Essay on Case 20 : Aurora Textile Company

1571 Words Nov 13th, 2012 7 Pages
Case 20: Aurora Textile Company

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,
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The main difference between investing in the Zinser machine and maintaining the status quo is an initial investment of $8.25 million and the receipt of $608,000 in after-tax sales proceeds from selling the existing machine. Additionally, there is an initial $50,000 ($32,000 after-tax) cost for training employees, but this cost is only incurred once (see exhibit 3). In their first year using the Zinser machine there will be a 5% decrease in sales volume, but selling price will increase 10%. Material costs per pound will be the same as the status quo, but conversion costs will decrease to $0.4077 per pound per year due to lower power, maintenance and return costs. Days of inventory held will also drop to about 20 days. All other assumptions are the same as the status quo. In this scenario, the NPV of the Hunter Plant is about $15.87million if Aurora invests in the new Zisner machine (see exhibit 3).

Incremental Cash Flows - The Net Effect of the New Project
When looking at the incremental cash flows for the new project, replacing the old machine with the Zinser machine is a good investment. The NPV of the investment is $6.33 million and the IRR is 28%, much higher than the 10% hurdle rate (see exhibit 4). While all the assumptions made could affect the NPV of the project, the major concern that could erode the value of the project is whether Aurora can survive for 10 years. In our early termination

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