Aurora Textile Company Summary: In early 2003, Michael, CFO of Aurora Textile Company, is deciding whether or not to install a new machine called Zinser 351 in order to save the declined sales and increase its competitive force. In deciding whether or not to invest Zinser 351, it is important to get the NPV and the payback period. To get the NPV and the payback period, we firstly need to forecast the future cash flows that the new machine will generate. We found the ten-year NPV to be $3,171,551 based on the FCFs that we forecast.
Also, we use the payback period to analyze the acceptance of this project. We found that the discounted payback period is 5. 69, which is less than the arbitrary cutoff point of 7. 87. Based on our forecast, the company should invest in the Zinser 351 because of the positive NPV and relatively small payback period Body: In our analysis, we determined that NPV is the most important factor determining if we should accept or reject the Zinser 351 project. Secondly, we established that the payback period is another contributing force in our decision.
The payback period tells us whether we can earn some money in the set period of time but this model has a few drawbacks, such as ignoring timing of cash flows and the positive cash flow after the payback period. In both calculations, NPV and payback period, we forecasted future cash flows (free cash flow).
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In order to forecast the free cash flow for the next ten years, we needed to first predict the operating cash flows—By adding EBIT to depreciation, less tax. To predict the next ten years of EBIT, we needed the proper sales figures, which we calculated by multiplying volume by sales price.
According to our spreadsheet, the sales price is $1. 1259 and we assume volume to decrease at a rate of 95 percent of the expected volume without Zinser per year—(95% of 120,000).
After calculating the operating cash flow for the next ten years, we needed to find estimated FCF (Free Cash Flow).
We found FCF by subtracting capital expense and change in NWC from OCF. Then, we used these FCFs to calculate the ten-year NPV. Our calculations yielded a NPV of $3,171,551 as we use the hurdle rate of 10%. In conclusion, the NPV for the long-term forecasts is positive so we should accept to install the Zinser 351.
Moreover, after predicting the next ten-year discounted free cash flows, we were able to calculate the discounted payback period of 5. 69, comparing with the arbitrary cut off point 7. 87. For the arbitrary cut off point, we use the average return on equity (net income/total equity) of the past 4 years, which is -12. 702%, because it is more accurate and consistent than using the ROE of 2002. Then, we assume that all the equity leaves the company at 12. 702%per year. Hence, the company can maintain operations for 7. 87 years (1/12. 702% = 7. 87).
Ultimately, if the Zinser 351’s payback period is more than 7. 87 years, the company will go bankrupt. According to the spreadsheet, we are able to report that our payback period, 5. 69, is less than 7. 87 and that we should accept to install Zinser 351. On the other hand, there are some issues of concern that we need to address if we use Zinser 351. First of all, the sale price will jump from $5 to $10 by using Zinser 351. This increase in price needs to be countered, so, we need to face the global competition from those foreign textile companies with lower costs.
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According to our spreadsheet, we can see the sales with Zinser is larger than the sales without Zinser, whereas the COGS with Zinser is lower than without Zinser,; thus, our profit margin will be widened in order. Also, the customer’s preference has forced the industry to improve the quality and we believe Zinser 351 will produce that desired high quality product which will give us an edge against those competitors. Additionally, Zinser can effectively decrease the amount of inventory that we use to run the business in comparison to the old machine.
As we know, Zinser can reduce the cotton inventories form 30 days to 20 days—dropping around 714,285. 71 pounds of inventory—per month opening the door for roughly $321,428. 57 of savings per month. Even though the old plant manager suggests using the cost-minimizing strategy, we suggest to consider the way we mentioned above. Then, we have determined the company is better off using Zinser because the WTO lifted the ban on quotas in 2005 resulting in increased competition. With the increased competition we will see that the upply of textiles will increase and force downward pressure on prices. Only the companies with high quality products can survive in this intense competition. We believe Zinser makes the company more competitive than those rivals because of the high quality outputs. According the sensitivity analysis, we still retain a positive NPV and relatively small payback period with Zinser, even after a 35% price drop. Furthermore, using Zinser can dramatically change our company’s outlook because its return as percent of volume is 1% (the return as percent of volume without Zinser is 1. 5%).
As our sensitivity analysis shows, the NPV with (without) Zinser is $3,171,551 (-$908,887) and the discounted payback period is 5. 69 (8. 28).
Finally, there is a cost-benefit approach for investing in the Zinser project that shareholders benefit. As we can see the declined sales for the past four years, the financial situation will be deteriorated continuously if we do nothing. Even though we give up our old machine for a little bit of a loss, we can still get the positive NPV for next ten years which is good for the shareholders because this project can consistently increase the financial situation.
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In conclusion, we should accept Zinser 351 because of the positive ten-year NPV, $3,171,551, and the fact the payback period, 5. 69, is less than the arbitrary cut off point 7. 87. Also, we can reap some merits for using Zinser, such as meeting the strict customer preference, decreasing the inventory, increasing the competitive force, decreasing the product return rate, and improving the financial situation of the company.
