Flash Memory Inc. Case

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- Forecasted Balance Sheet

Taking into account the key forecast assumptions for the years 2010 to 2012, we forecast a solid income statement (exhibit 2).

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Exhibit 2 – Forecasted Balance Sheet

The assumptions for accounts receivable and through experience-based figures for inventories, we find an upturn in total current assets of 54.9%, and an increase in total assets of 48.5%, which is primarily due to the expansion of sales rates estimated.

The surge of accounts payable causes higher total current liabilities yielding 34.6% higher liabilities in 2012, compared to 2009. All in all, we find higher shareholder equity and total liabilities of 12% after accounting for the adjusted rate of notes payable.

Since the contracting financial institution is only willing to lend additional capital to up to 70% of accounts payables’ face value, Flash Memory, Inc. shall maintain a level of notes payable that is below the 70% debt balance threshold at any time. We find, however, that this level of debt limit cannot be managed under the current conditions. This would force Flash Memory, Inc. to undertake additional expenses in order to borrow capital. Although we notice an improvement in 2012, we cannot say with confidence to which extent higher cost of borrowing will downwardly affect the company’s performance.

Consequently, Flash Memory, Inc.’s bank would not further lend money to the company in the underlying situation, but adapt to a more extensive and detailed monitoring by engaging the factoring division, thereby causing an increase of 2% of interest rates debited to Flash Memory, Inc. The bank would be forced to further elaborate the firm’s strategy and vision in order to understand and evaluate the business model at hand, which could be regarded non-sustainable due to the high level of debt capital included in the balance sheet.

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Task 2: Additional Investment Opportunities

Since, from a bank’s perspective, Flash Memory, Inc. is more likely to default in case of shifting economic conditions, an upward adjustment of interest rates would appear unneglectable. Therefore, the company should adversely investigate further investment opportunities in order to potentially decrease the cost of capital.

Therefore, Flash Memory, Inc. has developed a new product line to be launched in decent time. As we are interested to see the implications of an additional product line, we undertake a Net Present Value (NPV) analysis, which takes into account the Net Operating Profit after Taxes (NOPAT) in order to determine the Free Cash Flow, as well as the Weighted Average Cost of Capital (WACC). Accordingly, a new investment is generally considered once the overall NPV lies above zero.

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Exhibit 3 – WACC Calculation

As depicted in exhibit 3, the equity cost of capital is determined by taking into account a benchmark that is comprised of sector peers. We include the three main competitors in order to determine the beta factor, use the 10-year T-bill bond, which we believe is most suitable to the investment at hand due to the time to maturity. After accounting for the equity and debt ratios of the balance sheet, we find a WACC of 8.45%, which is significantly higher than the debt financing level of 4% or 6%, respectively, due to the calculation of the Capital Asset Pricing Model (CAPM), which is due to the compensation of risk that shareholders are requiring when holding equity (Fama & French, 2004). Following this, we determine the Total PV (Exhibit 4).

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Exhibit 4 – Investment Opportunity Assessment

First, we subtract the expenses from the operating profit in order to determine the NOPAT. We account for a 5-year depreciation of expenditures, underlying capital expenditures, as well as net working capital in order to generate the free cash flow (FCF). This cash flow indicates the amount of capital that Flash Memory, Inc. is able to either distribute to investors or reinvest. Since the overall NPV yields $3,741,000, it positively contributes to the company’s income statement.

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Task 3: Financing Investment Opportunities

Before launching and developing the new product line, the decision has to be made with regards to the source of financing underlying the expenditures. We therefore consider three different options.

- Debt Financing

We first analyze the implications of the product launch using debt only. Through the additional product we realize a boost in sales and a slight increase in the profit margin. More positively, we witness a surge in net income of 70.3% and corresponding improved Earnings per Share (EPS) of 4.01$ in 2012 compared to $2.36 in 2010 (exhibit 5).

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Exhibit 5 – Financing Strategy Without Equity Issuance, Income Statement

From a balance sheet perspective, we find that when financing the product line through debt, the company cannot withstand the threshold (exhibit 6). As mentioned above, the bank offering the debt financing would no longer offer the debt financing under prevailing conditions, hence, we disregard the option of debt only financing.

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Exhibit 6 – Balance Sheet Without Equity Issuance

- Issuance of Equity

Next, we calculate the financing of the new investment by taking account of the issuance of 300,000 shares of new common stock at a price of $25 each, whereas Flash Memory, Inc. can expect to receive $23 per share.

All conditions being equal to exhibit 5, we find a higher EBT margin and higher net income, which we attribute to the lower interest payments undertaken (exhibit 7). Since additional shares are outstanding, EPS are on a lower level compared to a debt financing solution and existing shareholders witness a dilution of shares.

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Exhibit 7 – Minimizing Debt-to-Capital Ratio, Income Statement

When adjusting for the balance sheet, we find, all conditions being equal, a significant decrease of the debt limit