CASE 21AURORA TEXTILE COMPANY Teaching Note Michael Pogonowski, the chief financial officer of Aurora Textile Company, was questioning whether the company should replace the current spinning machine at the Hunter production facility with a new ring-spinning machine, the Zinser 351. Because of the poor health of both the textile industry and Aurora Textile, the management team had become engaged in a debate as to whether the company should return excess cash to shareholders or invest in the new machine. The U.S. textile industry had begun to decline as manufacturing migrated to Asia to benefit from lower manufacturing costs. Most U.S. companies had not responded quickly to the changing industry dynamics and suffered heavy financial losses. This, in turn, precipitated a series of bankruptcies in the industry, and Aurora’s recent financial performance had been lackluster as well. The case presents enough information for side-by-side cash-flow projections for the existing spinning machine, which depreciates in 4 years, and the new Zinser machine, which has a 10-year depreciable life. The main driver of the cash flows and the NPV is the improvement in margins due to Aurora’s ability to charge higher prices in a higher-quality market. The margin benefit is offset, to some extent, by a decrease in volume sold and an increase in the liability associated with returns from retailers. A less significant driver is the number of days of cotton held in inventory. To simplify the analysis, the case specifies the cost of capital. The case is suitable for students just beginning to learn finance principles, but is also rich enough to use with experienced students and executives. The learning point about investing in a troubled industry can create a lively debate among students of all experience levels. In this regard, the case serves as a powerful example of one component of financial-distress costs: the reduction of viable investment opportunities owing to a shortened time horizon. The main learning points of the case include the following: The basics of incremental-cash-flow analysis: identifying the cash flows relevant to a capital-investment decision This teaching note was prepared by Lucas Doe (MBA/ME ’04), under the supervision of Professor Kenneth Eades of the Darden School of Business. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright © 2007 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
[email protected]. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. Rev. 2/08. 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. Craft a memo to the board of directors stating your recommendation about investing in the new Zinser machine. Conduct a sensitivity analysis to illustrate that impact and discuss the result as an example of the costs of financial distress. (5 min. (10 min. Teaching-Plan Outline (85-minute class) (10 min. -2- The construction of a side-by-side discounted-cash-flow analysis for a replacement decision How to adapt the NPV decision rule to a troubled industry The recognition that a reduced investment horizon is a significant consequence of financial distress The importance of sensitivity analysis to a capital-investment decision Suggested Assignment Questions 1. 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.) 4.) Discuss the textile industry and Aurora’s current financial condition. Part of your memo should explain why it is better to invest in the Zinser or to pay a dividend to the shareholders. (20 min. List the factors affecting the textile industry.) Discuss the conceptual trade-offs for making a new investment versus paying a dividend to shareholders. (15 min. .) Discuss the impact of being in a troubled industry on the value of the Zinser investment. 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. what do you get as the NPV for the project? What are the value drivers in your analysis? What do you estimate as the cost per pound for customer returns under the Zinser alternative? (Hint: for a replacement decision. What are the relevant cash flows for the Zinser investment? Using a 10% WACC and assuming a 36% tax rate.) Prepare the first few years of cash flows for the new Zinser machine and compute the NPV of the investment. Be sure to explain the primary reasons that justify your recommended course of action. 2.) Prepare the first few years of cash flows for the status quo.) Discuss the merits of doing two side-by-side sets of cash flows versus one comprehensive set of differenced cash flows. (15 min. Coupled with the strong dollar. Part of those protections was the quota system. Sales increased substantially in 2000. and most of the industry migrated to Asia to take advantage of those cost savings. but Aurora’s management has more work ahead to downsize the company and manage its assets more efficiently. this would make the U. producers. however. however. the industry was located near the industrial centers of the United States. which was scheduled to be removed January 1. market a prime target for exporters and put increased pressure on U. the company has failed to turn a profit (net income) for the past four years.) Epilogue. This is an important insight provided by the case. but quickly fell below 1999 levels. 2005. Students should recognize. Assets have been shrinking as Aurora closed down several manufacturing operations and reduced new investments in order to conserve cash. that asset turnover has declined. Aurora is in a troubled industry. it was apparent that the United States could not effectively compete against imports without government protections. It is apparent that Aurora has been facing the same economic pressures as its U. labor became expensive relative to offshore sources. the industry faced declining margins and declining market share. Moreover.S.” If the company can remain in business long enough to allow the Zinser’s efficiencies to be realized. The textile industry and Aurora Starting the class with a discussion about the financial health of both the industry and Aurora sets the stage for thinking about the investment decision for a financially troubled company. -3- (10 min. Once the students recognize the importance of economic life to the investment decision. If the company cannot survive beyond a few years. .S. forcing many companies into bankruptcy. despite the fact that it is operating in a declining industry. however. was whether transportation costs would be a strong enough deterrent to foreign competition to allow enough time for the Zinser to produce sufficient cash flows to add value to the company.S. Most U. The lower cost of labor and proximity to cotton production. there is clearly no reason to “throw good money after bad. Eventually. Originally. Although the results for 2002 offered some glimmer of hope for Aurora by showing a positive operating profit. U. The value of the Zinser is highly dependent on how long it will be in place. Textiles is a classic example of an industry that evolved within a changing set of economic conditions. accounts receivable and inventory show major signs of poor management as days sales outstanding and days inventory have both significantly increased since 1999. companies were unable to respond quickly to the changing industry dynamics. as a result. Rapidly changing customer preferences and fads created the need for shorter production lead times.S. motivated textile manufacturers to relocate in the South. The financial ratios in Exhibit TN1 paint a bleak picture of Aurora’s financial health. heavier products in the United States. For decades. The question. however. Aurora’s gamble is that the cost of shipping products from Asia to the United States would continue to allow the production of bulkier. however. the investment will add value to the company. the instructor can promise to return to this discussion later in the class as part of the sensitivity analysis. indicating that Aurora has not contracted assets as fast as the decline in sales. competitors: declining margins and sales.S. 45/lb. -4- Paying a dividend to shareholders After some discussion. Status quo cash flows Exhibit TN2 presents the base-case cash flows for the status quo: assuming that Aurora continues to operate the existing ring-spinning machine. which equals the frequency .43/lb. individual investors will not have positive NPV investment available to them. students will eventually realize that the dividend question is equivalent to asking whether management should pursue all positive net-present-value projects. Assuming that the student followed the suggestion in the study questions. ultimately. If not. times volume. Companies. conversion cost equals $0. Materials cost and conversion cost: Materials cost equals the materials cost per pound ($0. If we assume a reasonable amount of capital-market efficiency. The unhealthy nature of the textile industry appears to make the dividend question more complicated until the students recognize that even companies in poor businesses can create value. so why bother to write out the status quo cash flows?” After a bit of discussion.611 million) equals price per pound ($1. she will begin by talking about two sets of cash flows: one for the status quo and one for adding the Zinser. Subsequent years’ forecasts are grown by management’s guidance for growth of 2% and the inflation rate of 1%. however.000 lb. I like to cold-call a student to give an overview of her approach to the problem./week) times 52 weeks in a year. Likewise. But if the company expects to survive long enough. may well have access to positive NPV investments so that the shareholders of a public company will be better served if cash is invested in those projects rather than paid out as a dividend. the class should conclude that both methods should give the same answer and. we only need to know how things change. As discussed earlier. I strongly prefer the side-by-side cash flows as the analyst is less likely to omit relevant cash flows and more likely to understand the key value drivers of the project. the main concern for Aurora management should be whether the company can operate long enough for the Zinser to be a positive NPV project. then management should conclude that shareholders are better served by paying as much in dividends as the lenders will allow. it is the individual’s own preference that will decide which way to go. What follows are the explanations of each of the line items: Net sales: Year 1 sales ($26. Conversion cost includes the cost of returns from retailers.) times capacity per week (500. then the value of the company via its future cash flows will be maximized by investing in the project. however. The discounted-cash-flow analysis Before putting any numbers on the board.) times the volume for the year. I like to tell the student that her approach sounds reasonable and in line with the study-question suggestion: “Wouldn’t it be easier to create only one set of incremental cash flows? After all.0235/lb. Based on my experience teaching capital-investment analysis. -5- of retailer returns (1. Depreciation: Depreciation is computed using the straight-line method for the book value of the existing spinning machine ($2 million) and depreciable life of four years.000).000. Carryforward and carryback provisions in the tax code could eliminate any actual cash taxes for Aurora for many years to come. . Cash flows from investing in the Zinser Exhibit TN3 presents the base-case cash flows under the assumption that the Zinser machine is purchased.000) times the tax rate. when the inventory level is recovered.077/lb.05 million). the true tax rate on a present-value basis lies somewhere between the nominal rate of 36% and zero.5%) times the liability multiplier (the ratio of reimbursement cost to yarn revenue).25 million. I prefer to state it explicitly as an assumption for students (see the suggested assignment questions).5% × $1. but the case works better if students treat the analysis as if the company were facing the full tax rate. = $0. The effective marginal tax rate is difficult to estimate accurately. What follows are the explanations of those cash flows: Net initial investment: The total cash payment for the Zinser equals $8. Cash flow from depreciation equals depreciation ($500. an airflow-modification cost ($55. Returns as a cost per pound is computed by multiplying by the price per pound: 7. with the most recent percentage of sales at 7%.4 million) and tax savings of $216.000). Salvage value and initial investment: The salvage value and the initial investment are both zero for the existing machine. and a testing cost ($30.000 from the sale of the old spinning machine at less-than-book value (Exhibit TN4). a building-modification cost ($115. Training cost: Training cost is stated in the case as $50. Inventory: Inventory equals COGS divided by number of calendar days (360) times number of days of inventory (30). owing to its consistent string of losses.5% = 7.02/lb. The cash flow equals the change in inventory level each year until year 10.000). making the after-tax cost $32.5%. Thus. Selling and general administrative expenses: Exhibit TN1 shows that SG&A has been trending upward. This is an interesting issue to discuss as time permits. Taxes: Although the income statements reveal that the tax rate is 36%.000. which is assumed as the future relationship. Some students will point out that Aurora has not been paying taxes. that is. which comprises the cost of the machine ($8. The total cash payment is offset by the after-tax proceeds from the sale of the existing spinning machine ($1. Cost of capital: Cost of capital is stated in the case as 10%. $25/$5 = 5 × 1. less taxes on gain (Exhibit TN4). the conversion cost for Zinser equals $0. The net present value of the incremental cash flows using the 10% discount rate is $7. and the amount of volume decline. The value of the Zinser was $8. The four-year breakeven ignores any impact of salvage value on the NPV.) times the volume for the year. we should assume a positive salvage to reflect a more favorable outcome for the company. Salvage value: The salvage value for the new machine equals the market value after 10 years ($100.054 million.611 million) equals price per pound ($1.054 million and the internal rate of return (IRR) is 29%. Depreciation: Depreciation was computed using the straight-line method. when the inventory level is recovered. A zero salvage is more likely to be closer to what Aurora would realize if the company should fail and be forced to sell its assets under duress. Subsequent years’ forecasts are grown by management’s guidance for growth (2%) and the inflation rate of 1%. If Aurora is purchased by a competitor. The discussion at the beginning of class should prime students to consider how the economic life of the project affects its value to Aurora.45/lb. Any salvage value or any ability to take advantage of reported tax losses will serve to lower the break-even life and make the project more favorable to management. If the company survives for the entire 10 years. making for an annual depreciation expense of $825. ($0. the base-case analysis should prompt students to conclude that the Zinser adds value and is a better use of funds than paying a dividend so long as the investment horizon of 10 years is achievable. Epilogue .000. -6- Net sales: Year 1 sales ($26. Thus. times volume less power and maintenance cost savings of $0. however.43/lb.0077). Other value drivers to the analysis include the return frequency for the Zinser./week) times 52 weeks in a year. Exhibit TN5 presents a sensitivity analysis of the economic life of the project. − $0. the NPV equals $7.0768/lb. which was zero. Thus. The cash flow equals the change in inventory level each year until year 10.03/lb.43 – 0. the NPV is approximately a breakeven.25 million and the depreciable life was 10 years. ($0.000 lb. NPV calculation The incremental cash flows for the investment decision (Exhibit TN5) are computed as the Zinser cash flows (Exhibit TN3) less the status quo cash flows (Exhibit TN2).4077/lb.0077/lb.) times capacity per week (500. Inventory: Inventory equals COGS divided by number of days in a calendar year (360) times number of days of inventory (20).03 + 0. the amount of realized price increase.).0844/lb. Conversion cost equals $0. Case Exhibit 5 shows that the cost of returns is expected to increase by 10%.000) less net book value. Materials cost and conversion cost: Materials cost equals the materials cost per pound ($0.02/lb. or $0. If the company can survive four years. This makes the Zinser an example of how financial distress can create costs for a company. but it may suggest that management was overly optimistic about its position in the market. Any increase in volume increases shareholder value so that the investment creates noticeable upside potential. Against Aurora going forward with the investment: The highly competitive industry would see an increase in competition immediately following the removal of the quota system. This would be a good time to liquidate and return cash to shareholders. As the likelihood of bankruptcy rises and the expected life of the firm falls. assets are likely to have decreased further in value. . most long-term investments become infeasible for the company. Rapidly changing customer preference and fads may require more flexibility than Aurora has or can have. market more desirable for exporters. The integration of the global economy and the stronger dollar will only make the U. which is exactly what was needed to survive. Being in the profitable high-end market could motivate employees. The investment was made. Cheaper production costs abroad will continue to make it difficult for Aurora to compete. If time permits at the end of class. but the company failed after a couple of years and its assets were sold at bargain-basement prices. which could translate into increased volume sold. Management’s focus becomes very myopic in an attempt to meet short-term obligations and keep the firm afloat. Aurora would become a niche player that could quickly respond to customer demands. Below are typical arguments for and against attempting to keep the company alive: In favor of Aurora going forward with the investment: The Zinser would position Aurora in the profitable high-end market. the instructor can return to the discussion of the importance of the economic life before reporting the epilogue.S. The basic question is whether students believe that Aurora can survive long enough to realize a positive NPV. either because of depreciation or because of an asset glut in the market from the liquidation of other textile companies. This outcome does not. mean that the decision to invest was incorrect. If the firm waits five years. by itself. -7- The case is a stylized version of an actual investment decision faced by a company in the textile industry. 1% −4.6 98.1% Conversion cost/sales 33.7 18.7 64.4% Raw materials/sales 54.3% 53.37 1.08 Return on assets −2.8% Days sales outstanding 25.2% −9.9% 44.8% −3.5 40.39 1.5% −20.3% NI/sales −1.4% 0.8% −2.8 116. -8- Key drivers such as price increment and volume sold can change by small amounts to make the investment unprofitable.5 Days inventory 95.7% −6.8% −5.5% −3.28 1.9 Asset turnover 1.1% −1.9% 36.0% 53.4% −14.0% EBIT/sales −0.8% .8% −7. Exhibit TN1 AURORA TEXTILE COMPANY Financial Ratios (1999–2002) 1999 2000 2001 2002 Sales growth −6. and management may have very little influence on these factors.4% −19.4% 7.6% 37.2% 6.6% −20.1% 42.0% SGA/sales 5.2% Return on equity −6.0 186.9% 6. 085 1.411 2.820) SG&A (1.919) (1.365) (13.773 $33.000 26.072 31.613) (14.243 $29.077) (12.259 Salvage value 0 Free cash flows ($964) $1.143 28.152 1.187 1.520 27.769) (14.118 1.294) (2.277 Change in inventory (964) (29) (30) (31) (32) (33) (34) (35) (36) (37) 1.141 2.543 1.401 1.205 2.874) (15.440 $1.478 $1.337 $1.706 29.604) (14.611 $27.824 .403 $1.274 Cost of materials (11.591 28.498 1.415 $28.445 NOPAT 896 933 971 1.866 30.280 29.518) (11.185) (14.463 31.865) (12.454 1.723) (12.323) (15.096 $29.578 2.411 1.363) (2.462 $1.540) Conversion costs (11.223 1.341 2.015) (14.010 1.565 + Depreciation 500 500 500 500 0 0 0 0 0 0 Inventory 964 993 1.974 $30.200 Net sales $26.054 1.272 2.419 $1.879 $31.506 $2.435) (2.205) (13.037) (2.812 $32.370 1.367 $1.762 $34.050 27.442) (12.438) (14.973) (13.782 $35.227) (2.224) (12.098) (2.818) (13.593) (12.259 1. -9- Exhibit TN2 AURORA TEXTILE COMPANY Status Quo Cash Flows ($000) 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Year 0 1 2 3 4 5 6 7 8 9 10 Sales volume 26.162) (2.977) (2.517 1.378 $1.023 1.458 1.469) Depreciation (500) (500) (500) (500) 0 0 0 0 0 0 Operating margin 1. 327) (2.837 $3.484 + Depreciation 825 825 825 825 825 825 825 825 825 825 Inventory 610 629 648 667 687 708 730 752 774 798 822 Change in inventory (610) (18) (19) (20) (20) (21) (21) (22) (23) (23) 798 Net sale of old machine 1.252 3.852) $3.212 26.271 27.776) (13.808 $28.634 2.577 4.440 $3. -10- Exhibit TN3 AURORA TEXTILE COMPANY Cash Flows of Zinser Machine Investment ($000) 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Year 0 1 2 3 4 5 6 7 8 9 10 Sales volume 24.633 $3.373 28.005) (2.736 27.177) (12.247 $35.244 $34.929 3.700 25.130) (14.648 $29.418 4.348 $3.170 .034 3.828 2.908 5.081 5.314) (13.168 $5.109 Net sales $27.397) (2.940 29.545) (12.347 $37.971 4.342) (11.997) Conversion costs (7.259) (2.944 $4.141 3.282 $36.519 30.323 $32.443 NOPAT 2.984) (10.541 2.544) (2.470) (2.366 3.405 $31.513 $30.115 4.259 5.816 28.621) Depreciation (825) (825) (825) (825) (825) (825) (825) (825) (825) (825) Operating margin 3.559) SG&A (2.557) (14.066) (2.535 $3.474) (11.685) (12.054 $4.128) (2.716) (14.374) (10.194 25.687) (11.162) (13.924) (13.698 26.040 0 Zinser investment (8.729 2.010) (11.265 4.445 Cost of materials (11.733 $3.269 $33.401) (12.038) (12.193) (2.137) (11.740 4.250) After-tax training cost (32) After-tax salvage value $64 Free cash flows ($7.820) (12. 000 Building modification 115.000 Market value 500.040.500.000 Airflow modification 55.000 Testing 30.000 Loss (1.000 Sale of the Zinser at the End of Year 10 Book value $0 Market value 100.050.000 Gain 100.000 Net proceeds for existing machine $1. -11- Exhibit TN4 AURORA TEXTILE COMPANY Investment Outlay and Terminal-Value Calculations Sale of Existing Ring-Spinning Machine Book value $2.000) Net proceeds $64.000.000 Total cost $8.000 Purchase of the Zinser Price of Zinser $8.000) Tax savings (36%) 540.000 Tax on gain (36.000 .250. 155 $2.485 $4.168 $5.440 $3.367 $1.661 $2.128 $2.506 $2.269 $5.824 New Zinser ($7.348 $3.733 $3.054 .473 $5.050 $3.054 NPV (salvage = 25% book value.054 $4.419 $1.037 $2.399 $2.021 $6.337 $1.299 $6.812 $5.403 $1. -12- Exhibit TN5 AURORA TEXTILE COMPANY Incremental Cash Flows and NPV Sensitivity of Zinser Machine Investment ($000) Year 0 1 2 3 4 5 6 7 8 9 10 Existing spinning machine ($964) $1. 36% tax benefit on reported loss) ($2.054 NPV (zero salvage.150 $7.981 $2.332 $7.276 $7.633 $3.535 $3.944 $4.170 Incremental cash flows ($6.346 Project Life 0 1 2 3 4 5 6 7 8 9 10 NPV (salvage effect ignored) ($5.462 $1.440 $1.088) ($3. 36% tax benefit on reported loss) ($1.578) ($569) $425 $1.422 $6.525 $2.478 $1.837 $3.831) ($359) $1.517 $3.095 $2.459 $2.889) $1.378 $1.460 $3.592 $2.405) ($1.187 $4.852) $3.396 $2.658) ($1.441) ($269) $858 $2.