Flash Memory, Inc. faces stiff competition in an industry that maintains focus on new development and is challenged with ‘short product life cycles’ (Pg.2). Their future will be predicated on how they invest their cash flows and generate new business. This process will involve generating new financing and developing renovated product lines.
Flash Memory, Inc. specializes in the production of Solid State Drives (SSD) which makes up 80% of their revenue. The remaining 20% is comprised of high end/ high performance technology products that are distributed and purchased through the same avenues as their SSDs. Specific investments have been made by Flash to grow their SSD production due to an increase in market demand. In fact, sales revenue for SSDs has increased from 400Million to 5.3Billion over a 6-year period within the industry. Flash is well known for their production of this technology and as economic conditions have improved since early 2010 they have seen a large and rapid increase in sales.
Despite this rapid increase in sales, a need for financing is leaving Flash with some hard choices to make. The CFO Hathaway Browne wants analyze the financial options that are open to Flash and determine what the best option for the company is. This decision is made difficult since there are many large players in this market and a potential for others to expand their production is rising. With an unsteady pace of growth, another competitor entering the market could greatly diminish the already sporadic sales that Flash is currently experiencing. The company has three options when considering financing their prospective product line. They can issue common stock that would generate an increase of $6.9 million dollars. Obtain additional funding through their factoring group.
Or they can eliminate any new outside investments and use their current profits to finance the effort. We will break down the best options that Flash Memory, Inc. has in regards to financing and explain how we determined these solutions were the most advantageous. We have gained useful insight into the financial planning and investment requirements of this firm. Required financing for potential production is found within the Forecast Income Statement tab and Forecast Balance Sheet tab attached to this document. By using the Net Sales as a barometer of the health of the firm we can induce the necessity for financing. For instance, in 2011 the Cash that was generated through sales amounted to $4,752,000 dollars.
This amount of cash is over double the amount generated in 2008. While this is a clear sign that the business is growing and healthy, you can infer from this large increase in cash flow that a significant increase in demand has occurred within the market or a Flash Memory, Inc. choice to expand their production capabilities and or their product. While we know in this instance that the company is set to expand, these basic assumptions cab be made prior to applying any other information provided in the case study.
Once we dissected the information that was provided to us and forecasted the future projections, we applied two assumptions to the forecasting that we believe were beneficial options for Flash Memory. Those assumptions are that: 1. Investment would be made into the new product line and that there would be no issuance of new stock. This would be accompanied with a plan to borrow the funds at a rate of 9.25%. 2. Investment would be made into the new product line and an issuance of 300 thousand stocks would be issued. This would be accompanied with a plan to borrow the funds at a rate of 7.25%.
If you look at the charts located with our forecasting attachments you will see that in reference to our first assumption of an investment of 9.25% the net sales were increased by $44 million dollars. This increase resulted in an EPS of $3.98 versus the $2.56 that would have been experienced through continued production without any new production or investment. An increase of that size in EPS (when applied to the number of shares outstanding) would total $5,936,814.76 dollars. EPS is a direct representation of the amount of money made by the firm during the evaluation period. This EPS is a true representation of the amount of earnings because there was no amount borrowed by the company through this first assumption.
Return on Equity within 2012 was also observed to have increased to almost 7% above the industry average for consumer electronics equipment. The first assumption will require Flash Memory, Inc. to take on the highest amount of external debt in order to move forward with their prospective project. This increase in liabilities is shown through a significantly large amount of Current Liabilities when compared to our second option for financing. With more than a $7 million dollar increase in Current Liabilities, this amount of outstanding debt may make it difficult for them to finance productions in the future if their production line does not generate the revenue that they anticipate. A high Return on Equity would be the result of this more aggressive method of financing with 17.2% being the total for the first scenario in 2012 and 14.6% being the total for the second scenario in 2012. The EPS for our second scenario was not as high in the year 2012, but it does display a higher book value due to the 300,000 stocks issued during that time period with $23.46 Book Value Per Share.
As far as the Income Statement is concerned, this option does not seem the most advantageous toward the upmost goal of creating higher earnings and cash flows for investors. This second option of investing at 7.25% and issuing 300,000 stocks will not create the largest returns, but it will consistently generate higher revenue through the production line and maintain a safe distance from a higher Debt/Equity ratio. If the production line does not boost Sales the way that it is expected too, then this second scenario would allow for the company to recover more quickly without large outstanding external financing. We believe that the Flash memory should accept the investment opportunity based on the calculated NPV. As shown in the above calculations, the NPV from forecasted statements is $ 2,969. It is recommended to consider projects with positive NPV because the return from investing in the project would be higher than the cost of financing it. The larger the NPV, the more financial value the project will add to the Flash memory.
On the flip side, it is clear that a project will negative NPV will not add value to the company and hence, the project with negative NPV should be rejected. As noted in the forecasting statements for Flash drive, the company can expect a significant cash flow if it accepts the new project resulting in a positive significant net income. The new product will generate about $21.6 million in 2011 and $28 million in 2012 and 2013, followed by $11 million in 2014 and $5 million in 2015. This means that the new product will bring in higher sales in the beginning followed by a decline in the consecutive years because of the short product life cycles. However, the company believes that the new product is superior to existing memory products, therefore the profit margins over the life of cycle is expected to be 21%, which is another good reason to take up the project.
If this product is well received by the customers, it has a potential to add great value to the company in terms by generating additional cash flows, which in turn will create tremendous value to the existing shareholders and the company. As stated previously in this analysis, an aggressive level of outside financing will create much more external debt than if stock issuance were pursued more proactively. The inability to know how this product will actual sell leaves Flash Memory, Inc. with a higher level of uncertainty than we would prefer. While the higher level of external financing should generate a higher EPS for the company it will also create a very high Debt to Equity ratio, which will make it very important to reach their increase Sales goals in order to pay off their Current Liabilities.
As CFO Hathaway Browne, what financing alternative would you recommend to the board of directors to meet the financing needs you estimated in questions 2 through 4 above? What are the costs and benefit of each alternative?
After thorough analysis of the company’s current financial position and based on the projected future sales and potential growth opportunities, we highly recommend considering the option of issuing new common stocks. Given Flash drives source of funding, the company has the following alternatives to meet its financial obligation.
Rely solely on reinvestment of Flash’s earning to fund growth Obtain additional financing through their factoring group
A private sale of common stock
Based on the historical data, the company has not generated enough cash flow to support their operations and the current financial position of the company would limit them from taking up new projects. Hence, the option of reinvesting the earnings to fund growth is not applicable. So far, the company has used notes payable from a commercial bank; however it has reached the 70% limit set by the bank. This leaves the company with the other two options of borrowing additional funds from factoring group or a sale of common stock. There are some pros and cons for each of the options available. If the company goes with factoring group, the existing shareholders would retain the ownership of the company. The downside to this option far outweighs the benefits because the bank would increase the interest rate from 4% to 6% and the factoring group will monitor the accounts receivable closely and more aggressively.
Since the additional risk and higher costs are associated with the loan borrowed from factoring group, this option doesn’t seem to be a good fit for the company. The best option for financing would be to sell the common stock. By comparing the Flash memory’s number of shares outstanding with its competitors, it is evident that the equity financing is relatively low. This option seems to offer several advantages besides the other two options. By issuing common stock, the company and the existing shareholders would give up approximately 20% of its ownership, which is reasonable for a company that is facing continuous competition from companies holding larger market share within the industry. This option would easy the company by not having to worry about the interest rates and increase in debt.
What would investment in the new product line do to Flash’s required external financing? Which funding alternative, moving to the factoring group or issuing new equity, should CFO Hathaway Browne select to best meet the company’s needs?
a. Is there sufficient financing available in the existing bank loan agreement?
No, the existing bank loan agreement is insufficient to meet the financing requirements of the company. In order for the company to meet future demands and to run its operations, it will needs additional sources of funding. The options available for the company are either to borrow from the bank or to issue common stock. The latter seems to be a better option based on our analysis of the company.
b. Can the company take on more debt financing?
No, it is not recommended for the company to take on more debt financing as it would increase the company’s debt and interest rates.
c. How attractive is the proposal to move its bank financing arrangement to the factoring divisions?
It is not a good idea to consider factoring group to meet the financing requirements of flash memory. As mentioned earlier, the company has reached the maximum amount that can be borrowed based on its accounts receivable. Although, the factoring group has offered to provide additional loan to the company with some conditions such as continuous monitoring of Flash memory’s credit extension policy and accounts receivable, this alternative is not a good source of funding. Instead, the issue of new common stock would be an attractive alternative for meeting Flash drives financial obligations.
d. What is the impact of a private sale of new common stock?
A private sale of new common stock will dilute the ownership of existing shareholders. There is risk of drop in share prices when Flash Memory announces additional share issues. However, if the additional funds are invested efficiently to generate higher profits, share prices could rise, which benefits all shareholders. The impact would be on the company and existing shareholders because issuing of additional stock would result in a decrease in earnings per share, meaning the earnings will be divided by a greater number of shares.