Aurora Case.ppt

Case :

Aurora Auror a Textile

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Learning Objectives 

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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 capitalinvestment decision

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Suggested Questions for Advance Assignment 

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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. 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 NPVs—one 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.

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The textile industry and Aurora Textile industry in the U.S.   Aurora’s gamble 

Financial Ratios Data Source: P252-253 Exhibit 1,2 4

AURORA TEXTILE C OMPANY

Financial Ratios (1999 –2002)

1999

Sales growth

2000

2001

2002

−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%

−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%

 NI/sales

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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 

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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 management’s 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)

Year

Sales volume

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

0

1

2

3

4

5

6

7

8

9

10

27,591

28,143

28,706

29,280

$30,87 9 (13,60 4)

26,000

26,520

27,050

29,866

30,463

Net sales

$26,611

$27,41 5

$28,243

$29,096

$29,97 4

$31,81 2

Cost of materials

(11,723)

(12,077)

(12,442)

(12,818)

(13,205)

(14,015)

Conversion costs

(11,518)

(11,865)

(12,224)

(12,593)

(12,97 3)

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

(13,365)

31,072

31,200

$32,773

$33,76 2

$34,782

$35,27 4

(14,438)

(14,87 4)

(15,323)

(15,54 0)

(13,769)

(14,18 5)

(14,613)

(14,82 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 Free cash flows

0 ($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  

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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 management’s 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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