Questions to Be Answered about the Flash Memory Case

Questions to Be Answered about the Flash Memory Case 1. Assuming the company does not invest in the new product line prepare forecasted income statements and balance sheets at year-end 2010 2011 and 2012. Based on these forecastes estimate Flash’s required external financing: in this case all required financing takes the form of additional notes payable from its commercial bank for the same period.2. What course of action do you recommend regarding the proposed investment in the new product line? Should the company accept or reject this investment opportunity?3. How does your recommendation from question 2 above impact your estimate of the company’s forecasted income statements and balance sheets and required external financing in 2010 2011 and 2012? How do these forecasted income statements and balance sheets differ if the company relies solely on additional notes payable from its commercial bank compared to a sale of new equity?4. As CFO Hathaway Browne what financing alternative would you recommend to the board of directors to meet the financing needs you estimated in questions 1 through 3 above? What are the costs and benefits of each alternative? ATTACHMENT PREVIEW.coursehero.com/load_question_attachment.php?q_att_id=770154&thread_id=25982121″> Download attachment.coursehero.com/load_question_attachment.php?q_att_id=770154&thread_id=25982121″>.amazonaws.com/coursehero/qattachments_b60a40a8a896f556aba5c21f7a4bdb7db1cde73d_th.jpg?AWSAccessKeyId=AKIAIAYW2E6VOLDTI35A&Expires=1436348380&Signature=HXymU6FsIafDx49l4GeYPgyJGBE=” alt=”4230-PDF-ENG.pdf”>4230-PDF-ENG.pdfFor exclusive use George Mason University 20154230AUGUST 20 2010WILLIAM E. FRUHANCRAIG STEPHENSONFlash Memory Inc.In May of 2010 Hathaway Browne the CFO of Flash Memory Inc. was preparing the companysinvesting and financing plans for the next three years. As a small firm operating in the computer andelectronic device memory market Flash competed in product markets that reflected fast growth continuous technological change short product life cycles changing customer wants and needs alarge number of competitors and a high level of rivalry within the industry. These factors combinedto produce low profit margins and a continual need for additional working capital which adverselyimpacted Flashs financial position and its ability to finance important investment opportunities.BackgroundFlash was founded in San Jose California by four electrical engineers during the high tech boomof the late 1990s. The common stock of the company was originally owned 100% by the founders and additional shares were subsequently sold to two engineers who joined the company as bothemployees and owners. In 2010 these six individuals held the top management positions comprisedthe board of directors and still owned the entire equity in the firm.The company had enjoyed considerable success since its creation. As computers and otherelectronic devices became increasingly complex and powerful the demand for high performancecomponents particularly memory increased rapidly. From its founding Flash had focused on solidstate drives (SSDs) which comprised the fastest growing segment in the overall memory industry.Industry data showed the SSD market grew from approximately $400 million in 2007 to $1.1 billion in2009 and was further projected to grow to $2.8 billion in 2011 and $5.3 billion in 2013. SSDs wereparticularly well suited for use in smart phones laptop computers and net books and sales of theseproducts were expected to drive this robust growth.Flash was just one of many companies in the industry. Giants like Intel and Samsung as well assmaller specialized firms like Micron Technology SanDisk Corporation and STEC Inc. all saw theindustrys potential and competed for market share. This resulted in intense competition betweenproduct offerings high rivalry and low profit margins as a percent of sales.________________________________________________________________________________________________________________HBS Professor William E. Fruhan Jr. and Babson College Professor Craig Stephenson prepared this case solely as a basis for class discussion andnot as an endorsement a source of primary data or an illustration of effective or ineffective management. This case though based on real events is fictionalized and any resemblance to actual persons or entities is coincidental. There are occasional references to actual companies in thenarration.Copyright © 2010 President and Fellows of Harvard College. To order copies or request permission to reproduce materials call 1-800-545-7685 write Harvard Business Publishing Boston MA 02163 or go to http://www.hbsp.harvard.edu. This publication may not be digitized photocopied or otherwise reproduced posted or transmitted without the permission of Harvard Business School.This document is authorized for use only in TECM 643 SU15 CY16 by Gallay David George Mason University from May 2015 to November 2015. For exclusive use George Mason University 20154230 | Flash Memory Inc.In the spring of 2010 Flash specialized in the design and manufacture of SSDs and memorymodules that were sold to original equipment manufacturers (OEMs) distributors and retailers andended up in computers computing systems and other electronic devices. Flashs memorycomponents which constituted 80% of company revenue utilized flash memory technologya nonvolatile memory that is faster uses less power is more resistant to failure when compared withtraditional hard disk drives and continues to store information even after an electronic device isturned off. The remaining 20% of Flashs sales came from other high performance electroniccomponents sold through the same channels for the same end products.Due to changes in technology Flashs memory and other products experienced short product lifecycles. The companys new products typically realized 70% of their maximum sales level in their firstyear and maximum sales were reached and maintained in the second and third years. Years fourand beyond saw rapidly decaying sales and by year six the products were obsolete. This normalsales life cycle for the companys products however could be significantly shortened bytechnologically superior new products released by competitors. In a few instances Flashs productsquickly became worthless forcing significant inventory write-downs and reductions in profit.Flash responded to the risk of technological changes in the industry by aggressive spending onresearch and development to improve its existing product lines and add new ones. The companyhad successfully recruited and retained a highly skilled group of research engineers and scientists and the activities of this group had been supported by substantial budgetary allocations. Thiscombination of ample funding of an exceptional staff had resulted in high quality products whichwere well-respected by customers and competitors alike. Top management believed the reputationof Flashs products was one of its key competitive advantages and they were determined to maintainthis reputation through continued research and development expenditures.The success of Flashs memory components had resulted in compounded average annual salesgrowth of 7.6% per year since 2007 (Exhibit 1) and its investment in current assets had grown evenfaster at a 12.2% compounded average annual rate over the same period (Exhibit 2). Flash had usednotes payable obtained from the companys commercial bank and secured by the pledge of accountsreceivable to fund this growth of working capital. Although these notes payable were technicallyshort-term loans in actuality they represented permanent financing as the company continuallyrelied on these loans to finance both existing operations and new investments. The bank was willingto lend up to 70% of the face value of receivables and this funding arrangement had been satisfactoryuntil recently when the companys bank note payable balances had reached this 70% limit. The bankloan officer had made it clear to Browne that Flash had reached the limit of the banks ability toextend credit under the terms of the current loan agreement.As general economic conditions improved in the first few months of 2010 Flashs sales increasedrapidly and the company continued to generate profits in approximately the same percentage ofsales as in 2009. Unfortunately this rapid sales growth had also required a large increase in workingcapital and internal cash flow had not been sufficient to fund this increase in receivables andinventories. The banks position on extending additional financing remained the same and whenapproached in May about extending additional credit to the company the loan officer had beenunwilling to do so.The loan officer did however discuss the factoring division of the bank with Browne whichserviced higher-risk customers with more aggressive accounts receivable financing. The factoringgroup would lend up to 90% of a companys existing accounts receivable balances but this groupwould also monitor Flashs credit extension policies and accounts receivable collection activities morerigorously than the commercial loan department that currently managed the companys loanagreement. Because of the additional risk and greater cost associated with closer monitoring of the2BRIEFCASES | HARVARD BUSINESS SCHOOLThis document is authorized for use only in TECM 643 SU15 CY16 by Gallay David George Mason University from May 2015 to November 2015. For exclusive use George Mason University 2015Flash Memory Inc. | 4230loan the interest rate charged by the bank would increase from prime 4% to prime plus 6% on thetotal outstanding loan balance to Flash based off the May 2010 prime rate of 3.25%. In its forecastingprocess Flash calculated interest expense as the beginning of year debt balance multiplied by theappropriate interest rate. Although this would not produce a precise number for forecasted notespayable and interest expense Browne preferred to start with a simpler calculation and this produceda reasonable first estimate.Growth ProjectionsBased on the overall economic recovery and recent reports of robust sales of smart phones and netbooks in early May the company was forecasting full-year 2010 sales of $120 million with acorresponding cost of goods sold number of $97.32 million. Flashs projected year-end 2010 currentasset investment necessary to support this level of sales and cost of goods sold was also prepared toassess the companys immediate financing needs.CashAccounts receivableInventoryPrepaid expensesTotal current assets$ 3 960 00019 726 00013 865 000480 000$38 031 000These forecasts of working capital requirements were based on sales in recent months projecteddemand from OEMs distributors and retailers during the remainder of the year and expectedrelationships between the income statement and these working capital accounts. Cash had beenestimated at 3.3% of sales accounts receivable were calculated based on an estimated 60 days salesoutstanding and the inventory forecast assumed the company would improve its inventoryturnover holding only 52 days of cost of goods sold in inventory.Beyond 2010 the marketing manager had estimated that sales of the companys existing productswould reach $144 million in 2011. It was expected that sales would be maintained at that level in2012 but after that sales would decline to $128 million in 2013 and $105 million in 2014. In spite ofthe expected growth in the overall industry Flashs product line would be less competitive absentnew products which were significant improvements over previous offerings.In addition to these income statement and working capital forecasts there were other importantitems which would impact the companys forecasts and financing requirements. Purchases typicallymade up 60% of cost of goods sold and the year-end 2009 accounts payable balance represented 33days of purchases. This wasnt much greater than the 30-day payment period that Flash tried tomaintain but in 2010 and beyond the company was committed to achieve and maintain this number.The second of these items was research and development which was planned to increase in 2010 todrive new product innovation. Research and development expenditures had been approximately 5%of sales in recent years and in 2010 and beyond management was committed to maintainingexpenditures at this percent of sales. Selling general and administrative expenses were driven bysales volume and were expected to maintain their 2009 relationship with sales. Capital expendituresnecessary to support existing product lines and sales growth were projected at $900 000 per year in2010 through 2012. The final item was yearly depreciation expense which was calculated as 7.5% ofthe beginning of year balance of property plant & equipment at cost. A summary of these importantforecast assumptions is included (Exhibit 3).HARVARD BUSINESS SCHOOL | BRIEFCASESThis document is authorized for use only in TECM 643 SU15 CY16 by Gallay David George Mason University from May 2015 to November 2015.3 For exclusive use George Mason University 20154230 | Flash Memory Inc.Investment OpportunityOne of Hathaway Brownes primary responsibilities as CFO was to finance both the growth ofFlashs existing product lines and all new investments that were approved by the board of directors.Investment proposals were prepared by the companys design manufacturing and marketingmanagers thoroughly analyzed by Browne and the finance group and then sent to the board fordiscussion evaluation and finally acceptance or rejection.Browne had recently been given a proposal for a major new product line which was expected tohave a significant impact on the companys sales profits and cash flows. This new product line hadbeen in development for the past nine months and $400 000 had already been spent taking theproduct from the concept stage to the point where working prototypes had been built and werecurrently being tested. Flashs design and marketing people were very excited about this newproduct line believing its combination of speed size density reliability and power consumption would make it a winner in the fastest growing segment of the memory industry.Customer acceptance and competitor reaction to the new product line was uncertain but theprojects sponsors were confident it would generate sales of at least $21.6 million in 2011 and $28million in 2012 and 2013 before falling off to $11 million in 2014 and $5 million in 2015. The productwas also believed to be superior to existing memory products and would therefore command grossmargins of 21% throughout its life.Implementing this new product line would also require large investments and expenditures bythe company. New plant and equipment costing $2.2 million must be purchased and this specificequipment would be depreciated straight-line to zero salvage value over its five-year life. Thisdepreciation expense all flowed to cost of goods sold expense and was already included in theestimate that cost of goods sold would be 79% of sales. Flash also expected net working capitalwould be 26.15% of sales. This initial investment in equipment and net working capital would occurin 2010 and in subsequent years the net working capital would increase and then decrease as sales ofthe new product line rose and then fell. SG&A expenses were expected to be the same percent ofsales as the company experienced in 2009 but in addition the marketing manager also planned a onetime $300 000 advertising and promotion campaign simultaneous with the launch of the product in2011.Financing AlternativesAlthough the loan officer of Flashs commercial bank had stated the company could obtainadditional financing through their factoring group a private sale of common stock was anotherfinancing alternative. Investment bankers had indicated to Browne that the company could issue upto 300 000 shares of new common stock to a large institutional investor at a price of $25.00 per share.After deducting the investment bankers fee and other expenses associated with negotiating andclosing this private transaction the company could expect to receive about $23.00 per share. Browneneeded to analyze this proposed equity offering in comparison to the publicly traded common stockof a select group of competitors (Exhibit 4) and in comparison to Flashs forecasted results with andwithout a new equity offering.4BRIEFCASES | HARVARD BUSINESS SCHOOLThis document is authorized for use only in TECM 643 SU15 CY16 by Gallay David George Mason University from May 2015 to November 2015. For exclusive use George Mason University 2015Flash Memory Inc. | 4230In early May of 2010 current yields to maturity on debt securities of different credit quality were:Issue91-day Treasury bills10-year Treasury bonds10-year Corporate bonds10-year Corporate bonds10-year Corporate bondsBond RatingAAABBBYield to Maturity0.17%3.70%4.40%4.72%6.24?O Browne also believed the spread between the yield to maturity on long-term U.S. Treasurybonds versus the expected return of the overall stock market was about 6% and he used this numberas the market risk premium when calculating Flashs cost of equity capital.One other alternative to the external financing options was to rely solely on the reinvestment ofFlashs earnings to fund growth. Since the companys profit margins were relatively low this wouldnot provide sufficient funding to support forecasted sales of $120 million in 2010 and subsequentincreases; Flash would be forced to slow its rate of growth. Browne thought the favorable outlook forgrowth and profitability made this alternative unattractive but he was uncertain about whichfinancing alternative to recommend to management and the board of directors. In addition theboard of directors had expressed concern that Flashs notes payable balances continually approachedthe existing loan agreements 70% of accounts receivable limit. They felt this indicated the use of debtfinance was greater than the companys target debt-to-capital ratio of 18% which the board ofdirectors believed was appropriate for Flash Memory Inc.HARVARD BUSINESS SCHOOL | BRIEFCASESThis document is authorized for use only in TECM 643 SU15 CY16 by Gallay David George Mason University from May 2015 to November 2015.5 For exclusive use George Mason University 20154230 | Flash Memory Inc.Exhibit 1Income Statements 20072009 ($000s except earnings per share)2007Net salesCost of goods soldGross marginResearch and developmentSelling general and administrativeOperating incomeInterest expenseOther income (expenses)Income before income taxestaxesaIncomeNet incomeEarnings per share20082009$77 131$62 519$14 612$80 953$68 382$12 571$89 250$72 424$16 826$3 726$6 594$4 292$4 133$7 536$902$4 416$7 458$4 952$480-$39$652-$27$735-$35$3 773$223$4 182$1 509$2 264$89$134$1 673$2 509$1.52$0.09$1.68a In years 2007 and after Flash’s effective combined federal and state income tax rate was 40%.6BRIEFCASES | HARVARD BUSINESS SCHOOLThis document is authorized for use only in TECM 643 SU15 CY16 by Gallay David George Mason University from May 2015 to November 2015. For exclusive use George Mason University 2015Flash Memory Inc. | 4230Exhibit 2Balance Sheets 20072009 ($000s except number of shares outstanding)2007$$$$$2 21812 86411 07232426 4782009CashAccounts receivableInventoriesPrepaid expensesTotal current assets$$$$$Property plant & equipment at costLess: Accumulated depreciationNet property plant & equipment$ 5 306$792$ 4 514$ 6 116$ 1 174$ 4 942$ 7 282$ 1 633$ 5 649$ 27 939$ 31 420$ 35 120Accounts payableNotes payable (a)Accrued expensesIncome taxes payable (b)Other current liabilitiesTotal current liabilities$ 3 084$ 6 620$563$151$478$ 10 896$ 4 268$ 8 873$591$9$502$ 14 243$ 3 929$ 10 132$652$167$554$ 15 434Common stock at par valuePaid in capital in excess of par valueRetained earningsTotal shareholders’ equity$15$ 7 980$ 9 048$ 17 043$15$ 7 980$ 9 182$ 17 177$15$ 7 980$ 11 691$ 19 686Total liabilities & shareholders’ equity$ 27 939$ 31 420$ 35 120Number of shares outstanding1 491 6621 491 6621 491 662Total assets2 53610 9889 59230923 425December 31 2008$$$$$2 93414 67111 50935729 471a Secured by accounts receivable.b To avoid a penalty for underpayment of income taxes Flash made equal estimated tax payments quarterly on the15th of April June September and December of each year. The total of these four quarterly payments wasrequired to equal at least the lesser of (a) 90% of the taxes that would actually be incurred in the same year or(b) 100% of the taxes due on income of the prior year.HARVARD BUSINESS SCHOOL | BRIEFCASESThis document is authorized for use only in TECM 643 SU15 CY16 by Gallay David George Mason University from May 2015 to November 2015.7 For exclusive use George Mason University 20154230 | Flash Memory Inc.Exhibit 3Key Forecasting Assumptions and Relationships for 2010 Through 2012Line ItemAssumption or RatioCost of goods soldResearch and developmentSelling general and administrativeInterest expenseOther income (expenses)81.10% of sales5.0% of sales8.36% of salesBeginning of year debt balance × interest rate$50 000 of expense each yearCashAccounts receivableInventoriesPrepaid expensesProperty plant & equipment at costAccumulated depreciation3.3% of sales60 days sales outstanding52 days of cost of good sold0.4% of salesBeginning PP&E at cost capital expendituresBeginning A/D 7.5% of beginning PP&E at costAccounts payablePurchasesAccrued expensesIncome taxes payableOther current liabilities30 days of purchases60% of cost of goods sold0.73% of sales10% of income taxes expense0.62% of sales8BRIEFCASES | HARVARD BUSINESS SCHOOLThis document is authorized for use only in TECM 643 SU15 CY16 by Gallay David George Mason University from May 2015 to November 2015. 34f%n/a3 351-8.829.60225.315.27-57.74″x%3 9860.8433.17227.722.643.70 ?!y%3 5671.8328.99227.417.1810.63%SanDisk Corporation34f(r?1.68n/a1.49213.2012.75 ?%1.3639.84229.318.1317.87%3.7130-Apr-10aa Security analyst estimates for year-end EPS $ and Return on Equity; actual data on April 30 2010 for all other items.Sales ($ millions)EPS ($)Dividend per share ($)Closing stock price ($)Shares outstanding (millions)Book Value per share ($)ROECapitalization (book value)DebtEquityBeta coefficient810.09n/a1.49211.520.78%Flash Memory Inc.20082009771.52n/a1.49211.4313.28 070 0 90.208.7449.83.725.40$v%5 688-0.427.25769.110.08-4.13 07Selected Financial Information for Flash Memory Inc. and Selected Competitors 2007 through 2009Sales ($ millions)EPS ($)Dividend per share ($)Closing stock price ($)Shares outstanding (millions)Book Value per share ($)ROECapitalization (book value)DebtEquityBeta coefficientExhibit 40 0″70.094.2650.03.632.36%0 0541.4716.3449.45.6526.06@`%4 803-2.2910.56800.75.81-39.43%STEC Inc.31i%5 841-2.102.64772.58.00-26.21%Micron Technology200820090 0%1.0013.9050.35.4818.90%1.2933g%1.259.35847.66.6121.00%1.4630-Apr-10a4230-9-For exclusive use George Mason University 2015This document is authorized for use only in TECM 643 SU15 CY16 by Gallay David George Mason University from May 2015 to November 2015.