STATEMENT OF THE PROBLEM

Star River Electronics Ltd. is a large manufacturer and supplier of CD-ROMS. It was founded as a joint venture between
New Era Partners and Starlight Electronics Ltd. It has enjoyed a great deal of success in the past decade, due in large part to
their excellent reputation.
Star River does need to address several issues with the recent resignation of their former CEO. Digital Video Disks are
expected to cut into the CD-ROM market in the very near future, and with only 5% of their sales coming from this area, Star
River needs capital expenditures to increase their capacity in this sector. To finance this expenditure, they can use either
debt or equity. Also, a new packaging machine which would cut down on labor and overhead costs has been proposed, and
Star River needs to know whether to approve the purchase now, or wait three years, where new equipment would have to be
purchased to handle the projected growth rates. Finally, a weighted average cost of capital needs to be estimated for the
firm, which will help to answer this question of whether to wait or buy this equipment at the present time.
RELEVENT FACTS AND ASSUMPTIONS
DVDs have 14% more storage capacity than CD-ROMs
1999: CD-ROMs accounted for 93% of sales
oEstimated to decrease to 41%
2001: DVDs accounted for less than 5% of sales
oEstimated to increase to 59%
The new DVD manufacturing equipment will cost SGD54.6 million
oThe new equipment costs will be paid throughout the next two years.
oThe new equipment will be depreciated over seven years.
oAssume that funding for the new equipment will be through debt
Interest expense is weighted for short-term debt and long-term debt: 6.53%
The new packaging machine will cost SGD1.82 million.
oDepreciated over 10 years: SGD182,000 per year
oInitial year maintenance costs for machine's lifetime: SGD3,640
oPrice of new machine and maintenance costs increases by 5% per year
oSave SGD286,878 if new machine is purchased now
Current maintenance costs for old machine is SGD15,470
Assume tax rate remains the same at 24.5%
Assume that sales will increase at 15% per year
oOperating expenses and operating profit will increase by the same percentage
Assume that cash will increase at 15% per year
oAccounts receivable and inventories will also increase by the same percentage
Assume depreciation will be figured using double-declining balance method
Assume accounts payable and other accrued liabilities will increase by 15% per year
Cost of short-term debt: 5.2% + 1.5%
10-year Singapore treasury bond is the risk-free rate: 3.6%
Cost of long-term debt: 5.75%
Long-term inflation ~ 1.5%
Assume Singapore's equity market risk premium is approximately 6% (global equity market premium)
Wintronics, Inc. and STOR-Max Corp. were used in comparison for unlevering and relevering betas.
Assume new external funding is through debt
Used the hurdle rate of 8.11%, as opposed to 40% suggested by Koh
The weights of debt and equity remained the same
ANALYSIS
In our analysis, after looking at Star River's ratio analysis, we found that there is a significant inventory problem. It seems
that Star River's operations consist of taking out short-term debt to finance creating inventory. What this shows is that the
inventory that they are creating is becoming outdated before they are able to sell it. Another problem we found with their
ratios is that they are having problems collecting on their receivables. What this will ultimately lead to is a cash inflow
problem. With the lack of cash coming in and the increase in inventories, Star River will not be able to cover their current
obligations, therefore find themselves in a very high default risk. Star River also has the highest debt ratios compared to
their industry. This, also, shows that they are over leveraging themselves and creating excessive default risk. On the upside
of their financial ratios, they have been able to decrease their payables account, meaning they are paying more of their
obligations at the current time. Another good note is that they are able to create a decent return on equity and have a
coverage ratio of over 2.

The second task that needed to be finished was to forecast the income statement and the balance sheet for the next two
years. We grew sales at a 15% rate, which is the stated rate from Koh. Also, in forecasting the balance sheet, we only
showed debt financing for the capital expenditure of the DVD manufacturing equipment, which was the requested structure.
The forecasted balance sheet shows that there is a problem with current assets covering current liabilities. The way we
showed the financing of the capital expenditure was to keep the current weights of short-term borrowings and long-term
borrowings consistent with 2001. If Star River continues with their current borrowing structure, they will not be able to
cover all of their current obligations.
The third request was to come up with reasonable forecasts of book value return on equity and return on assets. The main
drivers in these forecasts are the growth assumption in sales and the hurdle rate we calculated, as well as the cash flows to
the firm.
The last request we addressed was to determine if the cost of waiting 3 years in investing in the new packaging equipment
outweighed purchasing now. To help compare these two scenarios, we had to determine an appropriate WACC. In
calculating our WACC, we took a weighted cost of our short-term debt and long-term debt to determine the appropriate
borrowing rate. To determine the appropriate cost of equity, we unlevered the industry's beta, which consisted of
Wintronics and STOR-Max Corp., and relevered that beta with our debt structure. Once we determined the appropriate
WACC, we looked at the price difference of the new equipment waiting three years and the costs associated with the old
equipment; then we looked at the costs associated with purchasing the new equipment at the current time. We discounted
the appropriate cash flows to the current time and compare the two outcomes.
RECOMMENDATIONS
We suggest Star River should take on the expenditures required for the DVD equipment and the new packaging machine at
the current time. The DVD equipment will better position them in this up coming market. By purchasing the new
packaging machine now instead of waiting three years, they will cut costs and add value to the firm.
When financing these expenditures, we feel they should lean more heavily toward equity and the use of more long-term
debt as opposed to short-term debt. This will help address their current liquidity and solvency problems. Also, they need to
address their increasing inventories. The days in receivables has been substantially increasing throughout the past few
years, which adds to holding costs. If Star River implements these changes, we feel they will be in a good position in the
CD-ROM and DVD market in the future and will be able to maximize shareholder value.
LIMITATIONS
This case has several areas presenting the possibility of future error. First of all, we did go ahead and use the 15% growth
assumption presented in the case. However, assuming a relatively large growth rate in sales in such a volatile industry as
this could present inflated numbers and expectations.
Also, it is hard to forecast how much growth in DVDs will actually occur. Technology is a very volatile industry, and to
make the assumption that we need to incur large expenditures on a relatively new product in the industry could put the
company in a bad position if the DVD market does not flourish as much as is expected.
Finally, we do not know if we will be able to borrow the additional debt requirements at the same rate we have previously
borrowed at. In reality, we probably will not be able to do so. Also, we have to take into consideration the reaction of
shareholders to possible dilution of shares by using equity to finance the new expenditures.
CRITIQUE
Overall we feel group four did a fairly decent job of covering the major issues in the case. We agree with them in their
recommendations on these issues, but found some significantly different numbers in our calculations on several of them.
In their calculation of the cost of debt, they assumed a rate of 7.5% on a 20-year note with annual interest payments. We
feel they should have provided justifications for using this rate. We used a weighted average of the short and long term debt
outstanding to come up with a rate of 6.53%. We do not think they should have ignored short-term debt, especially with it
comprising such a large percentage of their leverage structure.
In calculating the cost of equity, we agree with their recommendation to use only Wintronics and STOR-Max as comparison
companies to find the equity beta for Star River, as they most closely mirror it in the aspects of their current and future core
operations, and in their debt structures. However, after unlevering to find the asset beta for the industry and relevering it
into Star Rivers' structure, we found an equity beta of 1.93. Group four found it to equal 2.14, and we do not understand
what is causing this discrepancy.
Lastly, in one of their balance sheet predictions, their total assets did not equal liabilities plus shareholder's equity, which is
obviously a problem. If they had properly reviewed their handouts before they submitted them, they would have noticed
this problem.
Again, we do think group four did a good job of addressing the main problems this course presents, we just think they

should have spent more time verifying some of their calculations.