.7%
Return on equity (%) 16.7% 16.9% 11.7% 15.2%
Return on assets (%) 5.2% 5.2% 3.0% 3.9%
Leverage
Debt/equity ratio 1.13 1.21 1.99 2.20
Debt/total capital (%) 0.53 0.55 0.67 0.69
EBIT/interest (x) 2.45 2.48 1.82 2.18
Asset Utilization
Sales/assets 65.2% 64.0% 57.2% 57.4%
Sales growth rate (%) 15.0% 11.4% 15.6% 14.5%
Assets growth rate (%) 8.0% 13.5% 29.3% 14.2%
Days in receivables 112.4 115.6 110.7 122.1
Payables to COGS 36.5% 33.4% 25.6% 25.0%
Inventories to COGS 69.1% 72.1% 115.8% 119.3%
Liquidity
Current ratio 0.76 0.77 0.80 0.88
Quick ratio 0.41 0.41 0.31 0.34
 Case 2 Star River Electronics Ltd. 371

EXHIBIT 4 | Lim’s Memo Regarding New Packaging Equipment

MEMORANDUM

TO: Adeline Koh, President and CEO, Star River Electronics

FROM: Esmond Lim, Plant Manager

DATE: June 30, 2001

SUBJECT: New Packaging Equipment

Although our CD packaging equipment is adequate at current production levels, it is terribly inefficient. The new
machinery on the market can give us significant labor savings as well as increased flexibility with respect to the
type of packaging used. I recommend that we go with the new technology. Should we decide to do so, the new
machine can be acquired immediately. The considerations relevant to the decision are included in this memo.

Our current packaging equipment was purchased five years ago as used equipment in a liquidation sale of a
small company. Although the equipment was inexpensive, it is slow, requires constant monitoring and is frequently
shut down for repairs. Since the packaging equipment is significantly slower than the production equipment, we
routinely have to use overtime labor to allow packaging to catch up with production. When the packager is down
for repairs, the problem is exacerbated and we may spend several two-shift days catching up with production. I
cannot say that we have missed any deadlines because of packaging problems, but it is a constant concern
around here and things would run a lot smoother with more reliable equipment. In 2002, we will pay about
SGD15,470 per year for maintenance costs. The operator is paid SGD63,700 per year for his regular time, but he
has been averaging SGD81,900 per year because of the overtime he has been working. The equipment is on the
tax and reporting books at SGD218,400 and will be fully depreciated in three years’ time (we are currently using
the straight-line depreciation method for both tax and reporting purposes and will continue to do so). Because of
changes in packaging technology, the equipment has no market value other than its worth as scrap metal. But its
scrap value is about equal to the cost of having it removed. In short, we believe the equipment has no salvage
value at all.

The new packager offers many advantages over the current equipment. It is faster, more reliable, more flexible
with respect to the types of packaging it can perform, and will provide enough capacity to cover all our packaging
needs in the foreseeable future. With suitable maintenance, we believe the packager will operate indefinitely.

Thus, for the purposes of our analysis, we can assume that this will be the last packaging equipment we will ever
have to purchase. Because of the anticipated growth at Star River, the current equipment will not be able to
handle our packaging needs by the end of 2004. Thus, if we do not buy new packaging equipment by this year’s
end, we will have to buy it after three years’ time anyway. Since the speed, capacity, and reliability of the new
equipment will eliminate the need for overtime labor, we feel strongly that we should buy now rather than wait
another three years.

The new equipment currently costs SGD1.82 million, which we would depreciate over 10 years at SGD182,000
per year. It comes with a lifetime factory maintenance contract that covers all routine maintenance and repairs at a
price of SGD3,640 for the initial year. The contract stipulates that the price after the first year will be increased by
the same percentage as the rate of increase of the price of new equipment. Thus if the manufacturer continues to
increase the price of new packaging equipment at 5% per annum as it has in the past, our maintenance costs will
rise by 5% also. We believe that this sort of regular maintenance should insure that the new equipment will keep
operating in the foreseeable future without the need for a major overhaul.

Star River’s labor and maintenance costs will continue to rise due to inflation at approximately 1.5% per year over
the long term. Because the manufacturer of the packaging equipment has been increasing its prices at about 5%
per year, we can expect to save SGD286,878 in the purchase price by buying now rather than waiting three years.
The marginal tax rate for this investment would be 24.5%.
 Case 2 Star River Electronics Ltd. 372
372

EXHIBIT 5 | Data on Comparable Companies and Capital-Market Conditions

% of
Sales from Book Market Number of 5-Year
CD-ROM Price/ Value Price Shares Last Earnings
and/or DVD Earnings Book per per Outstanding Annual Growth
Name Production Ratio Beta D/E Share Share (millions) Dividend Forecast

Sing Studios, Inc. 20% 9.0 1.07 0.23 1.24 1.37 9.3 1.82 4.0%
Wintronics, Inc. 95% NMF 1.56 1.70 1.46 6.39 177.2 0.15 15.7%
STOR-Max Corp. 90% 18.2 1.67 1.30 7.06 27.48 89.3 none 21.3%
Digital Media Corp. 30% 34.6 1.18 0.00 17.75 75.22 48.3 none 38.2%
Wymax, Inc. 60% NMF 1.52 0.40 6.95 22.19 371.2 1.57 11.3%

Note: NMF means not a meaningful figure. This arises when a company’s earnings or projected earnings are negative.

Singapore’s equity market risk premium could be assumed to be close to the global equity market premium of 6%, given Singapore’s high rate of integration into global
markets.

Descriptions of Companies

Sing Studios, Inc.

This company was founded 50 years ago. Its major business activities historically had been production of original-artist recordings, management
and production of rock-and-roll road tours, and personal management of artists. It entered the CD-production market in the 1980s, and only recently
branched out into the manufacture of CD-ROMs. Most of its business, however, related to the manufacture and sale of MIDI (Music Instrument
Digital Interface) CDs.

Wintronics, Inc.

This company was a spin-off from a large technology-holding corporation in 1981. Although the company was a leader in the production of CD-ROMs
and DVDs, it has recently suffered a decline in sales. Infighting among the principal owners has fed concerns about the firm’s prospects.

STOR-Max Corp.

This company, founded only two years ago, had emerged as a very aggressive competitor in the area of CD-ROM and DVD production. It was
Star River’s major competitor and its sales level was about the same.

Digital Media Corp.

This company had recently been an innovator in the production of DVDs. Although DVD manufacturing was not a majority of its business (film
production and digital animation were its main focus), the company was projected to be a major competitor within the next three years.

Wymax, Inc.

This company was an early pioneer in the CD-ROM and DVD industries. Recently, however, it had begun to invest in software programming and
had been moving away from disc production as its main focus of business.
 Case 2 Star River Electronics Ltd. 373

ANSWER ALL OF THE QUESTIONS

1. Assess the current financial health and recent financial performance of the company. What
strengths and/or weaknesses would you highlight to Adeline Koh?
2. Forecast the firm’s financial statements for 2002 and 2003. What will be the external
financing requirements of the firm in those years? Can the firm repay its loan within a
reasonable period?
3. What are the key driver assumptions of the firm’s future financial performance? What are
the managerial implications of those key drivers? That is, what aspects of the firm’s
activities should Koh focus on especially?
4. What is Star River’s weighted-average cost of capital (WACC)? What methods did you use
to estimate WACC? What are the key assumptions that especially influence WACC?
5. What are the free cash flows of the packaging machine investment? Should Koh approve
the investment?
6. What are the issues in this case? In what order should Andy Chin and Adeline Koh address
them?
7. Should Koh approve the packaging machine investment? How did you analyze this issue?
8. How well has Star River done in the past? How healthy is it now?
9. Can Star River repay the bank loan? How did you construct your financial forecast, and
what does it show?
10. What are the key drivers of Star River’s forecasted financial need?
11. What various priorities should Koh give to all these issues?
Case 2 Star River Electronics Ltd. 374