Case 20 : Aurora Textile Company

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Case 20: Aurora Textile Company
GROUP QUESTIONS

Learning Objectives:
1.The basics of incremental-cash-flow analysis: identifying the cash flows relevant to a capital-investment decision 2.The construction of a side-by-side discounted-cash-flow analysis for a replacement decision 3.How to adapt the NPV decision rule to a troubled industry 4.The recognition that a reduced investment horizon is a significant consequence of financial distress 5.The importance of sensitivity analysis to a capital-investment decision

Case Questions

1.How has Aurora Textile performed over the past four years? Be prepared to provide financial ratios that present a clear picture of Aurora’s financial condition.

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 comparable with which to gauge the performance of Aurora, we utilized a trend analysis of the period 1999 through 2002. With 1999 as a reference point, we noticed that all measures of profitability have worsened. On a cumulative annual basis, net sales have been declining by 15%, while profit margins and ROA were always in the negative (see exhibit 1). While raw material cost as a percentage of net sales have been declining, the cost of conversion is escalating and affecting the bottom-line (see exhibit 1). It is obvious that Aurora needs to manage its expenses to generate profits from sales. While on the surface, the liquidity measures have improved (see exhibit 1), it is doubtful that the company has the ability to meet its current obligations with just cash and cash equivalents on hand. This is partially due to the fact that many of the firm’s current assets are predominantly account receivables and inventories. While it is true that the firm, its competitors, and the industry are continuing to lose money, an effective cost-control strategy – i.e. a strategy that improves profit margins, reduces operating costs, and appropriately manages inventory and account receivables will be crucial for Aurora to remain sustainable.

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 NPVs—one for the status quo and one for the new machine.) Status Quo

In the first year of the project, we calculated net sales assuming the current 500,000 pounds per week production level at a $1.0235 selling price per pound (52-week year). After the first 3 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. Change in inventory is cash spent 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 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 $8.91...
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