AURORA TEXTILE COMPANY

In January 2003, Michael Pogonowski, the chief financial officer of Aurora Textile Company, was questioning whether the company should install a new ring-spinning machine, the Zinser1 351, in the Hunter production facility. A primary advantage of the new ring spinner was its ability to produce a finer-quality yarn that would be used for higher-quality and higher-margin products. The finer-quality yarn would be sold in a niche market that would command a 10% increase in the selling price of yarn, which was currently $1.0235 a pound. In addition, the Zinser would provide increased efficiency as well as greater reliability, which Auroras operations management had been requesting for many years. The Zinsers efficiency would reduce operating costs, with lower power consumption and maintenance expenses. Sales volume, however, would be 5% lower than the current market, and the cost of customer returns would be higher, which, when combined with the $8.25 million installed cost, made the Zinser decision a difficult one.

Notwithstanding this outlook, most research analysts believed that the U.S. textile industry would grow around 2% in real terms, with prices and costs increasing at a 1% inflation rate for the foreseeable future.

Production Technology

Since 2000, the company had succeeded in cutting its SG&A spending by $3.9 million. These efforts had allowed the company to continue operations, but the difficult financial environment was expected to continue to present a challenge for Aurora.

The Zinser 351

The Zinser 351 would replace an older-generation spinning machine in the Hunter plant. The existing machine had been installed in 1997 and was carried on Auroras books at a value of $2 million. If replaced, the existing machine could be sold for about $500,000 for use in Mexico. Management felt that by the time the machine was fully depreciated in 4 years, it would have no market value. Management also believed that, with proper maintenance, the existing machine could continue to operate for 10 more years, at which point the plant was expected to have grown from its current production level of 500,000 pounds a week to its capacity of 600,000 pounds a week.

To match the current production capacity of the Hunter plant would require the purchase of a machine with 35,000 spindles at a cost of $8.05 million. In addition, there would be an installation cost of $200,000, for a total capitalized cost of $8.25 million.5 The new spinning machine would be fully depreciated (straight-line) in 10 years, at which point it would have zero book value, but was expected to realize $100,000 if sold on the open market. Aurora had already spent $15,000 on marketing research to gauge customer interest in its yarn as well as $5,000 on engineering tests concerning the suitability of Hunters ventilation, materials-flow, and inventory systems.

The cost structure of a textile plant was primarily composed of a materials cost (the cost of cotton) and a conversion cost, which included the cost of labor, dyes and chemicals, power, maintenance, customer returns for defects, and various other production and overhead costs. In 2002, the Hunter plants conversion cost was $0.43/lb. Most of the conversion costs would not be affected if the Zinser replaced the existing spinning machine. For example, there would be no change in the work force, although the current operators would need to be trained on the Zinser, at a one-time cost of $50,000, during the installation year. A significant benefit of the Zinser, however, was that it was expected to reduce power and maintenance costs equivalent to a savings of $0.03/lb. The cost of customer returns constituted $0.077/lb. of the conversion costs for 2002. Based on engineering and marketing projections, Pogonowski estimated that the cost of customer returns would rise to $0.084/lb. for the higher-quality yarn produced by the Zinser. As shown in Exhibit 5, the cost per pound was influenced by the return frequency (1.0%), the liability multiplier (7.5), and the expected increase in selling price per pound ($1.0235 110% = $1.126). Depreciation and SG&A expenses were not included as part of conversion costs. SG&A was estimated to remain at 7% of revenues for both the existing spinning machine and the Zinser.

Although the Zinsers reliability would reduce the inventory of unprocessed cotton, buffer stocks would be necessary to hedge against the uncertainties surrounding the cottons timely delivery to the plant as well as slowdowns and shutdowns due to production problems with the spinning machine. The Zinser was becoming widely used by many U.S. yarn producers, and had proved itself a highly reliable machine, with very few production delays, compared with earlier-generation spinning machines. This dependability had allowed most manufacturers to reduce their cotton inventories to 20 days from the average of 30 days (see Exhibit 6 for cotton spot prices).6 When asked about this benefit, the Hunter plant manager responded:

Pogonowski was sensitive to the fact that, over the past four years, shareholders had seen the value of their Aurora holdings fall from about $30 a share to its current price of $12. In light of such poor performance, shareholders might prefer to see the institution of a dividend rather than see money spent on new assets for Aurora. Nevertheless, if buying the Zinser could reverse the downward trend of Auroras stock price, then it would clearly be a welcome event for the owners. Aurora used a hurdle rate of 10% for this type of replacement decision. Pogonowski felt confident that the Zinser would return more than 10% over its expected life of 10 years, but he was less confident that Aurora would be able to remain in operation over that time span.

Questions

a) What is the ICF you will use for the valuation?

b) What will be your terminal cash flow?

c) What will be the relevant (marginal) OCF generated by the Zinzer machine in each of the next 10 years. Explain any assumption you make for sales growth over those years.

d) What is the NPV of switching to the Zinzer machine?

e) What is the IRR of switching?