Flash memory was founded in late 1990s. The small firm specialized in designing and manufacturing solid state drives and memory modules. Given the facts that products had short life cycles, and technologies changed frequently in the market, the competition was intensive in the industry and product profit margin was low. In order to stay ahead of competition, Flash memory needed to highly invest in R&D to create cutting-edge products so that customer’s wants and needs could be met. Currently, Flash memory enjoy the good reputation of its products and continue to focus on R&D which allows the company to maintain its competitive advantage. An investment opportunity in a new product line that has the potential to be extremely profitable is presented to flash memory as well. Significant investments in R&D and the new product line requires increasing working capital. Therefore, flash memory has a strong need of financing as low profit margin doesn’t provide enough cash flows for the future growth and the company also reach the bank’s lending limit. Three alternatives for additional financing are available for consideration. This report analyzes the new project based on the estimated WACC to decide if Flash memory should accept or reject this project. Furthermore, the report prepares three years pro-forma for 2010, 2011, 2012 to show the impact on the income statement with and without the new project so that financing requirements based on each scenario can be determined. Additionally, this report lists the pros and cons of three financing alternatives: obtaining external financing through factoring group or a private sale of common stock; rely solely on Internal financing through reinvestment of Flash’s earnings. Finally, this report makes recommendations to the board of directors about the investment decision on the new product line associated with the source of financing. Q1: Forecast income statements and balance sheets for 2010, 2011 and 2012 In the forecast income statements, we use average balances of the current and prior year amounts of notes payable to calculate interest expense. Because the balance of notes payable of 2010 and 2011 are over 70% of the balance of accounts receivable, which illustrates that the company has to raise additional fund at Prim+6%, i.e. 9.25%. Assuming the company does not invest in the new product line, based on the assumptions in the case, we have projected the notes payable balance for 2010, 2011, and 2012 will be $14,430,000, $17,114,000, and $13,418,000 respectively.
Q2: Estimate the WACC, Calculate NPV of the project.
In our forecast financial statements, the average capital structure is:
We choose STEC, Inc. as comparable company because they have similar size and ROE but different capital structure. STEC, Inc. doesn’t have any debt, we assume the beta of the STEC, Inc. is unlevered beta or beta of assets. Therefore, by using the formula: And also assume the beta of debt is zero, the beta of Flash Memory equals 1.84 The cost of equity equals 14.74%.
WACC equals 10.51%.
We have calculated the WACC to be 10.51%. Based on this WACC, the NPV of the new project is estimated to be $3,322,000. Because this project has a positive NPV and provides growth opportunities for the company overall, we recommend to proceed it. Q3: The impact of the proposed investment project on forecast income statement and balance sheet
We consider different scenarios, specially, if the company decide to raise fund by equity financing, it doesn’t need to seek more bank borrowings so that it is able to stay at current interest rate level, 7.25%. Equity financing will enable the company gain more profits compared to debt financing. In specific, the net profits of 2010, 2011 and 2012 are $4,249,000, $5,387,000 and $5,459,000. In respect of notes payable, if the company raises the fund by debt financing, the notes payable they need for the three years are $21,173,000, $24,170,000...
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