Summary and Problem:-

Aurora Textile Company (ATC), a yarn manufacture company which was established in the early 1900s, catered to both domestic and international textile industries. Aurora Textile financial performance has been poor during the last few years. Its four main major customer segments are hosiery, knitted outerwear, woven and industrial and specialty products. Also, Aurora’s managers believe that the woven market provides the best growth opportunity.. Aurora was left with four operational manufacturing plants after Aurora had to close four of its inefficient manufacturing plants in 2000. The operational manufacturing plants include Hunter, Rome, Barton and Butler.

Aurora relied heavily on the domestic textile market which compromised of 90% of its total revenue. But even in the domestic market aurora faced strict challenge and severe competition in the textile-mill industry which drove its margins to minimum. Relaxed trade policy of the United States and cheaper productions costs overseas meant that many yarn-manufacturing firms now moved abroad and started exporting their products to the US aggressively. A factor that contributed to the increased difficulty of aurora was shift in consumer preferences and fads which were experiencing a shift towards finer-quality yarn with minimum defects. Also the trend of customized goods increased. Additionally, enhancements in computerized technology eased the trace-back of defective products which resulted in increased dollar liability per garment. Moreover, a forthcoming ban on trade-quotas and Trade agreements resulted in an even more competitive domestic environment. As a result, Aurora’s demand for its products was affected heavily due to an overwhelming influx of similar products from overseas.

Regarding the processes, Ring spinning process was currently part of the operations at only one of Aurora’s four plants: Hunter. Even though the current process produced a higher quality of yarn, however, it was relatively expensive. A new spinning machine was suggested in place of it, and that is where Zinser 351 and Michael Pogonowski come into the spotlight.

Michael Pogonowski, CFO at Aurora Textile Company, had to make a challenging decision of wether replacing the older-generation spinning machine with Zinser 351, a new ring-spinning machine, at Aurora’s Hunter production facility which could prove crucial to ATC’s future.

The adverse financial climate was such that Aurora had faced consecutive losses for four years and as a result the company now faced a difficult situation concerning its working capital and cash flows. Michael now had to weigh in the costs and benefits of the Zinser 351. The company used a hurdle rate of 10% for such replacement projects. Zinser would produce a higher-quality yarn, thus enabling Aurora to charge a price that would be 10% higher than before. Moreover, lower power consumption and maintenance expenses would result in a savings of $0.03/lb. But since due to the increase in the price, the sales volume would suffer by suffer by 5%. Also note that the dollar liability per garment would now be higher since the superior product would cater to a higher-end market. To add to these down factors is the intimidating cost of USD 8.25 million which further increases the risk of the project. Also despite the increased reliability of Zinser, the plant manager of Hunter viewed this as a threat to his strategy of changing inventory in accordance with the

varying price trends. Also, cheap labor opportunities abroad further challenge the existence of Aurora. Additionally, price of Zinser 351 is increasing at a rate of 5% annually further increasing the tension. As a result, a delay in the project can seriously harm Aurora textile financially. Thus these mixed views added to the difficulty of the CFO’s decision who was confident that the project would provide a greater return than the hurdle rate, but was rather unsure if Aurora would even live to see this benefit.

Analysis of the problem:

(NOTE: Most of the numbers given are in thousands)

We have calculated the NPV and IRR for the two projects 1) Using existing Machinery, 2)Using Zinser 351. Also we have calculated incremental IRR. We will go through some basic assumptions, and for your reference I have attached some of our exhibits.

First of all we will go through the case where Aurora uses Zinser and replaces existing machinery, But before that we will need the initial Cashflow when replacing the machine. Following is the Cash Flow:

Initial CF ($ 000)Zinster Cost 8250Add training cost 50Sale Value of Old machine 500Book Value 2000Loss on Sale 1500Tax Gain on Loss of Sale 540Initial Outflow ($7,260.00)

As we can see the initial outflow is -7260 (in thousands)

Also the depreciation for Zincer is as follows:

Depreciation of Zinser ($) Machinery Cost $8,250,000 Scrap Value $0 Useful Life 10 Depreciation per year $825,000 Depreciation per year ($ 000) 825

The new conversion cost is:

New Conversion Cost ($/lb)Current conversion cost 0.43

Increase in Customer returns0.00

7Decrease in power & maintenance 0.03Conversion Cost 0.40

7Next we can calculate the forecasted income statement (look in the excel sheets). Some assumptions taken include 1% Inflation rate, 8.25 million machine will be depreciated over 10 years, no considerable changes in inventory, 0.2 % annual growth rate for the next 10 years and annual production =weekly prod * 52. Also SG and A expenses were estimated at 7% of Net sales. Once we got the NOPAT we calculated free cash flows as well (look in the exhibit for more details. We got the following results:

Hurdle Rate 10%NPV of Zinser 351 $10,626.73 IRR 40.34%

Now to show that using Zinser was better than existing machine we used the concept of Incremental IRR and NPV, For that we took similar assumptions (as stated above) and calculated the forecasted income statement for existing machine and found the free cash flows with existing machine. Then we calculated Incremental Cash flows, then Incremental IRR and NPV and the results were as follows:

Hurdle Rate 10%Incremental NPV $3,086.92 Incremental IRR 19.55%Profitability Index 2.44Payback Period 4.08 yearsDiscounted Payback Period 5.12 years

As we can see the Incremental IRR is greater than hurdle rate and Incremental NPV is greater than zero, therefore Zinser project should be accepted.

Recommendations:-

Apart from the numbers we would recommend that based on the current market conditions, it would be wise of Michael Pogonowski to not only rely on numbers. With a reasonable hurdle rate of 10%, the decision to incorporate Zinser 351 in the operations at Hunter facility seems to be the appropriate one since the benefits outweigh the costs involved, however management needs to consider other options which includes to either close down one or two of Aurora’s rotor-technology plants (say Rome and Butler) in order to set up a manufacturing plant abroad where production costs are significantly less. Thus the dependency of Aurora on the domestic industry will decrease. Also, Aurora to rank its product segments and terms of growth and focus on them accordingly. For example Aurora could strengthen its stronghold in wovens segment which believed to have a lot of growth potential. Similarly, Industry and specialty products also present favorable prospects for growth because of their high-margins. If the Zinser operation as well as these strategies can be implemented, they can turn around the table for Aurora.

ExhibitsFor Zinser Machine (Projected Income statement and FCF’s)

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012Pounds Shipped (000's) 26000 24748.96095 24798.01895 24847.1742 24896.42688 24945.7772 24995.22533 25044.77149 25094.41585 25144.15863 25194Selling price/lb $1.02 $1.14 $1.15 $1.16 $1.17 $1.18 $1.20 $1.21 $1.22 $1.23 $1.24Conversion cost/lb $0.43 $0.43 $0.44 $0.44 $0.45 $0.45 $0.46 $0.46 $0.47 $0.47 $0.47Raw material cost/lb $0.45 $0.46 $0.46 $0.46 $0.47 $0.47 $0.48 $0.48 $0.49 $0.49 $0.50Net sales $26,611.00 $28,142.25 $28,480.02 $28,821.84 $29,167.76 $29,517.83 $29,872.11 $30,230.63 $30,593.46 $30,960.65 $31,332.24Raw material cost $11,723.40 $11,270.90 $11,406.17 $11,543.07 $11,681.61 $11,821.81 $11,963.70 $12,107.29 $12,252.60 $12,399.66 $12,548.48Cost of conversion $11,169.60 $10,738.48 $10,867.36 $10,997.79 $11,129.79 $11,263.37 $11,398.55 $11,535.35 $11,673.80 $11,813.91 $11,955.70Gross Margin $3,718.00 $6,132.88 $6,206.49 $6,280.98 $6,356.36 $6,432.65 $6,509.86 $6,587.99 $6,667.06 $6,747.07 $6,828.05SG & A expenses $1,862.77 $1,969.96 $1,993.60 $2,017.53 $2,041.74 $2,066.25 $2,091.05 $2,116.14 $2,141.54 $2,167.25 $2,193.26Depreciation & amortization $500.00 $825.00 $825.00 $825.00 $825.00 $825.00 $825.00 $825.00 $825.00 $825.00 $825.00Operating Profit $1,355.23 $3,337.92 $3,387.88 $3,438.45 $3,489.62 $3,541.40 $3,593.81 $3,646.84 $3,700.51 $3,754.83 $3,809.80Tax rate 36% $487.88 $1,201.65 $1,219.64 $1,237.84 $1,256.26 $1,274.90 $1,293.77 $1,312.86 $1,332.19 $1,351.74 $1,371.53Net earnings $867.35 $2,136.27 $2,168.25 $2,200.61 $2,233.36 $2,266.50 $2,300.04 $2,333.98 $2,368.33 $2,403.09 $2,438.27

Start of 2003 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012NOPAT $2,136.27 $2,168.25 $2,200.61 $2,233.36 $2,266.50 $2,300.04 $2,333.98 $2,368.33 $2,403.09 $2,438.27Add Depreciation & Amortization $825.00 $825.00 $825.00 $825.00 $825.00 $825.00 $825.00 $825.00 $825.00 $825.00Change in Payables (Returns) $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00Change in Inventory $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00Terminal CF $100.00Free Cash Flows $2,961.27 $2,993.25 $3,025.61 $3,058.36 $3,091.50 $3,125.04 $3,158.98 $3,193.33 $3,228.09 $3,263.27

Free Cash Flow($ 000)

For Existing machine (Projected Income statement and FCF’s)

Inflation % 1%Annual Growth %0.20%

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012Pounds Shipped (000's) 26000 26051.5378 26103.1778 26154.9202 26206.7651 26258.7128 26310.7635 26362.9174 26415.1746 26467.5354 26520Selling price/lb $1.02 $1.03 $1.04 $1.05 $1.07 $1.08 $1.09 $1.10 $1.11 $1.12 $1.13Conversion cost/lb $0.43 $0.43 $0.44 $0.44 $0.45 $0.45 $0.46 $0.46 $0.47 $0.47 $0.47Raw material cost/lb $0.45 $0.46 $0.46 $0.46 $0.47 $0.47 $0.48 $0.48 $0.49 $0.49 $0.50Net sales $26,611.00 $26,930.39 $27,253.61 $27,580.71 $27,911.73 $28,246.73 $28,585.75 $28,928.83 $29,276.04 $29,627.41 $29,983.00Raw material cost $11,723.40 $11,864.10 $12,006.50 $12,150.60 $12,296.43 $12,444.02 $12,593.37 $12,744.52 $12,897.48 $13,052.27 $13,208.93Cost of conversion $11,169.60 $11,303.66 $11,439.33 $11,576.62 $11,715.56 $11,856.17 $11,998.47 $12,142.48 $12,288.21 $12,435.70 $12,584.95Gross Margin $3,718.00 $3,762.62 $3,807.78 $3,853.48 $3,899.73 $3,946.54 $3,993.91 $4,041.84 $4,090.35 $4,139.44 $4,189.12SG & A expenses $1,862.77 $1,885.13 $1,907.75 $1,930.65 $1,953.82 $1,977.27 $2,001.00 $2,025.02 $2,049.32 $2,073.92 $2,098.81Depreciation & amortization $500.00 $500.00 $500.00 $500.00 $500.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00Operating Profit $1,355.23 $1,377.50 $1,400.03 $1,422.83 $1,445.91 $1,969.27 $1,992.90 $2,016.82 $2,041.03 $2,065.52 $2,090.31Tax rate 36% $487.88 $495.90 $504.01 $512.22 $520.53 $708.94 $717.44 $726.06 $734.77 $743.59 $752.51Net earnings $867.35 $881.60 $896.02 $910.61 $925.38 $1,260.33 $1,275.46 $1,290.77 $1,306.26 $1,321.94 $1,337.80

Start of 2003 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012NOPAT $881.60 $896.02 $910.61 $925.38 $1,260.33 $1,275.46 $1,290.77 $1,306.26 $1,321.94 $1,337.80Add Depreciation & Amortization $500.00 $500.00 $500.00 $500.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00Change in Payables (Returns) $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00Change in Inventory $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00Terminal CF $0.00Free Cash Flows $1,381.60 $1,396.02 $1,410.61 $1,425.38 $1,260.33 $1,275.46 $1,290.77 $1,306.26 $1,321.94 $1,337.80

Free Cash Flow($ 000)