Case :

Aurora Textile

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 Learning Objectives

The basics of incremental-cash-flow analysis: identifying

the cash flows relevant to a capital-investment decision
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

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Suggested Questions for Advance Assignment
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.
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?
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.)
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. 3
 The textile industry and Aurora

Textile industry in the U.S.

Auroras gamble

Financial Ratios

Data Source:
P252-253 Exhibit 1,2
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 AURORA TEXTILE COMPANY
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%
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Paying a dividend to shareholders

Whether management should pursue all

positive net-present-value projects?

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 Status quo cash flows
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.

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 Selling and general administrative expenses: SG&A has been trending upward,
with the most recent percentage of sales at 7%, which is assumed as the future
relationship.
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: 36%
Cost of capital: 10%.

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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 volume 26,000 26,520 27,050 27,591 28,143 28,706 29,280 29,866 30,463 31,072 31,200
$27,41 $29,97 $30,87 $31,81 $33,76 $35,27
Net sales $26,611 5 $28,243 $29,096 4 9 2 $32,773 2 $34,782 4
(13,60 (14,87 (15,54
Cost of materials (11,723) (12,077) (12,442) (12,818) (13,205) 4) (14,015) (14,438) 4) (15,323) 0)
(12,97 (14,18 (14,82
Conversion costs (11,518) (11,865) (12,224) (12,593) 3) (13,365) (13,769) 5) (14,613) 0)
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

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 Cash flows from investing in the Zinser
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.

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 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.
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.
Net initial investment: $8.25 million
The total cash payment is offset by the after-tax proceeds from the sale of
the existing spinning machine
Training cost

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