Flash Memory, Inc

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 company’s 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 The fourth year and the proceeding years saw rapid decaying sales, and by the sixth year, the products were out of date.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 company’s products, however, could be significantly shortened by technologically superior new products released by competitors. Flash Memory Inc. had used notes payable obtained from the company’s 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 company’s 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 year’s 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 company’s 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 company’s 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 company’s 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 company’s 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) βE = equity or levered beta

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

25.8% 74.2% 1.25

βA = 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

βE = equity or levered beta βA = 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

βE = equity or levered beta βA = asset or unlevered beta

0.0% 100.0% 1.00 1.00

Average βA 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% βA = average asset beta for the industry βE = equity or levered beta

1.10 1.25

Cost of equity capital for Flash Ke = Rf + βE x Market Risk Premium Rf = risk-free rate of return βE = 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 company’s 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 business’s 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 Co’s receivables. With all three alternatives I would go with Invest in the New Product Line sale of 300000 shares; [email protected]%

------------------------------------------------------------------------------------------------------------------------