Aurora Textile Company Case Summary

Introduction

Aurora Textile Company (hereinafter “the Company”) is a yarn manufacturer that

produces cotton and synthetic/cotton blend yarns. The Company has operated for around 100

years, with the domestic textile market creating about 90% of the Company’s revenue. The

Company has four major customer segments, listed from the largest percentage of sales to the

least, they are: hosiery, knitted outerwear, wovens, and industrial and specialty products.

Recently, the U.S textile industry has undergone some hardships. One reason is that several

apparel makers have relocated their production facilities to Asia in search of lower costs.

Another issue is that consumers (especially in high-end markets) have little tolerance for yarn

defects. With the advent of better information technology systems, the liability costs of yarn

producers has increased due to the new ability to trace yarn defects back to the producer.

Because of these hardships, the Company’s sales have been steadily declining. In 2000,

the Company closed four manufacturing facilities. The Company currently has four plants

remaining in operation. The Hunter plant is seeking installation of a new ring-spinning machine,

the Zinser 351. This machine would yield higher quality yarn, allowing for sales in a niche

market that would increase the selling price of yarn by 10%. Additionally, operating costs would

be reduced through greater production efficiency. One downside is that sales volume would be

5% lower and another is that the cost of customer returns (although less frequent) would be

higher. The following is an analysis of cash flows showing whether Michael Pogonowski should

invest $8.25 million and purchase the new machine.

Analysis

Payback Period

The Payback Period is used to determine the length of time that is required to recover

the cost of the initial investment of a project. With the payback period there are two

disadvantages; one it does not take into account the time value of money and second it ignores

the benefits that occur after the investment is paid back. In the case of Aurora Textile the

payback period is 1.9945 years. Assuming a 1% annual inflation, the Payback Period is 1.9753

years. For the calculation of the Payback Period, see Exhibit 2.

Discounted Payback Period

The Discounted Payback Period will take into account the time value of money by

discounting the future cash flows to “time zero.” Using the Discounted Payback Period Aurora

Textile will earn back their initial investment in 2.4095 years. As with the Payback Period, the

Discounted Payback Period still does not recognize the benefits that occur after the investment

is returned. Assuming a 1% annual inflation, the Discounted Payback Period is 2.4212 years.

For the calculation of the Discounted Payback Period, see Exhibit 2.

Though both the Payback Period and Discounted Payback Period are tools Aurora Textile

Company can use to determine whether they should buy Zinser 351 Machine, the sole decision

should not rely on these two methods alone as they do not determine the overall profitability

of the project.

Profitability Index

The Profitability Index calculates how much excess returns a Company is receiving for

investing in a project. The higher the Profitability Index, the better the project. This calculation

takes the present value of expected cash inflows divided by the present value of expected cash

outflows. The project should be accepted if the ratio is greater than 1.0.

For Aurora Textile, the Profitability Index is 2.73. Assuming a 1% annual inflation, the

Profitability Index is 3.06. Because this ratio is greater than 1.0, the project should be accepted

using this decision rule by itself. For the calculation of the Profitability Index, see Exhibit 5.

Average Accounting Rate of Return

The Accounting Rate of Return uses Net Income to calculate the return on investment a

Company receives on a project. The higher the Accounting Rate of Return, the better the

project. The percentage return is calculated by taking the project’s average Net Income per

year divided by the average Book Value per year. If the projected returns an expected

Accounting Rate of Return greater than the target return of the Company, the project should be

accepted. This calculation is best utilized when comparing more than one mutually exclusive

project. The project with the highest Accounting Rate of Return is the one that should be

accepted.

For Aurora Textile, the Accounting Rate of Return is 0.32. This means the Company is

receiving less Net Income from the project than the book value of the equipment. Additionally,

when looking at each year individually, the ratio does not become greater than 1.0 until years 9

and 10 of the project. Assuming a 1% annual inflation, the Accounting Rate of Return is 0.35.

As a result, the project should be rejected using this decision rule alone. For the calculation of

the Accounting Rate of Return, see Exhibit 6.

Net Present Value

Net present value (NPV) is the difference between the present value of cash inflows and

the present value of cash outflows, which is a central tool for using the time value of money to

evaluate the potential of a long-term investment project. The calculation of present value of

cash inflows (PV) is based on discounted cash flow (DCF) analysis that uses future free cash flow

projections and discounts them using WACC. The calculation of NPV should take inflation and

returns into account. If the NPV of a project is positive, it should be accepted. Using a 10%

discount rate, the NPV of the resulting cash flows for this ten-year project is 14.24 million,

suggesting that the investment for purchasing a new ring-spinning machine, the Zinser 351,

would add huge value to the firm, see Exhibit 5. Assuming a 1% annual inflation, the NPV is

15.30 million. Even assuming that the project can last only four years and has a zero salvage

value––a sensitivity analysis, the calculated NPV is still positive value with 3.69 million (3.72

million if taking the inflation rate of 1% into account), see Exhibit 5. According to the NPV

analysis, the project may be accepted.

Internal Rate of Return

The internal rate of return (IRR) is a rate of return used in capital budgeting that makes the

net present value of all cash flows from a prospective project equal to zero, to measure the

profitability of an investment. Generally speaking, the higher a project's internal rate of return,

the more desirable it is to undertake the project. The calculated IRR for this project is 45.96%,

much higher than the discount rate of 10%, also demonstrating that it is desirable to undertake

this project, see Exhibit 6. Even if the project can last only four years, the IRR for Aurora Textile

is 31.41%, still indicating a feasible project, see Exhibit 6. Based on the analysis on the project’s

IRR, it is an acceptable investment.

Conclusion

Michael Pogonowski should purchase the Zinser 351 for the Hunter production facility.

The attached exhibits illustrate all decision rules assuming both no inflation and alternatively

assuming 1% inflation. The discount rate used is the 10% hurdle rate that the Company has

deemed appropriate for this type of replacement decision. When 1% inflation is calculated into

the cash flows, the discount rate is increased to 11% to maintain continuity between the cash

flow and discount rate. Additionally, our cash flows do not reflect the $15,000 spent on

marketing research or the $5,000 for engineering tests as these are sunk costs and should not

be weighed into the replacement decision.

The payback period is less than two years and the discounted payback period of 2.4095

is only slightly above the 2 year rule of thumb. The profitability index of 2.73 is greater than 1.

The average accounting rate of return (AARR) is 0.32, which is admittedly lower than most

companies would set as a target. However, the net present value of the company is positive

14.24 million, and the internal rate of return is 45.96%, which is greater than the discount rate

of 10%. Thus, all decision rules except for AARR indicate that replacement is a wise decision.

It is important to remember that external factors may also play a role in Michael’s

decision. For example, alterations to the assumptions about increases in sales volume,

decreases in return volume, and the adjustment for inflation could all greatly affect the decision

rule outcomes. Thus, Michael must be confident in all assumptions the Company is making.

Finally, our analysis shows that NPV and IRR indicate the replacement should be made if the

company can remain in operation for at least four years. Michael must be confident in the

continued operation of Aurora Textile Company when deciding to purchase the Zinser 351.