An alternative analogy to CREE's financials:
Picture a sidewalk restaurant selling exotic vegeterian hotdogs made of protein extracted from a rare algae, which is grown on-site under special lighting and temperatures, requiring special machinery to extract the edible components, which are miniscule in size.
The restaurant was initially built on an equity invstment of $100,000 in cash - $60k for PP&E, $20k to buy intellectual property from the inventor, and another $20k for operating cash.
However, since the algae grows REALLY slowly, the restaurant has sales of only $30,000. The business is profitable - for each hotdog it sells for $1.00, its net operating profits (after subtracting for COGS, SG&A, and depreciation) are $0.25 before tax (interest costs are nil, since there is no debt). Pre-tax operating profits are thus $7,500.
After the first year of operations, demand seems OK, so the restaurant wants to double its capital equipment and facilities, costing $50,000 or eight years' worth of profits from the original setup, or only four years' worth of profits from the "doubled" expansion.
Or it can borrow the money from a bank, with yearly interest payments of $6,000 over ten years, with payments totalling $60,000. This method would result in higher profitability ratios, due to financial leverage. The cost of debt is lower than the cost of equity.
Question: should the restaurant expand, and if so, should it fund the expansion through retained earnings or through debt?
Future demand for the exotic algae hotdog is not guaranteed to be at today's levels / prices. In fact, there are plenty of substitue hotdogs which will more of less do the same job.
Notes:
1) If the pathetically slow-growing algae can be made to grow twice as fast, all things being equal, sales turnover will double (asset turnover will go from 0.30 to 0.60) As a result, ROE will double. In fact, most other hotdog restaurants have a turnover which is nearly triple, or around 0.90.
2) If the restaurant is able to borrow for their expansion, ROE will also rise significantly because debt will cost less than equity
3) The restaurant decides to expand its output through internally generated funds. As a result, the business will not free cashflow positive for years 2, 3, 4, and 5.
4) Today marks the beginning of year 2. Is this business "profitable"? In order to value the business using DCF, shouldn't we be assigning a value of zero for years 2, 3, 4, 5?
Pretty crude analogy, I admit. Comments, anyone? |
