Star River Case Study Solution
Key driver assumptions of the firm’s future financial performance
The key assumptions for the forecasting are made on the basis of the sales and compound annual growth rate of various components from 1998 to 2002,since the sales of the company have increased so did its cost of production, admin and selling expense. The production cost is assumed to be 50 percent of sales, because the packaging equipment is well over its useful age and is causing the line of production to be inefficient. Thus, the company is in need to purchase new machine, reduce its overtime wages, maintain its cost and improve its efficiency. Another key driver of the company’s future profitability is its short term debt. The company should use another form of financing, to support its long term assets. The current financial position of the company does not support the decision of acquiring more debt because of its inability in paying off the debt obligations. Also, the large amount of inventories would continue to increase in the future, due to which the company’s management should focus on reducing its inventories.
Star River’s weighted-average cost of capital (WACC)
The weighted average cost of capital is calculated with the use of the various assumptions. The cost of equity is calculated using the CAPM approach, in which the risk free rate of return is 3.6 percent of 10-year Singapore Treasury bond, whereas the market risk premium is assumed to be 6 percent and beta is assumed to be the average of beta of all the comparable firms. Similarly, the cost of debt is simply calculated by dividing the interest expense by the total amount of debt,including both short term borrowing and long term borrowing. Additionally, the equity portion in the capital structure is calculated by multiplying the shareholder’s equity of 2001 of SGD 47004 with the average of market, to book the value ratio of all the comparable firms. The market to book value ratio is calculated by book value of the market capitalization. Thus, the debt portion and equity portion are 40 percent and 60 percent, respectively. All these values are incorporated in the formula of WACC,which has resulted in 9.52 percent.(Gallo, 2015).
Free cash flows of the packaging machine investment
The free cash flows of the packaging machine investment are calculated by assuming two scenarios: one for the purchase of packaging machine now and second for waiting for three years. In the first scenario, the additional cost of maintenance would be SGD3640 for the initial year, which would increase at the rate of 5 percent. Similarly, the cost of labor would be SGD63700 in first year, then it would increase at the inflation rate of 1.5 percent. The price of the new equipment would be SGD1.8 million, which would be depreciated at SGD182000 for the period of 10 years. Thus, free cash flows are calculated by adding depreciation in the cost after tax and deducting the capital expenditure. The terminal value of the investment is –SGD123980 and the net present value is -SGD1928794, which means that the decision of buying the machine is not suitable for the company, and would generate healthy cash flows in the long run.
The free cash flows of the packaging machine investment are calculated by assuming that the company would wait for three years. The company would need to pay additional cost of maintenance, i.e. SGD15470 for the initial year, which would increase at the inflation rate of 1.5 percent. Similarly, the cost of labor would be SGD81900 in first year, then it would increase at the inflation rate of 1.5 percent. The equipment would be depreciated at SGD218400 for the period of 3 years. Thus, free cash flows are calculated by adding depreciation in the cost after tax and deducting the capital expenditure. The terminal value of the investment is -SGD8539053 and the net present value is -SGD3543006,which means that the company should buy the packaging machine now than waiting for three years,because it would save cost of labor and thecost of maintenance, and it would improve the packaging optionsthat the company is offering to its customers. Also, the net present value of buying the packaging equipment now is greater than the present value of buying the packaging equipment after three years,due to which the company should not wait for three years to buy the packaging equipment.(Gallo, A Refresher on Net Present Value, 2014)..................
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