Aurora Textile Company

Case solution

Company Background
Aurora Textile Company is in a tough situation due to the troubled financial condition of both
the company and the U.S. textile industry as a whole. Manufacturers are migrating to Asia to
benefit from lower manufacturing costs and Aurora does not want to move operations
overseas. With net earnings in the negative, Aurora must now make the tough decision on
whether to invest more money into a struggling company or maintain the status quo.

Financial Analysis (1999 2002)

From 1999 through 2002, the financial performance of Aurora was unattractive and
disheartening. This could be attributed to the business risks that arose from the intense
competition that characterizes the industry in which Aurora operates. Absent an industry
benchmark or comparables with which to gauge the performance of Aurora, we utilized a
trend analysis of the period 1999 through 2002.

Status Quo
We calculated net sales assuming the current 500,000 pounds per week productionlevelata
$1.0235 selling price per pound (52-week year). After the first year, we assume sales will
grow by 2% in volume and 1% in price.Material and conversion costs will not change, but
will increase at a pace of 1%.SG&A costs are equal to 7% of net sales so will adjust
accordingly.The current equipment will be depreciatedusing the straight-line method with
zero salvage value.The current book value of the machine is $800,000 and the depreciation
expense is $200,000 for the next four years.Using these assumptions, keeping all else
constant, in a 10-year horizon the NPV of the Hunter Plant is about $8.9 million.

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New Project - Invest in Zinser Machine
The main difference between investing in the Zinser machine and maintaining the status quo
is an initial investmentof $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, but this cost is only incurred once (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
costswill 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 other assumptions are the
same as the status quo.In this scenario, the NPV of the Hunter Plant is about $14.42 million if
Aurora invests in the new Zisner machine (see exhibit 3).

Incremental Cash Flows -The Net Effect of the New Project

The NPV of the investment is $6.33 million and the IRR is 28%, much higher than the 10%
hurdle 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 survive for
10 years. In our early termination analysis (see exhibit 5), if we ignore the salvage valuethe
time horizon breakeven point of incremental NPV is between 4 and 5 years, about 4.5 years.
Therefore, the time period to breakeven might be less than 4 years. If the Zinser machine can
be sold for its 50% book value at early termination, it only needs 2 years for the project to
add value to the Aurora Textile Company.

Recommendation
Aurora Textile Company needs to innovate to stay competitive. The industry is moving
toward demand for a higher quality product, and Aurora cannot afford to fall behind. The
Zinser machine will help Aurora meet this demand.The NPV of the Hunter Plant is about
$14.42 million if Aurora invests in the Zisner machine, andonly $8.9 million without the
investment. In addition, when looking at the incremental cash flows of the investment, the

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 NPV is $6.33 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.

Aurora Textile Company

Financial Ratios Analysis (19992002)

1999 2000 2001 2002

Sales growth 6.56% 20.38% 19.38%
Raw materials/sales 54.01% 53.29% 53.86% 44.05%
Conversion cost/sales 33.94% 36.65% 37.07% 41.97%
Gross Margin/sales 12.05% 10.06% 9.07% 13.97%
SGA/sales 5.94% 6.19% 6.36% 6.99%
Interest Expense 2.76% 2.95% 2.80% 2.33%
Operating Profit/sales -0.08% -1.79% -3.41% 0.30%
NI/sales -1.82% -2.71% -6.07% -4.76%

Days sales outstanding 25.7 18.5 40.7 64.5

Days inventory 95.6 98.8 116 186.9
Asset turnover 1.37 1.39 1.28 1.08

Return on assets 2.5% 3.8% 7.8% 5.2%

Return on equity 6.2% 9.5% 20.4% 14.8%

Note: Although the sale growth increased through the four years except 2001.consequintly, the gross profit
increased from 12.05% to 13.97% at the end of the year 2002. On the other hand, the net profit was negatives
value. Throughout the four years, From this analysis it can be concluding that the company's financial
performance was tremendously bad.

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 Aurora Textile Company
Status Quo Cash Flows ($000)

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Year 0 1 2 3 4 5 6 7 8 9 10

Sales volumes 26,000 26,520 27,050 27,591 28,143 28,706 29,280 29,866 30,463 31,072 31,200
Avarage Salling Price 1.02 1.03 1.04 1.05 1.07 1.08 1.09 1.10 1.11 1.12 1.13
Net sales $26,611 $27,415 $28,243 $29,096 $29,974 $30,879 $31,812 $32,773 $33,762 $34,782 $35,274
New ARMC 0.45 0.45 0.46 0.46 0.46 0.47 0.47 0.48 0.48 0.49 0.49
Cost of materials 11,723 12,077 12,442 12,818 13,205 13,604 14,015 14,438 14,874 15,323 15,540
Conversion costs 11,518 11,865 12,224 12,593 12,973 13,365 13,769 14,185 14,613 14,820
SG&A 1,919 1,977 2,037 2,098 2,162 2,227 2,294 2,363 2,435 2,469
Depreciation 500 500 500 500 0 0 0 0 0 0
Operating margin 1,400 1,458 1,517 1,578 2,141 2,205 2,272 2,340 2,411 2,445
Tax@36% 504 525 546 568 771 794 818 842 868 880
NOPAT 896 933 971 1,010 1,370 1,411 1,454 1,498 1,543 1,565
+ Depreciation 500 500 500 500 0 0 0 0 0 0
Inventory 963.53 992.67 1022.65 1053.53 1085.35 1118.12 1151.89 1186.68 1222.52 1259.44 1277.25
Change in inventory -964 -29.13 -29.98 -30.88 -31.82 -32.78 -33.77 -34.79 -35.84 -36.92 1259.00
Salvage value 0
Free cash flows ($964) $1,367 $1,403 $1,440 $1,478 $1,337 $1,378 $1,419 $1,462 $1,506 $2,824

Note: Inventory= Cost of Material/365x30=964

Hurdle Rate/WACC = 10%

NPV of the Machine = $9,239.74

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 Aurora Textile Company
Cash flow for New Machine

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Year 0 1 2 3 4 5 6 7 8 9 10

Sales volumes 24,700 25,194 25,698 26,212 26,736 27,271 27,816 28,373 28,940 29,519 30,109
Avarage Salling Price 1.13 1.14 1.15 1.16 1.17 1.18 1.20 1.21 1.22 1.23 1.24
Net sales $27,808 $28,648 $29,513 $30,405 $31,323 $32,269 $33,244 $34,247 $35,282 $36,347 $37,445
New ARMC 0.45 0.45 0.46 0.46 0.46 0.47 0.47 0.48 0.48 0.49 0.49
Cost of materials 11,137 11,474 11,820 12,177 12,545 12,924 13,314 13,716 14,130 14,557 14,997
Conversion costs 7,984 10,374 10,687 11,010 11,342 11,685 12,038 12,401 12,776 13,162 13,559
SG&A 2,005 2,066 2,128 2,193 2,259 2,327 2,397 2,470 2,544 2,621
Depreciation 825 825 825 825 825 825 825 825 825 825
Operating margin 3,970 4,115 4,264 4,419 4,577 4,740 4,908 5,081 5,259 5,443
Tax@36% 1,429 1,482 1,535 1,591 1,648 1,706 1,767 1,829 1,893 1,960
NOPAT 2,541 2,634 2,729 2,828 2,929 3,033 3,141 3,252 3,366 3,484
+ Depreciation 825 825 825 825 825 825 825 825 825 825
Inventory 610.26 628.69 647.68 667.24 687.39 708.14 729.53 751.56 774.26 797.64 821.73
Change in inventory 610 -18.43 -18.99 -19.56 -20.15 -20.76 -21.39 -22.03 -22.70 -23.38 798.00
Net sale of old machine 1,040
Zinser investment 8,250
After-tax training cost 32
Salvage value 64
Free cash flows -7,852 $3,348 $3,440 $3,535 $3,633 $3,733 $3,837 $3,944 $4,054 $4,167 $5,171

Note: Inventory= Cost of Material/365x20=964

Note: only 1st Year sales volume will dicrease by 5 % but afterthat it will increase at 2%

Hurdle Rate/WACC = 10%

NPV of the Machine = $15,330.98

Aurora Textile Company

Investment Outlay and Terminal-Value Calculations

Sale of Existing Ring-Spinning Machine

Book value $2,000,000
Current Market value 500,000
Loss 1,500,000
Tax savings (36%) 540,000
Net proceeds for existing machine $1,040,000

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 Purchase of the Zinser
Price of Zinser $8,050,000
Building modification 115,000
Airflow modification 55,000
Testing 30,000
Total cost $8,250,000

Sale of the Zinser at the End of Year 10

Book value $0
Market value 100,000
Gain 100,000
Tax on gain @36% 36,000
Net proceeds $64,000

Aurora Textile Company

Incremental Cash Flows and NPV Sensitivity of Zinser Machine Investment ($000)

Year 0 1 2 3 4 5 6 7 8 9 10
Existing spinning machine ($964) $1,367 $1,403 $1,440 $1,478 $1,337 $1,378 $1,419 $1,462 $1,506 $2,824
New Zinser ($7,852) $3,348 $3,440 $3,535 $3,633 $3,733 $3,837 $3,944 $4,054 $4,168 $5,170
Incremental cash flows ($6,888) $1,981 $2,037 $2,095 $2,155 $2,396 $2,459 $2,525 $2,592 $2,662 $2,346

Net present Value = ($6,888) $1,801 $1,683 $1,574 $1,472 $1,488 $1,388 $1,296 $1,209 $1,129 $904
($5,087) ($3,404) ($1,830) ($358) $1,130 $2,518 $3,814 $5,023 $6,152 $7,056

Hurdle Rate/WACC = 10%

NPV of the Machine = $7,056

Project Life 0 1 2 3 4 5 6 7 8 9 10
NPV (salvage effect ignored) ($5,088) ($3,405) ($1,831) ($359) $1,128 $2,517 $3,812 $5,021 $6,150 $7,054
NPV (zero salvage, 36% tax benefit on reported loss)
($2,658) ($1,441) ($269) $858 $2,050 $3,187 $4,269 $5,299 $6,276 $7,054
NPV (salvage = 25% book value, 36% tax benefit on
($1,578)
reported ($569)
loss) $425 $1,399 $2,460 $3,485 $4,473 $5,422 $6,332 $7,054

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