What this shows is that the inventory that they are creating is becoming outdated before they are able to sell it. Another problem we found with their ratios is that they are having problems collecting on their receivables. What this will ultimately lead to is a cash inflow robber. With the lack of cash coming in and the increase in inventories, Star River will not be able to cover their current obligations, therefore find themselves in a very high default risk. Star River also has the highest debt ratios compared to their industry. This, also, shows that they are over leveraging themselves and creating excessive default risk.
On the upside of their financial ratios, they have been able to decrease their payable account, meaning they are paying more of their obligations at the current time. Another good note is that they are able to create a decent return n equity and have a coverage ratio of over 2. The second task that needed to be finished was to forecast the income statement and the balance sheet for the next two years. We grew sales ATA 15% rate, which is the stated rate from Koch. Also, in forecasting the balance sheet, we only showed debt financing for the capital expenditure of the DVD manufacturing equipment, which was the requested structure.
The forecasted balance sheet shows that there is a problem with current assets covering current liabilities. The way we showed the financing of the capital expenditure was to keep the current weights of short-term ironings and long-term borrowings consistent with 2001. If Star River continues with their current borrowing structure, they will not be able to cover all of their current obligations. The third request was to come up with reasonable forecasts of book value return on equity and return on assets.
The main drivers in these forecasts are the growth assumption in sales and the hurdle rate we calculated, as well as the cash flows to the firm. The last request we addressed was to determine if the cost of waiting 3 years in investing in the new packaging equipment outweighed purchasing now. To help compare these two scenarios, we had to determine an appropriate WAC. In calculating our WAC, we took a weighted cost of our short-term debt and long-term debt to determine the appropriate borrowing rate. To determine the appropriate cost of equity, we unleavened the industry's beta, which consisted of Wintriness and STORE- Max Corp.. And relived that beta with our debt structure. Once we determined the appropriate WAC, we looked at the price difference of the new equipment waiting three years and the costs associated with the old equipment; then we looked at the sots associated with purchasing the new equipment at the current time. We discounted the appropriate cash flows to the current time and compare the two outcomes. We suggest Star River should take on the expenditures required for the DVD equipment and the new packaging machine at the current time.
The DVD equipment will better position them in this up coming market. By purchasing the new packaging machine now instead of waiting three years, they will cut costs and add value to the firm. When financing these expenditures, we feel they should lean more heavily toward equity and the use of more long-term debt as opposed to short-term debt. This will help address their current liquidity and solvency problems. Also, they need to address their increasing inventories. The days in receivables has been substantially increasing throughout the past few years, which adds to holding costs.
If Star River implements these changes, we feel they will be in a good position in the CD-ROOM and DVD market in the future and will be able to maximize shareholder value. LIMITATIONS This case has several areas presenting the possibility of future error. First of all, we id go ahead and use the 15% growth assumption presented in the case. However, assuming a relatively large growth rate in sales in such a volatile industry as this could present inflated numbers and expectations. Also, it is hard to forecast how much growth in DVD's will actually occur.
Technology is a very volatile industry, and to make the assumption that we need to incur large expenditures on a relatively new product in the industry could put the company in a bad position if the DVD market does not flourish as much as is expected. Finally, we do not know if we will be able to borrow the additional debt requirements t the same rate we have previously borrowed at. In reality, we probably will not be able to do so. Also, we have to take into consideration the reaction of shareholders to possible dilution of shares by using equity to finance the new expenditures.
CRITIQUE Overall we feel group four did a fairly decent Job of covering the major issues in the case. We agree with them in their recommendations on these issues, but found some significantly different numbers in our calculations on several of them. In their calculation of the cost of debt, they assumed a rate of 7. 5% on a 20-year note with annual interest payments. We feel they should have provided Justifications for using this rate. We used a weighted average of the short and long term debt outstanding to come up with a rate of 6. 53%.
We do not think they should have ignored short-term debt, especially with it comprising such a large percentage of In calculating the cost of equity, we agree with their recommendation to use only Wintriness and STORE-Max as comparison companies to find the equity beta for Star River, as they most closely mirror it in the aspects of their current and future core operations, and in their debt structures. However, after enlivening to find the asset tea for the industry and relieving it into Star Rivers' structure, we found an equity beta of 1. 3. Group four found it to equal 2. 14, and we do not understand what is causing this discrepancy. Lastly, in one of their balance sheet predictions, their total assets did not equal liabilities plus shareholder's equity, which is obviously a problem. If they had properly reviewed their handouts before they submitted them, they would have noticed this problem. Again, we do think group four did a good Job of addressing the main problems this course presents, we Just think they should have spent more time verifying some of their calculations.