AURORA TEXTILE COMPANY

Company Background:

Aurora Textile Company is in a tough situation because of the troubled financial condition and US textile
industry as a whole. The manufacturers are relocating to the Asian market but the Aurora Textile
doesn’t want to shift its operations.

Financial Analysis:

From 1999 to 2002, the financial condition is not upto the mark. This is due to the market risks and
competition risks from the other competitors. Net sales have been declining by 15%.

1) The profit margins and the ROA have been declining (information utilized from Exhibit 1).
2) Raw material costs have been declining, however, the conversion cost is escalating and have
been affecting the bottom line. Keeping these things in mind, the Aurora Textile Company needs
to manage its expenses.
3) It is doubtful, that the company has the ability to meet its obligations because most of the
current assets are account receivables and inventories. (information utilized from exhibit 2)
To control these issues, the company needs to look at its cost-control strategy.

Assumptions:

This case study is based upon the idea that we have to analyze that the installation of new machine,
Zinser 351 needs to be installed or not, on the basis of the calculations of the incremental free cash
flows analysis. A couple of assumptions has been mentioned in the case study and some of them have
been assumed by us:

Sales & Volume: The plant is expected produce at least 500000 pounds a week, ( i.e. considering 52
weeks a year). In case of the old machine, the volume grows at 2% while the prices grows at 1% as the
inflation factor incorporated. In the case of Zinser, sales volume is considered 5% lower than the current
value, so this reduction factor has been incorporated. The selling price of the yarn is $1.0235, for
ongoing years, to normalize the sales price, the inflation factor is included. In addition, the maximum
volume to be produced is not more than 600000.

Costs of Goods Sold: The cost of goods sold is categorized into two parts:

a) Direct Costs: It has further been divided into 3 parts:

i) Direct Materials
ii) Cost of returns/pound
iii) Conversion costs/ pound = Conversion Cost – Cost of returns
In all of these costs, the inflation of 1% has been incorporated. The reduction of power and
maintenance cost is also incorporated in the Zinser conversion cost.

b) Indirect Cost: The SG&A is assumed to be 7% of the sales revenues for both the Zinser and the
existing spinning machine.
Depreciation: The straight line method has been used in both the case. In the first case, the depreciation
of $2 million plant for 4 years comes out to be 500000. While in the case of Zinser, the capitalized cost is
$8.25 million, so from the straight line depreciation, the value comes out to be $825000 for each year.

Taxes: The corporate taxes is considered 36% for each year as mentioned in the case study,

Inventory: The days considered in the inventory is 30 for the old machine, while for the Zinser, it is
considered 20 days because the new machine has reduced the dependability. The inventories of finished
goods and raw materials has been calculated on the basis of material costs and costs of goods sold
respectively.

Initial Investment: The initial Investment of the project has been calculated on the following transactions
in consideration:

a) Total capitalized cost $8.25 million of the plant

b) Sale of the existing machine $0.5 million
c) The tax savings from the old machine ($0.5 milliion – $2 million) * 36% = $0.54 million
d) Training expense after incorporation of taxes = $0.5 million * (1-0.36) = $32000
After including all these factors, the initial investment comes out to be $7242000.

Recommendation:

The Aurora Textile Company needs to innovate to stay competitive in the market. The company is
moving towards a high quality product, for which Aurora cannot affords to stay behind it. The Zinser
machine will help the company to meet this agenda. The NPV of the incremental cash flows in case in
which the inventories considered is finished goods and inventories considered raw materials is,
$7772421 and $7367726. The IRR for the first one is 31% and the other one is 28%, higher than the
hurdle rate. The major concern in all these things is the survival of the Aurora Textile Company for 10
years. In addition to acceptance of the project, the spot prices for cotton could be beneficial to the
Aurora Textile Company in the future. However, the company needs to implement other strategies to
improve their profit margins, which includes the reduction of operating charges, management of
inventories and account receivables. These changes will surely help the company to move in the right
direction.