ASTRAL RECORDS LTD., NORTH AMERICA:

SOME FINANCIAL CONCERNS

On August 24, 1993, her first day as chief executive officer (CEO) of Astral Records Ltd., North America (Astral NA), Sarah Conner confronted a host of management problems at the company. One week earlier, Astral NA's president and CEO had been killed in a tragic accident. Soon thereafter, Conner was appointed to fill the position immediately. Several issues in her in-box that first day were financial in nature, either requiring a financial decision, or with outcomes that would have major financial implications for the firm. That evening, Conner asked to meet with her assistant, Louis Tang, to begin addressing the most prominent issues.

Astral Records and the Compact-Disk Manufacturing Industry

Astral Records North America had been founded as a joint venture between Astral Records Ltd., U.K., and an American venture-capital firm, Bendini, Lambert, and Locke (BLL). Astral NA's sole business mission was to manufacture compact disks mainly as a subcontractor to major recording companies. Astral NA was known for producing the highest-quality compact disks in the industry. Compact disks were first mass-produced in 1980. By 1993, the manufacturing technology was fairly mature. Accordingly, small manufacturers had proliferated in the industry, exploiting the low entry barriers: a new, small plant would cost between $8 million and $10 million. Easy entry had led to price competition in recent years among disk replicators. One analyst said, The gross margins on CDs have eroded tremendously over the past five years. I don't see that there's any more maneuvering left on the price.

Financial Questions Facing Sarah Conner

That evening, Conner met with Louis Tang, a promising new associate whom she had brought along from BLL. Conner's brief discussion with Tang went as follows:

Conner: Back at BLL we looked at Astral as one of our most promising venture-capital investments. Now it seems that such optimism may not be warranted-at least until we get a solid understanding of the firm's past performance and its forecasted performance. Did you have any success with this?

Tang: Yes, the bookkeeper gave me these: the historical-income statements (Exhibit 1) and balance sheets (Exhibit 2) for the last four years. The accounting system here is still pretty primitive. However, I checked a number of the accounts, and they look orderly. So I suspect that we can work with these figures. From those statements, I calculated a set of diagnostic ratios (Exhibit 3).

Conner: I see that you have been busy. Unfortunately, I can't study them right now. I need you to review the historical performance of Astral NA for me, and to give me any positive or negative insights that you think are significant.

Tang: When do you need this?

Conner: At 7:00 a.m. tomorrow. I want to call on our banker tomorrow morning to get an extension on Astral's loan.

Tang: The banker, Farmington, said that Astral was "growing beyond its financial capabilities." What does that mean?

Conner: It probably means that he doesn't think we can repay the loan within a reasonable period. I would like you to build a simple financial forecast of our performance for the next two years (ignore seasonal effects) and show me what our debt requirements
will be at the fiscal years-ended 1994 and 1995. I think it is reasonable to expect that Astral's sales will grow at 15% each year. Use whatever assumptions seem appropriate to you based on your historical analysis of the results. For this forecast, you should assume that any external funding is in the form of debt.

Tang: But what if the forecasts show that Astral cannot repay the loan?

Conner: Then we'll have to go back to Astral NA's owners, BLL and Astral Records U.K.,1 for an injection of equity. Of course, BLL would rather not invest more funds unless we can show that the returns on such an investment would be very attractive, and/or that the survival of the company depends upon it. Thus, my third request is for you to examine what returns on book assets and book equity Astral NA will offer in the next two years and to identify the key driver assumptions of those returns. Finally, let me have your recommendations about operating and financial changes I should make based on the historical analysis and the forecasts.

Tang: The plant manager revised his request for a new packaging machine and thinks that these are the right numbers (see the plant manager's memorandum in Exhibit 4). Essentially, the issue is whether to invest now or to wait three years to buy the new
packaging equipment. The new equipment can save significantly on labor costs, but carries a price tag of $1 million. My hunch is that our preference between investing now versus waiting three years will hinge on the discount rate.

Conner: [laughing] The joke in business school was that the discount rate was always 10%.

Tang: That's not what my business school taught me! BLL always uses a 40% discount rate to value equity investments in risky start-up companies. But Astral is reasonably well established now and shouldn't require such a high-risk premium. I managed to pull
together some data (Exhibit 5) on comparable companies with which to estimate the required rate of return on equity.

Conner: Fine. Please estimate Astral's weighted-average cost of capital (WACC) and assess the packaging-machine investment. I would like the results of your analysis tomorrow morning at 7:00 a.m.

Attachment:- Astral Records Ltd., North America Some Financial Concerns.pdf