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Aurora Textile Company

Questions
Throughout your analysis you can assume that:
Revenues:
Annual revenues = Annual sales volume (in lb) Yarn price per lb, where
Annual sales volume = Weekly capacity (in lb) 52.
In year 0 (2002), weekly capacity of the old machine is 500,000 lbs and it is 5% less for the
Zinser machine. Annual sales volume will increase at a rate of 2% per year for both machines. In
year 0, yarn price is $1.0235/lb for old machine and it is 10% higher for the Zinser machine.
Yarn price will increase at an inflation rate of 1% per year for both machines.
Costs (excluding depreciation):
Material cost (which is cost of good sold COGS) in year 0 is $0.4509/lb for both machines and
will increase at an inflation rate of 1% per year.
Conversion cost in year 0 is $0.43/lb for the old machine. For the Zinser machine conversion
cost is less by $0.03/lb due to reduced power and maintenance costs but higher by $0.007/lb due
to increased customer returns. Conversion costs for both machines will increase at an inflation
rate of 1% per year.
SG&A cost will be 7% of annual revenues for both machines.
Net Working Capital (NWC):
The level of NWC (mostly inventory in this case) in each year for each machine is determined as
COGS
Days in inventory . Old machine has 30 days in inventory and the Zinser machine has
365

20 days in inventory.
1. How has Aurora Textile performed over the past four years? Please provide financial
ratios (such as days sales in inventory, days sales in receivables or collection period,
asset turnover, profit margin, EBIT margin, return on assets, and return on equity) 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? (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.)
a. What are the initial outlays for each machine?
b. What are the net cash flows associated with the old machine and the Zinser
machine? In other words, what are the benefits over time?
c. What are the terminal values of each machine?

4.

5.

6.

7.

d. Using 10% discount rate and assuming 36% tax rate, what is the NPV for the
replacement project? Does the net present value (NPV) warrant the investment in
the Zinser machine?
Now assume 3% inflation rate (instead of 1% given in the case) and redo your
calculations in part 3. Inflation will affect yarn price, material cost, and conversion cost.
Inflation will also affect the discount rate by increasing it to 12.18%. Does this
adjustment affect the attractiveness of the Zinser machine?
Please estimate the impact on NPV from a change in any of the following elements:
a. Aurora will survive only 4 years, thus investment horizon is 4 years only
b. Due to consistent string of losses incurred in previous years, Aurora will not be in
a tax paying position for many years to come. Thus effective tax rate is 0%.
c. Although it is expected that the sales volume returned due to defective yarn will
drop to 1% with the Zinser machine, however due to unforeseen circumstances it
will drop to 1.25% only.
Now go back to part 3 and assume that due to obsolescence the old machine will not last
for ten years and needs to be replaced in four years. The Zinser machine will still go for
ten years if installed today. Estimate the total cash flows associated with the old machine
(they should stay the same for the Zinser machine), and calculate the Equivalent Annual
Cash Flow for each. Is investing in the Zinser machine a good idea based on these
calculations?
Based on the above analysis, should Michael Pogonowski proceed with the project? Craft
a brief 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.