(Solved): Required: The financial statements for KnowNet for fiscal 2022 and fiscal 2021 are provided abov ...

Required:

The financial statements for KnowNet for fiscal 2022 and fiscal 2021 are provided above. You should analyze them as you deem appropriate. Based on your work, comment on the memo from Ted Chapman. Do you agree or disagree with his analysis and conclusions?

Make sure your response covers the following points, in addition to any other issues you think are relevant:

1. What is the situation facing JDI?

2. Assuming all sales are made on account, how much cash did KN receive from its customers in 2022? Show your calculation.

3. Comment on the following points in the memo prepared by Ted Chapman.

A. Ted’s analysis suggests that KN will be profitable in three years. On what estimates of revenue and expenses did he base this forecast? Do you agree? Why or why not?

B. Ted believes the important questions to ask are "does KN have a reasonable plan to become profitable?" and "does KN have the cash to survive until profitability is achieved?" What other questions might you have?

C. Ted estimates that KN is “burning” approximately $10,000,000 of cash per year, based on fiscal 2022. Is this correct? Comment on how cash has been sourced and how it has been used.

D. Ted says, “if we decide not to make an equity investment, KN should be able to obtain additional debt or equity financing from creditors or investors.” Do you agree? Why or why not?

4. Should JDI pursue an alliance with KN? Give reasons for and against and then give your recommendation.

Jordan Davis, lncorporated (JDI) is a major publisher of college textbooks focused on business education. At the company's quarterly strategy meeting senior management decided to expand into business education materials aimed at corporations that require entry-level and mid-level managers to complete training courses to improve their business skills. For such training, content (in the opinion of JDI's senior management) is best delivered via the internet since it has cost advantages and allows for flexibility in scheduling employee training. JDI has existing content in almost all business areas including accounting, finance, marketing, management, and information systems as well as connections to authors who can develop new materials. However, the firm does not have experience delivering content over the Internet and does not have a sales force with experience selling to the corporate training market. Given JDI wants a rapid entry into this market, it plans on developing a strategic alliance with a company that has experience in selling to the corporate market and in delivery of content via the Internet. One of the companies JDI is considering as a partner is KnowNet, Inc. KnowNet is an infrastructure and services company that supports corporate communication and training. The company has approximately 65 satellitelinked communication centers that corporations can use for live video conferencing or training. KnowNet has also developed a platform to deliver pre-recorded training to personal computers via the Internet. For clients that need help developing training materials, KnowNet has three production studios for designing and recording client content. A due diligence team from JDI has met with executives from KnowNet, viewed demonstrations of content delivered over the Internet using the KnowNet platform, and visited a KnowNet production facility. The team is quite impressed with KnowNet and believes an alliance with the company would be a great fit since KnowNet does not specialize in developing content (it only assists companies with designing and recording content) whereas JDI is a content expert. JDI is going to be investing heavily to modify its existing content to make it more focused on the corporate training market and to make it compatible with KnowNet's delivery platform. Thus, it wants to gain some assurance that KnowNet will be around in the foreseeable future to continue selling and delivering the materials to the corporate market. To assess the financial stability of KnowNet, the JDI due diligence team performed financial analysis and held discussions with various executives and KnowNet. When finished with its investigation, the due diligence team prepared the following memo supporting a partnership with KnowNlet TO: Peter Gandrell (CEO), Christine Sayers (CFO), and Drew Marshall (Director of New Initiatives) FROM: Ted Chapman, lead manager, due diligence team investigating KnowNet SUBJECT: Report on Financial Condition of KnowNet In fisca12022/fisca12021, KnowNet (KN) suffered losses of $\$26,893,086/\$19,909,857$. In spite of these losses, the team recommends forming an alliance with $\mathrm{KN}$. KN, like most companies in this space, is an early stage company and losses are not unexpected. The important questions to ask are "does KN have a reasonable plan to become profitable?" and "does KN have the cash to survive until profitability is achieved?" We believe the answer to both questions is yes. In 2022, operating expenses increased substantially resulting in an increased loss. However, per our discussions with executives at $\mathrm{KN}$, the increased operating expenses are due in large part to a major advertising campaign and expansion of the sales force. The result is that $\mathrm{KN}$ achieved substantial brand recognition, and in 2022 revenue increased by 20 percent. The company believes that, now that it has achieved its brand recognition goals, it can cut operating expenditures (including advertising and sales force salaries) back to a level of 80 percent of the amounts in fiscal 2022 , or $\$27,609,269(80\%\times 34,511,586)$. With current revenue at $\$17,547,648$, and assuming an ongoing revenue growth rate of 20 percent, the company will be profitable in three years (i.e., at the end of fiscal 2025 , revenue of $\$30,322,337$ will exceed expenses of $\$27,609,269)$. It appears to us that achieving profitability in three years is a very feasible goal. The company has expanded its Web hosting options to a $24/7$ basis and is now able to service clients with training demands around the world. In the fourth quarter of fiscal 2022, the company signed contracts with four additional Fortune 500 clients to deliver services in 2024. The revenue from this prestigious group of clients is, of course, not reflected in the financial statements for 2022. Also, keep in mind that our partnership with $\mathrm{KN}$ will provide incremental revenue to the company. Of course, achieving profitability will only be possible if the company does not run out of cash. At the end of fiscal 2022 , $\mathrm{KN}$ had approximately $\$20,000,000$ in cash and cash equivalents. The net decrease in cash and cash equivalents in fiscal 2022 was approximately $\$10,000,000$. Thus, it appears that the company will be able to survive for at least two years (through fiscal 2024). At that point, assuming our net initiative is a success, we may want to make an equity investment in $\mathrm{KN}$ to provide the company with the cash it will need to survive a third year beyond 2024 (i.e., through fiscal 2025). Assuming an annual decrease in cash of $\$10,000,000$, we would need to make an equity investment of $\$10,000,000$. At the end of year 3 , as discussed above, $\mathrm{KN}$ will be profitable and likely able to fund itself internally. An investment of $\$10,000,000$ would give us a substantial equity position in a firm that we predict will be successful. Furthermore, it would allow us to have a substantial say in the direction of $\mathrm{KN}$, thus ensuring that the company remains focused on our long-run needs in addition to the needs of its other clients. Alternatively, in light of the fact that the company will be only a year away from profitability at the end of fiscal 2024, if we decide not to make an equity investment, KN should be able to obtain additional debt or equity financing from creditors or investors.