Case 20 : Aurora Textile Company

Case 20 break of day textile society GROUP QUESTIONS Learning Objectives 1. The basics of incremental- bills-flow analysis identifying the notes flows relevant to a capital- enthronization close 2. The construction of a side-by-side discounted-cash-flow analysis for a replacement finish 3. How to adapt the NPV decision rule to a troubled intentness 4. The actualization that a reduced investment horizon is a significant egress of financial distress 5. The importance of sensitivity analysis to a capital-investment decision Case Questions 1. How has dawning Textile performed over the past four long time?Be prepared to provide financial ratios that present a unmortgaged picture of dawnings financial condition. From 1999 through 2002, the financial process of Aurora was unattractive and disheartening. This could be attri scarceed to the business risks that arose from the intense competition that characterizes the fabrication in which Aurora ope counts. Absent an fabricati on benchmark or a deal(p) with which to gauge the performance of Aurora, we utilized a trend analysis of the center 1999 through 2002. With 1999 as a reference point, we noticed that all mea for sures of positiveness go for worsened.On a cumulative annual basis, net gross sales have been declining by 15%, while profit margins and ROA were always in the ostracise (see exhibit 1). While raw material cost as a percentage of net sales have been declining, the cost of conversion is escalating and touch the bottom-line (see exhibit 1). It is obvious that Aurora inevitably to manage its expenses to generate boodle from sales. While on the surface, the liquidity measures have improved (see exhibit 1), it is provisional that the company has the ability to meet its current obligations with just cash and cash equivalents on hand.This is partially referable to the fact that many of the firms current assets are predominantly account receivables and inventories. While it is true that the firm, its competitors, and the effort are continuing to lose money, an effective cost-control schema i. e. a strategy that improves profit margins, reduces operating cost, and fitly manages enrolment and account receivables leave alone be crucial for Aurora to remain sustainable. 2. List the factors affecting the textile industry. What do you think is the aver of the industry in the United States?How should you incorporate the state of the textile industry into your analysis? Why should anyone invest money in the industry? 3. What are the relevant cash flows for the Zinser investment? Using a 10% WACC and take for granted a 36% tax rate, what do you mend as the NPV for the externalise? What are the value drivers in your analysis? What do you estimate as the cost per pound for customer returns under the Zinser substitute? (Hint for a replacement decision, analysts often find it helpful to prepare cardinal sets of cash flows and two NPVsone for the status quo and one f or the modern machine. billet Quo In the first grade of the project, we calculated net sales assuming the current 500,000 pounds per week toil level at a $1. 0235 merchandising price per pound (52-week year). After the first 3 year, we assume sales ordain grow by 2% in volume and 1% in price. Material and conversion costs will not change, merely will increase at a pace of 1%. SG&A costs are equal to 7% of net sales so will adjust accordingly. Change in inventory is cash worn-out(a) so it should be considered when calculating cash flows.In our analysis we calculated inventory by dividing COGS by the number of days in a year and then multiplying by the number of days of inventory held, 30 days in the status quo scenario. The current equipment will be depreciated using the straight-line system with zero salvage value. The current book value of the machine is $800,000 and the dispraise expense is $200,000 for the next four years. Using these assumptions, keeping all else consta nt, in a 10-year horizon the NPV of the Hunter limit is about $8. 1 jillion (see exhibit 2). New Project Invest in Zinser Machine Aurora Textile Company besides has the option of drop in a new Zinser machine for the Hunter Plant. The main difference amid investing in the Zinser machine and maintaining the status quo is an initial investment of $8. 25 million and the receipt of $608,000 in after-tax sales proceeds from selling the existing machine. Additionally, there is an initial $50,000 ($32,000 after-tax) cost for training employees, only this cost is only incurred erst (see exhibit 3).In their first year using the Zinser machine there will be a 5% decrease in sales volume, but selling price will increase 10%. Material costs per pound will be the same as the status quo, but conversion costs will decrease to $0. 4077 per pound per year due to lower power, maintenance and return costs. Days of inventory held will also drop to about 20 days. All another(prenominal)(a) as sumptions are the same as the status quo. In this scenario, the NPV of the Hunter Plant is about $15. 87million if Aurora invests in the new Zisner machine (see exhibit 3). Incremental Cash Flows The web Effect of the New ProjectWhen looking at the incremental cash flows for the new project, replacing the old machine with the Zinser machine is a good investment. The NPV of the investment is $6. 33 million and the IRR is 28%, much mellow than the 10% burial vault rate (see exhibit 4). While all the assumptions made could affect the NPV of the project, the major concern that could erode the value of the project is whether Aurora can sustain for 10 years. In our early termination analysis (see exhibit 5), if we edit the salvage value the time horizon breakeven point of incremental NPV is between 4 and 5 years, about 4. years. However, even if Aurora come togethers down, the earlier they terminate, the higher the salvage value of the Zinser machine will be. Therefore, the time period to breakeven efficacy be less than 4 years. If the Zinser machine can be interchange for its 50% book value at early termination, it only needs 2 years for the project to add value to the Aurora Textile Company. 4. How sensitive is the economic life of the Zinser investment to its value to investors? In other words, if the company get dismissals the entire 10 years, what is the NPV of the project?What if the company can survive only four years, what is the NPV of the project? For our sensitivity analysis, the main things we focused on were production levels and price. Here is a chart representing the IRRs for certain production levels and prices. Our production level estimates were based on the fact that we dont issue how the market will react with increased foreign competition. The textile harvest-festival rate we used for our most likely model is the domestic rate of growth, not the world growth rate.We dont know if let foreign competitors into the market would signif icantly shift the industry out of the States or if it will keep a constant growth (at 2%). Our price estimates were based on the new WTO mandate that is going into effect in 2005. With the tariffs and quotas on the textile industry being lifted, there will be a significant growth in the amount of textile goods imported into America. Even though the cost may be high to transport these goods into the states 5. What would be your recommendation to the Board of Directors?Specifically would it be reveal to invest in the Zinser or to pay a dividend to the shareholders. Be sure to explain the primary reasons that justify your recommended course of action. The U. S. textile industry is going through a tumultuous time, and most companies are experiencing losses. Therefore, it would seem like an odd time to invest more money into the company. However, as the industry evolves Aurora Textile Company needs to innovate to stay competitive. The industry is moving toward demand for a higher qualit y product, and Aurora cannot present to fall behind.The Zinser machine will help Aurora meet this demand. If the project were accepted, the Zinser machine would replace the current machine in the Hunter Plant. Because the other three Aurora plants would not be affected by this decision, we compared the cash flows of only the Hunter plant with the new machine and without. The NPV of the Hunter Plant is about $15. 86 million if Aurora invests in the Zisner machine, and only $8. 91 million without the investment. In assenting, when looking at the incremental cash flows of the investment, the NPV is $6. 6 million and the IRR is 28%, much higher than the 10% hurdle rate. taking all of this into consideration Aurora should invest in the project. In addition to accepting this project, falling spot prices for cotton could be beneficial to Aurora Textile Company in the future. However, the company also needs to implement other strategies to improve their profit margins, including reducin g operating costs and appropriately managing inventory and account receivables. These changes will help Aurora move in the right direction to ensure that they are not forced to shut down operations in the foreseeable future