CASE 21
AURORA TEXTILE COMPANY 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 Aurora’s 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 Aurora’s 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
[email protected]. 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 means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. Rev. 2/08.
-2The construction of a side-by-side discounted-cash-flow 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
analysis
for
a
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 Aurora’s 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 NPVs—one 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 Aurora’s 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.
-3(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 Aurora’s 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 Aurora’s 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. Aurora’s 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 Zinser’s 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.
-4Paying 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: “Wouldn’t 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 individual’s 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 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
-5of 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 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: 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 $32,000.
-6Net 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. 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. Epilogue
-7The 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. Management’s 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 companies.
-8Key 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 AURORA TEXTILE COMPANY Financial Ratios (1999–2002)
1999 Sales growth Raw materials/sales Conversion cost/sales SGA/sales EBIT/sales NI/sales Days sales outstanding Days inventory Asset turnover Return on assets Return on equity
54.0% 33.9% 5.9% −0.1% −1.8%
2000 −6.6% 53.3% 36.6% 6.2% −1.8% −2.7%
2001 −20.4% 53.9% 37.1% 6.4% −3.4% −6.1%
2002 −19.4% 44.1% 42.0% 7.0% 0.3% −4.8%
25.7 95.6 1.37
18.5 98.8 1.39
40.7 116.0 1.28
64.5 186.9 1.08
−2.5% −6.2%
−3.8% −9.5%
−7.8% −20.4%
−5.2% −14.8%
-9Exhibit TN2 AURORA TEXTILE COMPANY Status Quo Cash Flows ($000)
Year Sales volume Net sales Cost of materials Conversion costs SG&A Depreciation Operating margin NOPAT + Depreciation Inventory Change in inventory Salvage value Free cash flows
2002 0
2003 1
2004 2
964 (964)
26,520 $27,415 (12,077) (11,518) (1,919) (500) 1,401 896 500 993 (29)
27,050 $28,243 (12,442) (11,865) (1,977) (500) 1,458 933 500 1,023 (30)
($964)
$1,367
$1,403
26,000 $26,611 (11,723)
2005 3
2006 4
2007 5
2008 6
2009 7
2010 8
2011 9
2012 10
27,591 28,143 28,706 29,280 29,866 30,463 31,072 31,200 $29,096 $29,974 $30,879 $31,812 $32,773 $33,762 $34,782 $35,274 (12,818) (13,205) (13,604) (14,015) (14,438) (14,874) (15,323) (15,540) (12,224) (12,593) (12,973) (13,365) (13,769) (14,185) (14,613) (14,820) (2,037) (2,098) (2,162) (2,227) (2,294) (2,363) (2,435) (2,469) (500) (500) 0 0 0 0 0 0 1,517 1,578 2,141 2,205 2,272 2,341 2,411 2,445 971 1,010 1,370 1,411 1,454 1,498 1,543 1,565 500 500 0 0 0 0 0 0 1,054 1,085 1,118 1,152 1,187 1,223 1,259 1,277 (31) (32) (33) (34) (35) (36) (37) 1,259 0 $1,440 $1,478 $1,337 $1,378 $1,419 $1,462 $1,506 $2,824
-10Exhibit TN3 AURORA TEXTILE COMPANY Cash Flows of Zinser Machine Investment ($000)
Year
2002 0
2003 1
2004 2
2005 3
2006 4
2007 5
2008 6
2009 7
2010 8
2011 9
2012 10
Sales volume Net sales Cost of materials Conversion costs SG&A Depreciation Operating margin NOPAT + Depreciation Inventory Change in inventory Net sale of old machine Zinser investment After-tax training cost After-tax salvage value
24,700 25,194 25,698 26,212 26,736 27,271 27,816 28,373 28,940 29,519 30,109 $27,808 $28,648 $29,513 $30,405 $31,323 $32,269 $33,244 $34,247 $35,282 $36,347 $37,445 (11,137) (11,474) (11,820) (12,177) (12,545) (12,924) (13,314) (13,716) (14,130) (14,557) (14,997) (7,984) (10,374) (10,687) (11,010) (11,342) (11,685) (12,038) (12,401) (12,776) (13,162) (13,559) (2,005) (2,066) (2,128) (2,193) (2,259) (2,327) (2,397) (2,470) (2,544) (2,621) (825) (825) (825) (825) (825) (825) (825) (825) (825) (825) 3,971 4,115 4,265 4,418 4,577 4,740 4,908 5,081 5,259 5,443 2,541 2,634 2,729 2,828 2,929 3,034 3,141 3,252 3,366 3,484 825 825 825 825 825 825 825 825 825 825 610 629 648 667 687 708 730 752 774 798 822 (610) (18) (19) (20) (20) (21) (21) (22) (23) (23) 798 1,040 0 (8,250) (32) $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
-11Exhibit TN4 AURORA TEXTILE COMPANY Investment Outlay and Terminal-Value Calculations
Sale of Existing Ring-Spinning Machine Book value Market value Loss Tax savings (36%) Net proceeds for existing machine
Purchase of the Zinser Price of Zinser Building modification Airflow modification Testing Total cost
$2,000,000 500,000 (1,500,000) 540,000 $1,040,000
$8,050,000 115,000 55,000 30,000 $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
-12Exhibit TN5 AURORA TEXTILE COMPANY Incremental Cash Flows and NPV Sensitivity of Zinser Machine Investment ($000)
Year Existing spinning machine New Zinser Incremental cash flows
Project Life NPV (salvage effect ignored) NPV (zero salvage, 36% tax benefit on reported loss) NPV (salvage = 25% book value, 36% tax benefit on reported loss)
0 ($964) ($7,852) ($6,889)
0
1 $1,367 $3,348 $1,981
2 $1,403 $3,440 $2,037
3 $1,440 $3,535 $2,095
4 $1,478 $3,633 $2,155
5 $1,337 $3,733 $2,396
6 $1,378 $3,837 $2,459
7 $1,419 $3,944 $2,525
8 $1,462 $4,054 $2,592
9 $1,506 $4,168 $2,661
10 $2,824 $5,170 $2,346
1 ($5,088)
2 ($3,405)
3 ($1,831)
4 ($359)
5 $1,128
6 $2,517
7 $3,812
8 $5,021
9 $6,150
10 $7,054
($2,658)
($1,441)
($269)
$858
$2,050
$3,187
$4,269
$5,299
$6,276
$7,054
($1,578)
($569)
$425
$1,399
$2,460
$3,485
$4,473
$5,422
$6,332
$7,054
