CONCH

CORPORATE FINANCE

FIRST ASSIGNMENT

To: Board of Directors Conch Republic

From: Jay McCanless

1.0 Executive summary

Our Personal digital assistant (PDA) is one of the major revenue producing items. The sale of

our current PDA model in the market is excellent due to its variety tropical colors. However

as with any electronic item, technology changes rapidly and our current PDA has limited

features in comparisons with the competitors.

Conch Republic electronics (CRE) is considering the development of a more sophisticated

PDA with additional features including cell phone capability and being able to run different

forms of productivity software designed for business. CRE see the future potential growth in

this new PDSA or smartphone. According to Haskin, David demand for smartphones is

growing and is taking over the market share of traditional PDA.

The capital requirement to develop this new smartphone is going to be quite significant and

CRE has accepted the fact that financing of the new project would have to be made from

existing cash resources and outside finance.

Assumptions Made

• CRE’s reserves would only be able to provide 60% of the capital required

• Present manufacturing capacity will not be able to support the new manufacturing line.

• CRE have identified suitable outsourcing manufacturers

• CRE will consider adopting Google’s operating system (OS) Android.

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2.0 Introduction

The Personal digital assistant (PDA) is currently one of CRE’s major revenue producing

items. With the rapid changes of technology, our current PDA has limited features in

comparison with our competitors’. Our PDA is at the maturity stage of the Product Life

cycle and soon will be at the decline stage. In order to remain relevant and increased market

share, the management is planning to develop a more sophisticated PDSA or smartphone.

The new smartphone will have all the features of the existing PDA while incorporating newer

features such as cell phone capability and the ability to run different forms of productivity

software desired by business and other users. CRE could increase sales by targeting different

market segments such as businessmen and college students who will find the productivity

software attractiveness.

The capital requirement to develop this new PDA or smartphone is will be significant.

Management has accepted the fact that the financing of this new project would have to be

made from existing cash resources and outside finance. The management also needs to

consider the most appropriate business model to apply. Could the manufacturing be out

sourced to an electronic manufacturer with the expertise in this area or to use our existing

manufacturing capability to do so?

The key issues facing management for this project can be summarized as the following:-

The Corporate financing risks involved

The rate of return expected for the project

The rate of return expected by outside investors

The decision making complexities for a project of this nature.

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3.0 Components In A Smartphone

“We're in love with all of the things our phones can do. But what are the basic components

and technologies that help it work its magic? What's under the hood, as it were, of the typical

smartphone?” (How Stuff Works)

I. Phone Display, touch screen durable glass variety

II. Processor

III. Built in memory and slots for memory cards

IV. Microchips to run the various applications such as image sensor for camera

V. Operating System (OS) such as Windows Mobile, Android etc.

The present components used in our current PDA need to be upgraded in order to produce the

smartphones. CRE will need to use faster processor in order to run the various business

applications and have larger built in memory for storage space. Likewise, CRE would also

need to develop new OS or consider licensing rights to use Microsoft‘s Windows or Goggle’s

Android OS.

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4.0 Business Models Consideration

4.1 Option 1: Using Existing Manufacturing Capability

CRE could consider using the existing manufacturing capability to manufacture the new

smartphone. When manufacturing organizations are making key decisions regarding

manufacturing facilities the important aspect that comes to mind is capacity. Capacity has

technological, structural, economic and strategic connotations. To a certain extent

manufacturing capacity also decides the nature and purpose of a business unit.

CRE will need capital investments to increase capacity and also to invest in technology to

leap from PDA maker to a smart phone manufacturer. Software engineers and relevant

manpower need to be hired to get the job done. CRE also need to evaluate whether the

present premise is suitable to accommodate the extra job functions.

4.2 Option 2: Outsourcing The Manufacturing of the Smartphone

CRE could also outsource the manufacturing of the smartphone. Outsourcing is contracting

with another company or person to do a particular job or function for you. It is not unusual

for companies to outsource regularly. Outsourcing can help companies be more efficient and

cost effective. Apple is also outsourcing the manufacturing of its IPhone. CRE would only

need to pay the outsourced manufacturer the agreed price for the smartphone. It only involves

variable cost. CRW do not need to worry fixed costs such as overheads, workers’ salaries and

benefits and etc.

The above are two business models which CRE is considering and the Board would need to

select.

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V.0Key Issues

5.1 The Corporate Financing Risks Involved

Managing risk is an important part of operating a business. Corporate financial risk is

any situation or scenario that may impede a company's ability to achieve its financial

goals. In Option1, CRE would need to invest on a new plant to start the new production

line. New machineries need to be purchased and would also require a large amount of

capital. CRE would also need to increase the manpower for the new production line.

In order to finance Option 1, CRE could look into its own existing resources and also

retained earnings. Both of this would be able to provide about 60% of the required

capital. The remaining 40% would need to be sourced through equity or debt. CRE could

have a rights issue which provides a way of raising new share capital by means of an

offer to existing shareholders, inviting them to subscribe cash for new shares in

proportion to their existing holdings.

CRE could use retained earnings to fund the investment. The use of retained earnings as

opposed to new shares or debentures avoids issue costs. CRE is aware that the company

must restrict its self-financing through retained profits because shareholders should be

paid a reasonable dividend, in line with realistic expectations. Drop in future dividend

earnings will cause unhappiness for the shareholders.

Another alternative is for CRE to get financing from a bank. By taking the bank loan,

CRE will be exposed to interest rate movement risk. Interest rate can fluctuate and the

variations could be significant due to present economic climate. It might seem attractive

to keep bringing on debt when the company needs money, a practice knowing as

“levering up,” but each loan will be noted on the credit rating.

CRE would also need to ensure that operating profit is adequate to service bank interest.

If not, the loan may default and becomes none performing loan (NPL).

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For option 2, it is straight forward as CRE would only pay for the number of units

manufactured by the outsourced manufacturer as per contract agreement. Total cost of

production per unit may be higher but there is no extra cost involved.

5.2 The Rate of Return Expected For The Project

To manufacture a new PDSA or smartphone would involve a high investment cost. To

incorporate new features into the smartphone such as cell phone capability, camera and

ability to run different forms of productivity software will need high investment on

research and development to develop new operation system (OS). There is a need to be

innovative as the smartphone technology changes fast.

Technology is racing forward at such a fast pace that consumers are having trouble

keeping up. According to HTC, in 2007, the average shelf life for smartphones was

around three years. Now, the average shelf life for smartphones is about six to nine

months. Goldman assures that "the market cycle at some point will stop shortening

because customers can't absorb new products so fast, but it definitely will not go back to

the way it was (Ferreira, Annie)."

For an investment to be worthwhile, the expected return on capital must be greater than

the cost of capital. The cost of capital is the rate of return that capital could be expected

to earn in an alternative investment of equivalent risk. If a project is of similar risk to a

company's average business activities it is reasonable to use the company's average cost

of capital as a basis for the evaluation. A company's securities typically include both debt

and equity; one must therefore calculate both the cost of debt and the cost of equity to

determine a company's cost of capital. However, a rate of return larger than the cost of

capital is usually required.

Cost of equity = Risk free rate of return + Premium expected for risk

Shareholders will demand higher return for high risked investment, which is the premium for the expected risk.

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5.3 The Rate of Return Expected By Outside Investors

There are several different sources of outside investors. Individuals, business contacts, business angels investment funds and venture capitalists for larger investments. Outside investment can suit promising businesses that do not expect to produce a lot of spare cash in the short term but offer the potential of greater returns over the longer term.

Capital used for funding a business should earn returns for the capital providers who risk

their capital. For an investment to be worthwhile, the expected return on capital must be

greater than the cost of capital. In other words, the risk-adjusted return on capital that is,

incorporating not just the projected returns, but the probabilities of those projections must be

higher than the cost of capital.

Expected Rate of Return (ERR)

ERR = Risk free rate of return + Premium expected for risk

To attract outside investors, the ERR should be higher than a risk free investment such as

fixed deposit (FD). For example, if the present FD rate is 3%, the return must be more than

that. The premium expected depends on the risk of investment. As the smartphone

technology changes fast, this investment is quite risky. Outside investors would expect a

higher premium for the risk they need to take. CRE is considering a premium of 8% to 10%,

to ensure that outside investors will consider investing in our venture.

Outside investors would also include joint ventures with other corporations. Samsung and

HTC have formed strategic alliances with Google, where they produced smartphones using

the Android operating system software owned by Google. Even though the software is open-

source, device manufacturers cannot use Google's Android trademark unless Google certifies

that the device complies with their Compatibility Definition Document (CDD). Devices must

also meet this definition to be eligible to license Google's closed-source applications,

including the Android Market.

This type of joint venture helps smartphone manufacturers from spending extra cost to

develop operating system while Google’s Android will see a bigger demand. Google will

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earn extra revenue from advertisement and increased purchases via the Android Market

which offers many software applications for the smartphones.

5.4 The Decision Making Complexities

In order to maintain our market share and to grow the business, CRE’s management knows

that we need to produce the new smartphones. Current demand for smartphones have been

increasing yearly and players like Apple, RIM and Samsung have a good head start in this

segment.

CRE could manufacture the smartphone which will allow the company to have full control on

quality control as well as trade secret such as new software or technology. CRE have done a

feasible study and the present premise would not be able to run another production line for

the new smartphone. There is a need to build a new premise or lease it to have the capacity to

produce the new smartphone. CRE would also need to hire skillful workforce to run the

operation. The capital investment needed will be large and the management would need to

consider financing the investment via equity or debt.

Alternatively, CRE could also outsource the manufacturing like Apple on its I-phones. CRE

would not need to increase capacity such as investment on factory, machinery, equipment and

also increase in workforce. CRE would not need to raise extra capital and only pay for the

units manufactured as per agreement with the manufacturer. There is minimal financial risk

and CRE would not need to invest heavily on research and development (R&D) to

manufacture the smartphones. To save further cost, CRE could also ensure the smartphones

have an open operating system which could run on Windows Mobile or Google’s Android

operating system. Large manufacturers such as Samsung, HTC and LG are utilizing this

system.

There are several potential problems that may arise from outsourcing manufacturing. Problem

with quality control may arise as CRE would not be able to have control on the

manufacturing plant. In event of delay in production, CRE may lose sales and incur losses.

CRE must ensure that the manufacturer be held liable and will compensate any losses due to

delays or poor quality.

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CRE would need share expertise with the manufacturer and incorporate certain technology

and software from present PDA into the new smartphones. There is a possibility of these

‘trade secrets’ being leaked out to the competitors. Apple and Samsung’s various lawsuits are

clear examples on the risks of intellectual property infringement (Yang Jung).

5.5 Recommendation

Looking at the two business considerations, it will not be easy to make a decision. CRE’s

shareholders must study the key issues and also take into consideration the complexities of

making the decision.

The change in smartphone technology is racing forward at such a fast pace that consumers

are having trouble keeping up. CRE would need high capital injection in order to compete

with the big players such as Apple, RIM, Samsung and HTC. Big computer manufacturers

such as Dell and Acer have also taken the plunge into the smartphone market. Even after

investing heavily on R&D and including extra hardware and features, we cannot predict the

total success of the smartphone, as Kiju, Shin reported how even LG lost the smartphone

race.

I would propose CRE to adopt option 2, where the manufacturing is outsourced to a

manufacturer. The manufacturer would be able to incorporate new hardware and also new

features to compliment what is available on our current PDA and create a smartphone.

Capital cost is minimized and CRE would have less exposure due to product failure.

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References

1. Choose the right finance when starting up. Get outside investors to help finance your

business. Available online at http://www.businesslink.gov.uk/bdotg/action/detail?

type=RESOURCES&itemId=1076795354 (Accessed on 29/6/2011)

2. Ferreira, Annie. Android OS changes smartphone life cycle. The Vista February 16,

2011. Available online at http://www.theusdvista.com/business/android-os-changes-

smartphone-life-cycle-1.2000033 (Accessed on 1/7/2011)

3. Gitman, Lawrence & Zutter, Chad J. Principles of Managerial Finance 13th Edition.

Pearson Education Ltd.

4. Haskin, David. Another nail in the PDA's coffin? Computerworld (30-10- 2006)

Available online at

http://www.computerworld.com/s/article/9004592/Another_nail_in_the_PDA_s_coffi

n_?source=rss_topic15 (Accessed on 29/6/2011)

5. Kiju, Shin. How LG lost the smartphone race. CNN February 15, 2011. Available

online at

http://money.cnn.com/2011/02/15/news/international/lg_smartphone_failure.fortune/

index.htm (Accessed on 2/7/2011)

6. How Stuff Works. What are the hardware components of smartphones? Available

online at http://curiosity.discovery.com/question/hardware-components-of-

smartphones (Accessed on 28/6/2011)

7. Yang Jung. Apple Files Patent Suit Against Samsung in Seoul, Escalating Legal

Dispute. Bloomberg news Jun 24, 2011. Available online at

http://www.bloomberg.com/news/2011-06-24/apple-files-patent-suit-against-

samsung-electronics-in-s-korea.html (Accessed on 30/6/2011)

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