Silk Road Textile Company Case Study Assingment Help With Solution
Silk Road Textile Company
It was 2014, Michael Bolton, the chief financial officer of Silk Road Textile Company, was thinking whether the company should replace the current open-end spinning machine (hereafter OSM) at their WA production facility with a new ring-spinning machine (hereafter RSM). The Australia textile industry had begun to decline as manufacturing migrated to Asia to benefit from lower manufacturing cost.
Silk Road’s recent financial performance had been lacklustre as well. Mr Bolton believed that the decision to invest in the new technology was complicated by Silk Road’s current financial performance. Yet, Silk Road was competing in a few selected markets that were likely to continue to survive foreign competition. Apparently, RSM was more expensive than OSM, but the yarn quality from RSM was better. And the price for RSM had been increasing 5% annually, which recognized by Mr Bolton that there was unlikely to be a better time to upgrade to RSM.
However, not every member of the management team agreed with Mr Bolton. Some argued that it would be cheaper to continue with the current open-end machine. So, Michael Bolton had his financial team to work out a capital budget analysis to see whether this proposal was viable or not. And his financial team prepared all of the numbers together as below: The current OSM had been installed in later 1990s with book value of $2 million. If replaced, the existing machine could be sold for about $500,000 for use in Vietnam. Management felt that by the time the machine was fully depreciated in 4 years, it would have no market value. Yet, management also believed that with proper maintenance, the OSM 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.
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The purchasing price of the new machine of RSM would be $8.05 million. Installation cost would be $200,000. The new RSM 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. Silk Road had already spent $15,000 on marketing research to gauge customer interest in its yarn as well as $5,000 on engineering tests. In 2014, the Silk Road’s conversion cost was $0.43/lb. Most of the conversion costs would not be affected if the RSM replaced the existing open-end machine. A significant benefit of the RSM 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 was $0.077/lb of the conversion costs for 2014. Mr Bolton also estimated that the cost of customer returns would rise to $0.084/lb for the higher quality yarn produced by the new RSM. As shown in the Exhibit 1 below, 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 expenses were not included as part of conversion costs. SG&A was estimated to remain at 7% of revenues for both the existing and replacing machines.
What are the relevant cash flows for the RSM investment?
Using a 10% cost of capital and assuming a 36% tax rate, what do you get as the NPV or IRR 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 RSM alternative? (Hint: for a replacement decision, 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. Sensitivity of the investment should also be considered) 3
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