Flash Memory Case Study Final Exam Rohit Parnerkar

Flash Memory Case Study

Rohit Parnerkar
Flash Memory Case Study Final Exam Rohit Parnerkar

1. What is Flash Memory weighted average cost of capital? Make sure to clearly
show your calculation of the following as part of your answer?

A: Flash Memory Inc. is a privately held company where the 6 individual hold entire equity of
the firm. Flash competed in a low profit, fast growth, short product lifecycle business which
needs constant investment in Research & Development.

For Calculating Current WACC of the Firm (as of May 2010), I have Considered Following a
Debt to Capital Ratio of 34% i.e. 34% Debt 66% Equity. Please Refer to Exhibit1.

We are given that, the current Cost of Debt is 7.25%, which prime rate of 3.25% + 4% Risk
Premium applicable for 70% funding of accounts receivable. For calculating cost of equity we
need a Beta of comparable listed entity. I have considered Beta of Micron technology which
has a Capital Structure very similar with Flash Memory and competes same category. First we
need to unleveraged the beta to isolate beta of equity which we can further use to estimate
cost of equity.

First, Levered Beta of Micron Technology is 1.25, this represents the sensitivity of the
company at current capital structure towards the industry. I have isolated the beta of equity
which we can use in CAPM model to calculate cost of capital for Flash Memory.

Below is Formula for Leveraging are releveraging this Beat to arrive at Cost of Capital for
Flash Memory:

Using the Above, formula I could determine that Unlevered Beta is 0.965.

Further, I used this Beta to arrive at Cost of Equity using below Formula. Thus, I could
determine that Current Cost of Equity for Flash Memory was 8.75%.

Now we had D/E Ratio and Cost of Debt & Cost of Equity, I could easily calculated out
current WACC. Formula for Weighted Average Cost of Capital is as following:

∗ ∗ ∗ 1

D/E 34/66
Flash Memory
COD 7.25%
D/E+D 34%
COE 8.75%
E/E+D 66%
(1-T) 60%
WACC 7.26%

Thus, my WACC Comes to 7.26% with a Debt to Capital Ratio 34%.

Flash Memory Case Study Final Exam Rohit Parnerkar

2. Should Flash Memory accept or reject the proposed investment in the new
product line?

A: As Mentioned in the case study, the Flash Memory in an industry which needs constant
investment in Research & Development. With an investment of $2.2mn company would be
able to access an innovative product line and possibly have a first mover advantage. It is also
mentioned that the new product line has higher margins over sales (COGS is 79% vs 81.10%
of Sales).

Further, we understand that the Company has already reached its Notes Payable limit and
any further borrowing will attract stringent terms and higher, the management is of the view
that company must dilute the equity if need be but must bring the Ratio of Debt in its overall
capital structure to 18%. Thus for evaluating the Project the IRR must be greater than the
WACC. I have used a WACC of 10.03% with Capital Structure as 18:82 Debt to Equity.
Please See Exhibit 2. Based on my Calculations I am of the view that company must accept
project. The Project has an IRR of 21.9%. and has a Positive Net Present Value.
Please not and expenditure of $400,000 is treated as sunk cost and is not included as a part
of calculation.

3. Assuming the company does not invest in the new product line, how much
external funding would Flash Memory require between 2010 and 2012?

A: Please Refer to Exhibit3 Assuming That Flash Memory does not accept the new Product
line we can clearly seen that the Company maintain healthy growth forecast. Our Sales
Figures are based on estimates provided by marketing team. For further clarity I have
mentioned the source of each calculation in the comments column.
I have assumed that company continues to fund its Funding Requirements using Debt
Financing as long as it maintains the 70% of Accounts Receivable threshold.

2010 2011 2012

Notes payable (Additional Funding ) $13,310 $15,423 $11,435
Notes Payable/Accounts Receivable 67% 64% 48%

While calculating there are 2 assumption that I have mare,

1. Company Continuous to Debt Finance it Business as long as the ration of Notes
Payable to Account Receivable remains under 70%.
2. Number of Days is 360 in a year. This is done for Calculation continence and does not
change the outcome.
Flash Memory Case Study Final Exam Rohit Parnerkar

4. How would accepting the proposed investment in the new product line impact
the amount of external funding that Flash Cards would require between 2010
and 2012? Would you recommend that Flash cards use debt, equity, or a
combination of both debt and equity to raise the necessary funds for its
funding?

A: Please Refer Exhibit4. Assuming Flash Memory accepts the new Investment we see that in
very first year i.e. in 2010. The company needs to invest more than 7 million in the new
project which results in increase in Debt to Capital. The board is of the view that an ideal
Debt Equity ratio is around 22%. While we consistently see that this ratio is breached.
Howere based on the projections of the company we can see that the company forecasts
higher sales and better margins in the future.

According to me, company must continue using debt financing for its Working Capital
Requirements, further, the company has a substantial amount of Retained Earnings which it
can Use for Funding this Project. Flash Memory should avoid issuing additional Capital, as
dilution of equity would result in loss of management discretion.
 Exhibit 1

Market Data
Tax Rate 40% D/E 34/66
Debt to Equity Ratio 51.52% Flash Memory
Prime Rate 3.25% COD 7.25%
Risk Premium 4.00% D/E+D 34%
US Treasury 10years 3.70% COE 11.28%
Risk Premium (Rm-Rf) 6.00% E/E+D 66%
D/E Ratio 33/67 (1-T) 60%
Micron
Beta for Equity 1.25 WACC 8.92%
D/E Ratio 19/81
SanDisk
Beta for Equity 1.36
D/E Ratio 0/100
STEC
Beta for Equity 1

Beta when Debt Equity Ratio is '33/67 1.25 = 1 60% 33/67 * Beta
Micron 1.25 = 1.295522388 X
= 0.965

Flash = 1 60% 52% 0.965

= 1.309090909 0.96486
= 1.2631

= 3.70% 1.2631 X 6%
Cost of Equity For Flash
= 11.28%
 Exhibit 2 D/E 18/82
Flash Memory
COD 7.25%
D/E+D 18%
COE 11.28%
E/E+D 82%
Flash Memory, Inc. (1-T) 60%
Net Present Value of Investment in New Product Line ($,000) WACC 10.03%
2010 2011 2012 2013 2014 2015 Comments
Investment in equipment -$2,200

Net working capital required to support sales $5,648 $7,322 $0 $2,877 $1,308 $1,308 26.15% of Sales as Forcasted by Flash Memory Inc.
Investment in Net Working Capital -$5,648 -$1,674 $7,322 -$2,877 $1,569 $1,308 Addational Working Capital Needed Y-O-Y

Sales $21,600 $28,000 $0 $11,000 $5,000 Forcast by Project Sponser

COGS (includes equipment depreciation) $17,064 $22,120 $0 $8,690 $3,950 COGS extimated at 79% of Sales
R&D $0 $0 $0 $0 $0
SG&A $1,806 $2,341 $0 $920 $418 Exibit 3
Launch promotion $300 $0 $0 $0 $0 One time Promotion Expense in '11

Income before Taxes $2,430 $3,539 $0 $1,390 $632 EBITA

Taxes $972 $1,416 $0 $556 $253 Income Tax 40%

Net Income $1,458 $2,124 $0 $834 $379 EAT

Depreciation on Straight Line $440 $440 $440 $440 $440 Straight Line Depriciation in 5 Years - Given

Cash flow from operations $1,898 $2,564 $440 $1,274 $819

Total cash flow -$7,848 $225 $9,886 -$2,437 $2,843 $2,127
NPV @ WACC $1,950.23
IRR 20.1%
Flash Memory, Inc.
Assumptions:
All Borrowings at 7.25%
360 Days in a year
Exhibit 3
Income Statement ($000s except earnings per share)
Actual Forecast as per Exibit 3
2007 2008 2009 2010 2011 2012 Comments

Sales $77,131 $80,953 $89,250 $120,000 $144,000 $144,000 Estimates by Marketing Department
COGS $62,519 $68,382 $72,424 $97,320 $116,784 $116,784 COGS = 81.10% of sales as per Exibit 3
Gross margin $14,612 $12,571 $16,826 $22,680 $27,216 $27,216

R&D $3,726 $4,133 $4,416 $6,000 $7,200 $7,200 R&D = 5.0% of sales as per Exibit 3
SG&A $6,594 $7,536 $7,458 $10,032 $12,038 $12,038 SG&A = 8.36% of sales as per Exibit 3
Operating income $4,292 $902 $4,952 $6,648 $7,978 $7,978

Interest expense $480 $652 $735 $735 $965 $1,118 Interest expense = 7.25% of Previous Years Notes Payable
Other income (expenses) -$39 -$27 -$35 -$50 -$50 -$50 Other income (expenses) = $50k each year as per Exibit 3

Income before income taxes $3,773 $223 $4,182 $5,963 $7,063 $6,909 EBT

Income taxes $1,509 $89 $1,673 $2,385 $2,825 $2,764 Income taxes = 40% Exibit 1 Foot Note
Net income $2,264 $134 $2,509 $3,578 $4,238 $4,146 Net Income Part of retained Earnings

Earnings per share $1.52 $0.09 $1.68 $2.40 $2.84 $2.78

Balance Sheet ($000s except shares outstanding and book value per share) Exhibit 3

Actual Forecast
2007 2008 2009 2010 2011 2012 Comments

Cash $2,536 $2,218 $2,934 $3,960 $4,752 $4,752 Cash = 3.3% of sales as per Exibit 3
Accounts receivable $10,988 $12,864 $14,671 $20,000.00 $24,000.00 $24,000.00 Accounts receivable = 60 days sales outstanding as per Exibit 3
Inventories $9,592 $11,072 $11,509 $14,057.33 $16,868.80 $16,868.80 Inventories = 52 days of cost of good sold as per Exibit 3
Prepaid expenses $309 $324 $357 $480 $576 $576 Prepaid expenses = 0.4% of sales as per Exibit 3
Total current assets $23,425 $26,478 $29,471 $38,497 $46,197 $46,197

Property, plant & equipment at cost $5,306 $6,116 $7,282 $8,182 $9,082 $9,982 PP&E = Beginning PP&E at cost + CE as per Exibit 3
Less: Accumulated depreciation $792 $1,174 $1,633 $2,246.35 $2,927.50 $3,676.15 Accum.Depri. = Beginning A/D + 7.5% of PP&E at cost per Exibit 3
Net property, plant & equipment $4,514 $4,942 $5,649 $5,936 $6,155 $6,306

Total assets $27,939 $31,420 $35,120 $44,433 $52,351 $52,503

Accounts payable $3,084 $4,268 $3,929 $6,000 $7,200 $7,200 Accounts payable = 30 days of purchases which are 60% of sales
Notes payable $6,620 $8,873 $10,132 $13,310 $15,423 $11,435 Funding Required (Balancing Number)
NotesPayable/Accounts Recivable 60% 69% 69% 67% 64% 48%
Accrued expenses $563 $591 $652 $876 $1,051 $1,051 Accrued expenses = 0.73% of sales as per Exibit 3
Income taxes payable $151 $9 $167 $239 $283 $276 IT payable = 10% of IT expense as per Exibit 3
Other current liabilities $478 $502 $554 $744 $893 $893 Other current liabilities = 0.62% of sales as per Exibit 3
Total current liabilities $10,897 $14,244 $15,435 $21,170 $24,850 $20,856

Common stock at $0.01 per share par value $15 $15 $15 $15 $15 $15
Paid in capital in excess of par value $7,980 $7,980 $7,980 $7,980 $7,980 $7,980
Retained earnings $9,048 $9,182 $11,691 $15,269 $19,507 $23,652 Previous Balance + Net Income for Current year
Total shareholders' equity $17,043 $17,177 $19,686 $23,264 $27,502 $31,647

Total liabilities & shareholders' equity $27,940 $31,421 $35,121 $44,433 $52,351 $52,503
Number of shares outstanding 1,491,662 1,491,662 1,491,662 1,491,662 1,491,662 1,491,662 No Addational Share issue required
Book value per share $11.43 $11.52 $13.20 $15.60 $18.44 $21.22
Return on equity 13.28% 0.78% 12.75% 15.38% 15.41% 13.10%
Interest coverage ratio (times) 8.9 1.4 6.7 9.1 8.3 7.1
Notes payable / accounts receivable 60.2% 69.0% 69.1% 66.6% 64.3% 47.6%
Notes payable / shareholders' equity 38.8% 51.7% 51.5% 57.2% 56.1% 36.1%
Total liabilities / shareholders' equity 63.9% 82.9% 78.4% 91.0% 90.4% 65.9%
Flash Memory, Inc.
Assumptions:
Company Accepts New Project
360 Days in a year Exhibit 4.1

Forecasted of B/S & Income Satements

Income Statement ($000s except earnings per share)
Actual Forecast as per Exibit 3
2007 2008 2009 2010 2011 2012 Comments

Sales $77,131 $80,953 $89,250 $120,000 $165,600 $172,000 Sales Estimate + Sales of New Business Line
COGS $62,519 $68,382 $72,424 $97,320 $133,848 $138,904 COGS includes COGS for new business
Gross margin $14,612 $12,571 $16,826 $22,680 $31,752 $33,096

R&D $3,726 $4,133 $4,416 $6,000 $7,200 $7,200 R&D = 5.0% of sales as per Exibit 3
SG&A $6,594 $7,536 $7,458 $10,032 $13,844 $14,379 SG&A incudes forNew Busniess
Operating Income $4,292 $902 $4,952 $6,648 $10,708 $11,517

Interest expense $480 $652 $735 $937 $1,236 $1,383

Other income (expenses) -$39 -$27 -$35 -$50 -$350 -$50 includes one time promotion Exp & One Time Commission

Income before income taxes $3,773 $223 $4,182 $5,761 $9,821 $10,184 EBT

Income taxes $1,509 $89 $1,673 $2,304 $3,929 $4,074 Income taxes = 40% Exibit 1 Foot Note
Net income $2,264 $134 $2,509 $3,456 $5,893 $6,110 Net Income Part of retained Earnings

Earnings per share $1.52 $0.09 $1.68 $2.32 $3.95 $4.10

Exhibit 4.2

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

Actual Forecast
2007 2008 2009 2010 2011 2012 Comments

Cash $2,536 $2,218 $2,934 $3,960 $5,465 $5,676 Cash = 3.3% of sales as per Exibit 3
Accounts receivable $10,988 $12,864 $14,671 $20,000.00 $27,600.00 $28,666.67 Accounts receivable = 60 days sales outstanding as per Exibit 3
Inventories $9,592 $11,072 $11,509 $14,057.33 $19,333.60 $20,063.91 Inventories = 52 days of cost of good sold as per Exibit 3
Prepaid expenses $309 $324 $357 $480 $662 $688 Prepaid expenses = 0.4% of sales as per Exibit 3
Total current assets $23,425 $26,478 $29,471 $38,497 $53,061 $55,095

Property, plant & equipment at cost $5,306 $6,116 $7,282 $5,982 $6,882 $7,782 Includes new plant
Less: Accumulated depreciation $792 $1,174 $1,633 $2,081.35 $2,597.50 $3,181.15 Accum.Depri. = Beginning A/D + 7.5% of PP&E at cost per Exibit 3
Net property, plant & equipment $4,514 $4,942 $5,649 $3,901 $4,285 $4,601

Total assets $27,939 $31,420 $35,120 $42,398 $57,345 $59,695

Accounts payable $3,084 $4,268 $3,929 $6,000 $8,280 $8,600 Accounts payable = 30 days of purchases as per Exibit 3
Notes payable $6,620 $8,873 $10,132 $17,053 $19,075 $5,898 *Balancing Number*
NotesPayable/Accounts Recivable 60% 69% 69% 85% 69% 21%
Accrued expenses $563 $591 $652 $876 $1,209 $1,256 Accrued expenses = 0.73% of sales as per Exibit 3
Income taxes payable $151 $9 $167 $230 $393 $407 IT payable = 10% of IT expense as per Exibit 3
Other current liabilities $478 $502 $554 -$4,904 -$647 $8,388 includes Addational WC Requirement
Total current liabilities $10,897 $14,244 $15,435 $19,256 $28,311 $24,550

Common stock at $0.01 per share par value $15 $15 $15 $15 $15 $15
Paid in capital in excess of par value $7,980 $7,980 $7,980 $7,980 $7,980 $7,980 No Addational Share issue required
Retained earnings $9,048 $9,182 $11,691 $15,147 $21,040 $27,151 Previous Balance + Net Income for Current year
Total shareholders' equity $17,043 $17,177 $19,686 $23,142 $29,035 $35,146

Total liabilities & shareholders' equity $27,940 $31,421 $35,121 $42,398 $57,345 $59,696

Number of shares outstanding 1,491,662 1,491,662 1,491,662 1,491,662 1,491,662 1,491,662 No Addational Share issue required

Book value per share $11.43 $11.52 $13.20 $15.51 $19.47 $23.56

Return on equity 13.28% 0.78% 12.75% 14.94% 20.30% 17.39%

Interest coverage ratio (times) 8.9 1.4 6.7 7.1 8.7 8.3
Notes payable / accounts receivable 60.2% 69.0% 69.1% 85.3% 69.1% 20.6%
Notes payable / shareholders' equity 38.8% 51.7% 51.5% 73.7% 65.7% 16.8%
Total liabilities / shareholders' equity 63.9% 82.9% 78.4% 83.2% 97.5% 69.9%