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This case is about Star River and how the firm is in the middle of financial crisis that was induced by rapid growth. The CEO basically wants to improve the financial health of the company and ask for help to make some decisions. The CEO asks one of the analyst for help in reviewing the historical performance of the firm, forecast financing requirements for the next two years, exercise the forecasting model to identify the key drivers of the assumptions, estimate Star River’s weighted-average cost of capital and lastly to analyze the proposed investment in a packaging machine.
The two main issues in this case are the project analysis and financial forecasting. The project should be analyzed before doing the forecasting, because any recommendations on the project will affect financial forecasting for the next two years.
First of all an analysis of the packaging machine investment’s hurdle rate is required. I will use comparable firm parameters approach to figure out the hurdle rate (WACC) of the firm using the information provided in Exhibit 5. The cost of debt should be calculated using the bond information given in footnote 2 of case under Exhibit 2. The cost of equity should be calculated using the Capital Asset Pricing Model.
After calculating WACC my second analysis would be of the packaging machine investment. I will use incremental analysis and calculate NPV of the incremental cash flows of both strategies (to wait or to invest now). After calculating NPV’s of both scenarios I will calculate the difference between the two.
In order to review the historical health of the firm I will calculate different ratios and gross margins and would try to see the trend. I will use Gordon Growth Model to find out the sustainable growth rate for the firm using historical data and then would compare it with its actual growth rate.
Finally, I will do a financial forecast in order to figure out firms’ ability to repay its loans. I will use simple percentages-of-sales forecasting technique. I will use existing trends in my forecast to show the implications of current policies before making my own recommendations. During my forecast I will use New Era Partners loan to find out the interest rates. I will make the short-term debt as my plug.
In order to find out what are some of the key drivers’ of the analysis I will further run different sensitivity analysis. I think some of the key drivers of our assumptions could be sales growth, production costs as a percentage of sales, inventories as a percentage of cost of goods sold etc.
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Merits & Demerits of Proposed Analysis:
Calculating the NPV of the packaging machine investment first would save a lot of time and work, as it will have a direct impact on the financial forecasting of next two years. Using company comparable technique would help us estimate the WACC accurately. Finding out the key driver assumptions in our forecast would enable us to pin point factors that directly affects the profitability of the firm in the future.
The only demerit in this analysis would be that there is no quick fix to the firm’s inability to repay its short-term debt in the next two years. It appears to me that the firm has a much bigger problem to worry about and I think the firm will need more debt after two years then now. The firm should seek a source of long-term capital which this analysis fail to provide. Long-term capital would help pay the short-term debt and would also enable the firm to run in the future. Basically the firm is using its long-term assets to finance its short-term debt. Another thing that this analysis fails to record is the impact of different economic conditions in the future on the profitability of the firm.