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Teaching Note

Michael Pogonowski, the chief financial officer of Aurora Textile Company, was
questioning whether the company should replace the current spinning machine at the Hunter
production facility with a new ring-spinning machine, the Zinser 351. Because of the poor health
of both the textile industry and Aurora Textile, the management team had become engaged in a
debate as to whether the company should return excess cash to shareholders or invest in the new
machine. The U.S. textile industry had begun to decline as manufacturing migrated to Asia to
benefit from lower manufacturing costs. Most U.S. companies had not responded quickly to the
changing industry dynamics and suffered heavy financial losses. This, in turn, precipitated a
series of bankruptcies in the industry, and Auroras recent financial performance had been
lackluster as well.

The case presents enough information for side-by-side cash-flow projections for the
existing spinning machine, which depreciates in 4 years, and the new Zinser machine, which has
a 10-year depreciable life. The main driver of the cash flows and the NPV is the improvement in
margins due to Auroras ability to charge higher prices in a higher-quality market. The margin
benefit is offset, to some extent, by a decrease in volume sold and an increase in the liability
associated with returns from retailers. A less significant driver is the number of days of cotton
held in inventory. To simplify the analysis, the case specifies the cost of capital.

The case is suitable for students just beginning to learn finance principles, but is also rich
enough to use with experienced students and executives. The learning point about investing in a
troubled industry can create a lively debate among students of all experience levels. In this
regard, the case serves as a powerful example of one component of financial-distress costs: the
reduction of viable investment opportunities owing to a shortened time horizon. The main
learning points of the case include the following:

The basics of incremental-cash-flow analysis: identifying the cash flows relevant to a

capital-investment decision

This teaching note was prepared by Lucas Doe (MBA/ME 04), under the supervision of Professor Kenneth Eades
of the Darden School of Business. It was written as a basis for class discussion rather than to illustrate effective or
ineffective handling of an administrative situation. Copyright 2007 by the University of Virginia Darden School
Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to No part of this publication may be reproduced, stored in a retrieval system,
used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying,
recording, or otherwisewithout the permission of the Darden School Foundation. Rev. 2/08.
The construction of a side-by-side discounted-cash-flow analysis for a
replacement decision
How to adapt the NPV decision rule to a troubled industry
The recognition that a reduced investment horizon is a significant consequence of
financial distress
The importance of sensitivity analysis to a capital-investment decision

Suggested Assignment Questions

1. How has Aurora Textile performed over the past four years? Be prepared to provide
financial ratios that present a clear picture of Auroras financial condition.
2. List the factors affecting the textile industry. What do you think is the state 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
assuming a 36% tax rate, what do you get as the NPV for the project? What are the value
drivers in your analysis? What do you estimate as the cost per pound for customer returns
under the Zinser alternative? (Hint: for a replacement decision, analysts often find it
helpful to prepare two sets of cash flows and two NPVsone for the status quo and one
for the new machine.)
4. Craft a memo to the board of directors stating your recommendation about investing in
the new Zinser machine. Part of your memo should explain why it is better 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.

Teaching-Plan Outline (85-minute class)

(10 min.) Discuss the textile industry and Auroras current financial condition.
(10 min.) Discuss the conceptual trade-offs for making a new investment versus paying a
dividend to shareholders.
(5 min.) Discuss the merits of doing two side-by-side sets of cash flows versus one
comprehensive set of differenced cash flows.
(15 min.) Prepare the first few years of cash flows for the status quo.
(20 min.) Prepare the first few years of cash flows for the new Zinser machine and compute
the NPV of the investment.
(15 min.) Discuss the impact of being in a troubled industry on the value of the Zinser
investment. Conduct a sensitivity analysis to illustrate that impact and discuss the
result as an example of the costs of financial distress.
(10 min.) Epilogue.

The textile industry and Aurora

Starting the class with a discussion about the financial health of both the industry and
Aurora sets the stage for thinking about the investment decision for a financially troubled
company. Textiles is a classic example of an industry that evolved within a changing set of
economic conditions. Originally, the industry was located near the industrial centers of the
United States. The lower cost of labor and proximity to cotton production, however, motivated
textile manufacturers to relocate in the South. Eventually, however, U.S. labor became expensive
relative to offshore sources, and most of the industry migrated to Asia to take advantage of those
cost savings. Rapidly changing customer preferences and fads created the need for shorter
production lead times. Most U.S. companies were unable to respond quickly to the changing
industry dynamics; as a result, the industry faced declining margins and declining market share,
forcing many companies into bankruptcy.

The financial ratios in Exhibit TN1 paint a bleak picture of Auroras financial health. It
is apparent that Aurora has been facing the same economic pressures as its U.S. competitors:
declining margins and sales. Although the results for 2002 offered some glimmer of hope for
Aurora by showing a positive operating profit, the company has failed to turn a profit (net
income) for the past four years. Sales increased substantially in 2000, but quickly fell below
1999 levels. Assets have been shrinking as Aurora closed down several manufacturing
operations and reduced new investments in order to conserve cash. Students should recognize,
however, that asset turnover has declined, indicating that Aurora has not contracted assets as fast
as the decline in sales. Moreover, accounts receivable and inventory show major signs of poor
management as days sales outstanding and days inventory have both significantly increased since
1999. Aurora is in a troubled industry, but Auroras management has more work ahead to
downsize the company and manage its assets more efficiently.

For decades, it was apparent that the United States could not effectively compete against
imports without government protections. Part of those protections was the quota system, which
was scheduled to be removed January 1, 2005. Coupled with the strong dollar, this would make
the U.S. market a prime target for exporters and put increased pressure on U.S. producers.
Auroras gamble is that the cost of shipping products from Asia to the United States would
continue to allow the production of bulkier, heavier products in the United States. The question,
however, was whether transportation costs would be a strong enough deterrent to foreign
competition to allow enough time for the Zinser to produce sufficient cash flows to add value to
the company. This is an important insight provided by the case. The value of the Zinser is highly
dependent on how long it will be in place. If the company cannot survive beyond a few years,
there is clearly no reason to throw good money after bad. If the company can remain in
business long enough to allow the Zinsers efficiencies to be realized, however, the investment
will add value to the company, despite the fact that it is operating in a declining industry. Once
the students recognize the importance of economic life to the investment decision, the instructor
can promise to return to this discussion later in the class as part of the sensitivity analysis.
Paying a dividend to shareholders

After some discussion, students will eventually realize that the dividend question is
equivalent to asking whether management should pursue all positive net-present-value projects.
If we assume a reasonable amount of capital-market efficiency, individual investors will not have
positive NPV investment available to them. Companies, however, may well have access to
positive NPV investments so that the shareholders of a public company will be better served if
cash is invested in those projects rather than paid out as a dividend. The unhealthy nature of the
textile industry appears to make the dividend question more complicated until the students
recognize that even companies in poor businesses can create value. As discussed earlier, the
main concern for Aurora management should be whether the company can operate long enough
for the Zinser to be a positive NPV project. If not, then management should conclude that
shareholders are better served by paying as much in dividends as the lenders will allow. But if
the company expects to survive long enough, then the value of the company via its future cash
flows will be maximized by investing in the project.

The discounted-cash-flow analysis

Before putting any numbers on the board, I like to cold-call a student to give an overview
of her approach to the problem. Assuming that the student followed the suggestion in the study
questions, she will begin by talking about two sets of cash flows: one for the status quo and one
for adding the Zinser. I like to tell the student that her approach sounds reasonable and in line
with the study-question suggestion: Wouldnt it be easier to create only one set of incremental
cash flows? After all, we only need to know how things change, so why bother to write out the
status quo cash flows?

After a bit of discussion, the class should conclude that both methods should give the
same answer and, ultimately, it is the individuals own preference that will decide which way to
go. Based on my experience teaching capital-investment analysis, however, I strongly prefer the
side-by-side cash flows as the analyst is less likely to omit relevant cash flows and more likely to
understand the key value drivers of the project.

Status quo cash flows

Exhibit TN2 presents the base-case cash flows for the status quo: assuming that Aurora
continues to operate the existing ring-spinning machine. What follows are the explanations of
each of the line items:

Net sales: Year 1 sales ($26.611 million) equals price per pound ($1.0235/lb.) times
capacity per week (500,000 lb./week) times 52 weeks in a year. Subsequent years forecasts are
grown by managements guidance for growth of 2% and the inflation rate of 1%.

Materials cost and conversion cost: Materials cost equals the materials cost per pound
($0.45/lb.) times the volume for the year. Likewise, conversion cost equals $0.43/lb. times
volume. Conversion cost includes the cost of returns from retailers, which equals the frequency
of retailer returns (1.5%) times the liability multiplier (the ratio of reimbursement cost to
yarn revenue); that is, $25/$5 = 5 1.5% = 7.5%. Returns as a cost per pound is computed by
multiplying by the price per pound: 7.5% $1.02/lb. = $0.077/lb.

Selling and general administrative expenses: Exhibit TN1 shows that SG&A has been
trending upward, with the most recent percentage of sales at 7%, which is assumed as the future

Inventory: Inventory equals COGS divided by number of calendar days (360) times
number of days of inventory (30). The cash flow equals the change in inventory level each year
until year 10, when the inventory level is recovered.

Depreciation: Depreciation is computed using the straight-line method for the book value
of the existing spinning machine ($2 million) and depreciable life of four years. Cash flow from
depreciation equals depreciation ($500,000) times the tax rate.

Salvage value and initial investment: The salvage value and the initial investment are
both zero for the existing machine.

Taxes: Although the income statements reveal that the tax rate is 36%, I prefer to state it
explicitly as an assumption for students (see the suggested assignment questions). Some students
will point out that Aurora has not been paying taxes, owing to its consistent string of losses. The
effective marginal tax rate is difficult to estimate accurately. Carryforward and carryback
provisions in the tax code could eliminate any actual cash taxes for Aurora for many years to
come. Thus, the true tax rate on a present-value basis lies somewhere between the nominal rate
of 36% and zero. This is an interesting issue to discuss as time permits, but the case works better
if students treat the analysis as if the company were facing the full tax rate.

Cost of capital: Cost of capital is stated in the case as 10%.

Cash flows from investing in the Zinser

Exhibit TN3 presents the base-case cash flows under the assumption that the Zinser
machine is purchased. What follows are the explanations of those cash flows:

Net initial investment: The total cash payment for the Zinser equals $8.25 million, which
comprises the cost of the machine ($8.05 million), a building-modification cost ($115,000), an
airflow-modification cost ($55,000), and a testing cost ($30,000). The total cash payment is
offset by the after-tax proceeds from the sale of the existing spinning machine ($1.4 million) and
tax savings of $216,000 from the sale of the old spinning machine at less-than-book value
(Exhibit TN4).

Training cost: Training cost is stated in the case as $50,000, making the after-tax cost
Net sales: Year 1 sales ($26.611 million) equals price per pound ($1.02/lb.)
times capacity per week (500,000 lb./week) times 52 weeks in a year. Subsequent years
forecasts are grown by managements guidance for growth (2%) and the inflation rate of 1%.

Materials cost and conversion cost: Materials cost equals the materials cost per pound
($0.45/lb.) times the volume for the year. Conversion cost equals $0.43/lb. times volume less
power and maintenance cost savings of $0.03/lb. Case Exhibit 5 shows that the cost of returns is
expected to increase by 10%, or $0.0077/lb. ($0.0844/lb. $0.0768/lb.). Thus, the conversion
cost for Zinser equals $0.4077/lb. ($0.43 0.03 + 0.0077).

Inventory: Inventory equals COGS divided by number of days in a calendar year (360)
times number of days of inventory (20). The cash flow equals the change in inventory level each
year until year 10, when the inventory level is recovered.

Salvage value: The salvage value for the new machine equals the market value after 10
years ($100,000) less net book value, which was zero, less taxes on gain (Exhibit TN4).

Depreciation: Depreciation was computed using the straight-line method. The value of
the Zinser was $8.25 million and the depreciable life was 10 years, making for an annual
depreciation expense of $825,000.

NPV calculation

The incremental cash flows for the investment decision (Exhibit TN5) are computed as
the Zinser cash flows (Exhibit TN3) less the status quo cash flows (Exhibit TN2). The net
present value of the incremental cash flows using the 10% discount rate is $7.054 million and the
internal rate of return (IRR) is 29%. Thus, the base-case analysis should prompt students to
conclude that the Zinser adds value and is a better use of funds than paying a dividend so long as
the investment horizon of 10 years is achievable.

The discussion at the beginning of class should prime students to consider how the
economic life of the project affects its value to Aurora. Exhibit TN5 presents a sensitivity
analysis of the economic life of the project. If the company survives for the entire 10 years, the
NPV equals $7.054 million. If the company can survive four years, the NPV is approximately a
breakeven. The four-year breakeven ignores any impact of salvage value on the NPV. A zero
salvage is more likely to be closer to what Aurora would realize if the company should fail and
be forced to sell its assets under duress. If Aurora is purchased by a competitor, however, we
should assume a positive salvage to reflect a more favorable outcome for the company. Any
salvage value or any ability to take advantage of reported tax losses will serve to lower the
break-even life and make the project more favorable to management. Other value drivers to the
analysis include the return frequency for the Zinser, the amount of realized price increase, and
the amount of volume decline.

The case is a stylized version of an actual investment decision faced by a company
in the textile industry. The investment was made, but the company failed after a couple of years
and its assets were sold at bargain-basement prices. This outcome does not, by itself, mean that
the decision to invest was incorrect, but it may suggest that management was overly optimistic
about its position in the market.

If time permits at the end of class, the instructor can return to the discussion of the
importance of the economic life before reporting the epilogue. The basic question is whether
students believe that Aurora can survive long enough to realize a positive NPV. This makes the
Zinser an example of how financial distress can create costs for a company. As the likelihood of
bankruptcy rises and the expected life of the firm falls, most long-term investments become
infeasible for the company. Managements focus becomes very myopic in an attempt to meet
short-term obligations and keep the firm afloat.

Below are typical arguments for and against attempting to keep the company alive:

In favor of Aurora going forward with the investment:

The Zinser would position Aurora in the profitable high-end market.

Being in the profitable high-end market could motivate employees, which could translate
into increased volume sold.
Any increase in volume increases shareholder value so that the investment creates
noticeable upside potential.
Aurora would become a niche player that could quickly respond to customer demands,
which is exactly what was needed to survive.

Against Aurora going forward with the investment:

The highly competitive industry would see an increase in competition immediately

following the removal of the quota system.
Cheaper production costs abroad will continue to make it difficult for Aurora to compete.
Rapidly changing customer preference and fads may require more flexibility than Aurora
has or can have.
The integration of the global economy and the stronger dollar will only make the U.S.
market more desirable for exporters.
This would be a good time to liquidate and return cash to shareholders. If the firm waits
five years, assets are likely to have decreased further in value, either because of
depreciation or because of an asset glut in the market from the liquidation of other textile
Key drivers such as price increment and volume sold can change by small amounts
to make the investment unprofitable, and management may have very little influence on
these factors.

Exhibit TN1
Financial Ratios (19992002)

1999 2000 2001 2002

Sales growth 6.6% 20.4% 19.4%
Raw materials/sales 54.0% 53.3% 53.9% 44.1%
Conversion cost/sales 33.9% 36.6% 37.1% 42.0%
SGA/sales 5.9% 6.2% 6.4% 7.0%
EBIT/sales 0.1% 1.8% 3.4% 0.3%
NI/sales 1.8% 2.7% 6.1% 4.8%

Days sales outstanding 25.7 18.5 40.7 64.5

Days inventory 95.6 98.8 116.0 186.9
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%

Exhibit TN2
Status Quo Cash Flows

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

Sales volume 26,000 26,520 27,050 27,591 28,143 28,706 29,280 29,866 30,463 31,072 31,200
Net sales $26,611 $27,415 $28,243 $29,096 $29,974 $30,879 $31,812 $32,773 $33,762 $34,782 $35,274
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 1,401 1,458 1,517 1,578 2,141 2,205 2,272 2,341 2,411 2,445
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 964 993 1,023 1,054 1,085 1,118 1,152 1,187 1,223 1,259 1,277
Change in inventory (964) (29) (30) (31) (32) (33) (34) (35) (36) (37) 1,259
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

Exhibit TN3
Cash Flows of Zinser Machine Investment

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

Sales volume 24,700 25,194 25,698 26,212 26,736 27,271 27,816 28,373 28,940 29,519 30,109
Net sales $27,808 $28,648 $29,513 $30,405 $31,323 $32,269 $33,244 $34,247 $35,282 $36,347 $37,445
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 3,971 4,115 4,265 4,418 4,577 4,740 4,908 5,081 5,259 5,443
NOPAT 2,541 2,634 2,729 2,828 2,929 3,034 3,141 3,252 3,366 3,484
+ Depreciation 825 825 825 825 825 825 825 825 825 825
Inventory 610 629 648 667 687 708 730 752 774 798 822
Change in inventory (610) (18) (19) (20) (20) (21) (21) (22) (23) (23) 798
Net sale of old machine 1,040 0
Zinser investment (8,250)
After-tax training cost (32)
After-tax salvage value $64

Free cash flows ($7,852) $3,348 $3,440 $3,535 $3,633 $3,733 $3,837 $3,944 $4,054 $4,168 $5,170

Exhibit TN4
Investment Outlay and Terminal-Value Calculations

Sale of Existing Ring-Spinning Machine

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

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 (36,000)
Net proceeds $64,000

Exhibit TN5
Incremental Cash Flows and NPV Sensitivity of Zinser Machine Investment

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 ($6,889) $1,981 $2,037 $2,095 $2,155 $2,396 $2,459 $2,525 $2,592 $2,661 $2,346

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
reported loss) ($1,578) ($569) $425 $1,399 $2,460 $3,485 $4,473 $5,422 $6,332 $7,054