Accounting Task. Please kindly go through it

Use the information given in the case to appraise Laurentian Bakeries expansion into the US frozen pizza market. Your report should (i) discuss the assumptions you make (ii) show calculations of WACC (iii) show calculations of the after tax cash flows, the NPV and other capital appraisal tools you may wish to use (in addition to NPV). You should also explain your recommendations. Along with your report, you can submit an excel file showing your calculations

S w 9A95B029 Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F249205 Rob Barbara prepared this case under the supervision of Professors David Shaw and Steve Foerster solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. Ivey Management Services prohibits any form of reproduction, storage or transmittal without its written permission. This material is not covered under authorization from CanCopy or any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Management Services, c/o Richard Ivey School of Business, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail cases@ivey.uwo.ca. Copyright 1995, Ivey Management Services Version: (A) 2002-04-22 In late May, 1995, Danielle Knowles, vice-president of operations for Laurentian Bakeries Inc., was preparing a capital project expenditure proposal to expand the company's frozen pizza plant in Winnipeg, Manitoba. If the opportunity to expand into the U.S. frozen pizza market was taken, the company would need extra capacity. A detailed analysis, including a net present value calculation, was required by the company's Capital Allocation Policy for all capital expenditures in order to ensure that projects were both profitable and consistent with corporate strategies. COMPANY BACKGROUND Established in 1984, Laurentian Bakeries Inc. (Laurentian) manufactured a variety of frozen baked food products at plants in Winnipeg (pizzas), Toronto (cakes) and Montreal (pies). While each plant operated as a profit center, they shared a common sales force located at the company's head office in Montreal. Although the Toronto plant was responsible for over 40 per cent of corporate revenues in fiscal 1994, and the other two plants accounted for about 30 per cent each, all three divisions contributed equally to profits. The company enjoyed strong competitive positions in all three markets and it was the low cost producer in the pizza market. Income Statements and Balance Sheets for the 1993 to 1995 fiscal years are in Exhibits 1 and 2, respectively. case centre Distributed by The Case Centre www.thecasecentre.org All rights reserved North America t +1 781 239 5884 f +1 781 239 5885 e info.usa@thecasecentre.org Rest of the world t +44 (0)1234 750903 f +44 (0)1234 751125 e info@thecasecentre.org Purchased for use on the Corporate Finance, at Manchester Business School Worldwide Ltd.. Taught by Arif Khurshed, from 1-May-2015 to 31-Oct-2015. Order ref F249205. Usage permitted only within these parameters otherwise contact info@thecasecentre.org LAURENTIAN BAKERIES Page 2 9A95B029 The company's success was, in part, the product of its management's philosophies. The cornerstone of Laurentian's operations included a commitment to continuous improvement; for example all employees were empowered to think about and make suggestions for ways of reducing waste. As Danielle Knowles saw it: \"Continuous improvement is a way of life at Laurentian.\" Also, the company was known for its above average consideration for the human resource and environmental impact of its business decisions. These philosophies drove all policy-making, including those policies governing capital allocation. Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F249205 Danielle Knowles Danielle Knowles' career, which spanned 13 years in the food industry, had included positions in other functional areas such as marketing and finance. She had received an undergraduate degree in mechanical engineering from Queen's University in Kingston, Ontario, and a masters of business administration from the Ivey Business School. THE PIZZA INDUSTRY Major segments in the pizza market were frozen pizza, deli-fresh chilled pizza, restaurant pizza and take-out pizza. Of these four, restaurant and take-out were the largest. While these segments consisted of thousands of small, family-owned establishments, a few very large North American chains, which included Domino's, Pizza Hut and Little Caesar's, dominated. Although 12 firms manufactured frozen pizzas in Canada, the five largest firms, including Laurentian, accounted for 95 per cent of production. McCain Foods was the market leader with 44 per cent market share, while Laurentian had 21 per cent. Per capita consumption of frozen pizza products in Canada was one-third of the level in the United States where retail prices were lower. ECONOMIC CONDITIONS The North American economy had enjoyed strong economic growth since 1993, after having suffered a severe recession for the two previous years. Interest rates bottomed-out in mid-1994, after which the U.S. Federal Reserve slowly increased rates until early 1995 in an attempt to fight inflationary pressures. Nevertheless, North American inflation was expected to average three to five per cent annually Purchased for use on the Corporate Finance, at Manchester Business School Worldwide Ltd.. Taught by Arif Khurshed, from 1-May-2015 to 31-Oct-2015. Order ref F249205. Usage permitted only within these parameters otherwise contact info@thecasecentre.org Laurentian sold most of its products to large grocery chains, and in fact, supplying several Canadian grocery chains with their private label brand frozen pizzas generated much of the sales growth. Other sales were made to institutional food services. Page 3 9A95B029 for the foreseeable future. The Bank of Canada followed the U.S. Federal Reserve's lead and increased interest rates, in part to protect the Canadian dollar's value relative to the value of the U.S. dollar. The result was a North American growth rate of gross domestic product that was showing signs of slowing down. Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F249205 All capital projects at Laurentian were subject to review based on the company's Capital Allocation Policy. The latest policy, which had been developed in 1989 when the company began considering factors other than simply the calculated net present value for project evaluation, was strictly enforced and managers were evaluated each year partially by their division's return on investment. The purpose of the policy was to reinforce the management philosophies by achieving certain objectives: that all projects be consistent with business strategies, support continuous improvement, consider the human resource and environmental impact, and provide a sufficient return on investment. Prior to the approval of any capital allocation, each operating division was required to develop both a Strategic Plan and an Operating Plan. The Strategic Plan had to identify and quantify either inefficiencies or lost opportunities and establish targets for their elimination, include a three-year plan of capital requirements, link capital spending to business strategies and continuous improvement effort, and achieve the company-wide hurdle rates. The first year of the Strategic Plan became the Annual Operating Plan. This was supported by a detailed list of proposed capital projects which became the basis for capital allocation. In addition to meeting all Strategic Plan criteria, the Operating Plan had to identify major continuous improvement initiatives and budget for the associated benefits, as well as develop a training plan identifying specific training objectives for the year. These criteria were used by head office to keep the behaviour of divisional managers consistent with corporate objectives. For example, the requirement to develop a training plan as part of the operational plan forced managers to be efficient with employee training and to keep continuous improvement as the ultimate objective. All proposed projects were submitted on an Authorization for Expenditure (AFE) form for review and approval (see Exhibit 3). The AFE had to present the project's linkage to the business strategies. In addition, it had to include specific details of economics and engineering, involvement and empowerment, human resource, and the environment. This requirement ensured that projects had been carefully thought through by forcing managers to list the items purchased, the employees Purchased for use on the Corporate Finance, at Manchester Business School Worldwide Ltd.. Taught by Arif Khurshed, from 1-May-2015 to 31-Oct-2015. Order ref F249205. Usage permitted only within these parameters otherwise contact info@thecasecentre.org LAURENTIAN'S PROJECT REVIEW PROCESS Page 4 9A95B029 Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F249205 Approval of a capital expenditure proposal was contingent on three requirements which are illustrated in Exhibit 4. The first of these requirements was the operating division's demonstrated commitment to continuous improvement (C.I.), the criteria of which are described in Exhibit 5. The second requirement was that all projects of more than $300,000 be included in the Strategic Plan. The final requirement was that for projects greater than $1 million, the operating division had to achieve its profit target. However, if a project failed to meet any of these requirements, there was a mechanism through which emergency funds might be allocated subject to the corporate executive committee's review and approval. If the project was less than $1 million and it met all three requirements, only divisional review and approval was necessary. Otherwise, approval was needed from the executive committee. The proposed Winnipeg plant project was considered a Class 2 project as the expenditures were meant to increase capacity for existing products or to establish a facility for new products. Capital projects could fall into one of three other classes: cost reduction (Class 1); equipment or facility replacement (Class 3); or other necessary expenditures for R&D, product improvement, quality control and concurrence with legal, government, health, safety or insurance requirements including pollution control (Class 4). A project spending audit was required for all expenditures; however, a savings audit was also needed if the project was considered either Class 1 or 2. Each class of project had a different hurdle rate reflecting different levels of risk. Class 1 projects were considered the most risky and had a hurdle rate of 20 per cent. Class 2 and Class 3 projects had hurdle rates of 18 per cent and 15 per cent, respectively. Knowles was responsible for developing the Winnipeg division's Capital Plan and completing all AFE forms. WINNIPEG PLANT'S EXPANSION OPTIONS Laurentian had manufactured frozen pizzas at the Toronto plant until 1992. However, after the company became the sole supplier of private-label frozen pizzas for a large grocery chain and was forced to secure additional capacity, it acquired the Winnipeg frozen pizza plant from a competitor. A program of regular maintenance and equipment replacement made the new plant the low cost producer in the industry, with an operating margin that averaged 15 per cent. The plant, with its proven commitment to continuous improvement, had successfully met its profit objective for the past three years. After the shortage of capacity had been identified as the plant's largest source of lost opportunity, Purchased for use on the Corporate Finance, at Manchester Business School Worldwide Ltd.. Taught by Arif Khurshed, from 1-May-2015 to 31-Oct-2015. Order ref F249205. Usage permitted only within these parameters otherwise contact info@thecasecentre.org involved in the project, the employees adversely affected by the project, and the effect of the project on the environment. Page 5 9A95B029 Annual sales had matched plant capacity of 10.9 million frozen pizzas when Laurentian concluded that opportunities similar to those in Canada existed in the United States. An opportunity surfaced whereby Laurentian could have an exclusive arrangement to supply a large U.S.-based grocery chain with its privatelabel-brand frozen pizzas beginning in April, 1996. As a result of this arrangement, frozen pizza sales would increase rapidly, adding 2.2 million units in fiscal 1996, another 1.8 million units in fiscal 1997, and then 1.3 million additional units to reach a total of 5.3 million additional units by fiscal 1998. However, the terms of the agreement would only provide Laurentian with guaranteed sales of half this amount. Knowles expected that there was a 50 per cent chance that the grocery chain would order only the guaranteed amount. Laurentian sold frozen pizzas to its customers for $1.70 in 1995 and prices were expected to increase just enough to keep pace with inflation. Production costs were expected to increase at a similar rate. Laurentian had considered, but rejected, three other alternatives to increase its frozen pizza capacity. First, the acquisition of a competitor's facility in Canada had been rejected because the equipment would not satisfy the immediate capacity needs nor achieve the cost reduction possible with expansion of the Winnipeg plant. Second, the acquisition of a competitor in the United States had been rejected because the available plant would require a capital infusion double that required in Winnipeg. As well, there were risks that the product quality would be inferior. Last, the expansion of the Toronto cake plant had been rejected as it would require a capital outlay similar to that in the second alternative. The only remaining alternative was the expansion of the Winnipeg plant. By keeping the entire frozen pizza operation in Winnipeg, Laurentian could better exploit economies of scale and assure consistently high product quality. The Proposal The expansion proposal, which would require six months to complete, would recommend four main expenditures: expanding the existing building in Winnipeg by 60 per cent would cost $1.3 million; adding a spiral freezer, $1.6 million; installing a new high speed pizza processing line, $1.3 million; and acquiring additional warehouse space, $600,000. Including $400,000 for contingency needs, the total cash outlay for the project would be $5.2 million. The equipment was expected to be useful for 10 years, at which point its salvage value would be zero. On-going capital expenditures, projected to be equal to annual depreciation, would be needed to keep the equipment up-to-date. Purchased for use on the Corporate Finance, at Manchester Business School Worldwide Ltd.. Taught by Arif Khurshed, from 1-May-2015 to 31-Oct-2015. Order ref F249205. Usage permitted only within these parameters otherwise contact info@thecasecentre.org Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F249205 management was eager to rectify this problem as targeted for in the Strategic Plan. Because the facility had also included the proposed plant expansion in its Strategic Plan, it met all three requirements for consideration of approval for a capital project. Page 6 9A95B029 Added to the benefit derived from increased sales, the project would reduce production costs in two ways. First, the new high-speed line would reduce plantwide unit cost by $0.019, though only 70 per cent of this increased efficiency would be realized in the first year. There was an equal chance, however, that only 50 per cent of these savings could actually be achieved. Second, \"other\" savings totaling $138,000 per year would also result from the new line and would increase each year at the rate of inflation. Each year, a capital cost allowance (CCA), akin to depreciation, would be deducted from operating income as a result of the capital expenditure. This deduction, in turn, would reduce the amount of corporate tax paid by Laurentian. In the event that the company did not have positive earnings in any year, the CCA deduction could be transferred to a subsequent year. However, corporate earnings were projected to be positive for the foreseeable future. Knowles compiled the eligible CCA deduction for 10 years (see Exhibit 6). For the purpose of her analysis, she assumed that all cash flows would occur at the appropriate year-end. Three areas of environmental concern had to be addressed in the proposal to ensure both conformity with Laurentian policy and compliance with regulatory bodies and local by-laws. First, design and installation of sanitary drain systems, including re-routing of existing drains, would improve sanitation practices of effluent/wastewater discharge. Second, the provision of water-flow recording meters would quantify water volumes consumed in manufacturing and help to reduce its usage. Last, the refrigeration plant would use ammonia as the coolant as opposed to chloro-fluro-carbons. These initiatives were considered sufficient to satisfy the criteria of the Capital Allocation Policy. THE DECISION Knowles believed that the project was consistent with the company's business strategy since it would ensure that the Winnipeg plant continued to be the low cost producer of frozen pizzas in Canada. However, she knew that her analysis must Purchased for use on the Corporate Finance, at Manchester Business School Worldwide Ltd.. Taught by Arif Khurshed, from 1-May-2015 to 31-Oct-2015. Order ref F249205. Usage permitted only within these parameters otherwise contact info@thecasecentre.org Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F249205 The land on which the Winnipeg plant was built was valued at $250,000 and no additional land would be necessary for the project. While the expansion would not require Laurentian to increase the size of the plant's administrative staff, Knowles wondered what portion, if any, of the $223,000 in fixed salaries should be included when evaluating the project. Likewise, she estimated that it cost Laurentian approximately $40,000 in sales staff time and expenses to secure the U.S. contract that had created the need for extra capacity. Last, net working capital needs would increase with additional sales. Working capital was the sum of inventory and accounts receivable less accounts payable, all of which were a function of sales. Knowles estimated, however, that the new high-speed line would allow the company to cut two days from average inventory age. Page 7 9A95B029 Knowles considered the implications if the project did not provide sufficient benefit to cover the Class 2 hurdle rate of 18 per cent. Entering the U.S. grocery chain market was a tremendous opportunity and she considered what other business could result from Laurentian's increased presence. She also wondered if the hurdle rate for a project that was meant to increase capacity for an existing product should be similar to the company's cost of capital, since the risk of the project should be similar to the overall risk of the firm. She knew that Laurentian's board of directors established a target capital structure that included 40 per cent debt. She also reviewed the current Canadian market bond yields, which are listed in Exhibit 7. The spread between Government of Canada bonds and those of corporations with bond ratings of BBB, such as Laurentian, had recently been about 200 basis points (two per cent) for most long-term maturities. Finally, she discovered that Laurentian's stock beta was 0.85, and that, historically, the Toronto stock market returns outperformed long-term government bonds by about six per cent annually. Purchased for use on the Corporate Finance, at Manchester Business School Worldwide Ltd.. Taught by Arif Khurshed, from 1-May-2015 to 31-Oct-2015. Order ref F249205. Usage permitted only within these parameters otherwise contact info@thecasecentre.org Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F249205 consider all factors, including the project's net present value. The plant's capital allocation review committee would be following the procedures set out in the company's Capital Allocation Policy as the basis for reviewing her recommendation. Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F249205 1993 Revenues Cost of Goods Sold Gross Income 1994 1995 91.2 27.4 63.8 95.8 28.7 67.1 101.5 30.5 71.0 Operating Expenses Operating Income 50.1 13.7 52.7 14.4 55.8 15.2 Interest Income Before Tax 0.9 12.8 1.0 13.4 1.6 13.6 Income Tax Net Income 4.2 8.6 5.2 8.2 5.2 8.4 $ $ Purchased for use on the Corporate Finance, at Manchester Business School Worldwide Ltd.. Taught by Arif Khurshed, from 1-May-2015 to 31-Oct-2015. Order ref F249205. Usage permitted only within these parameters otherwise contact info@thecasecentre.org Page 8 9A95B029 Exhibit 1 INCOME STATEMENT For The Year Ending March 31 ($ millions) Page 9 9A95B029 Exhibit 2 BALANCE SHEET For The Year Ending March 31 ($ millions) 1994 1995 6.2 11.3 6.2 0.3 0.0 24.0 9.4 11.8 6.6 0.6 0.9 29.3 13.1 12.5 7.0 2.2 0.9 35.7 35.3 36.1 36.4 59.3 65.4 72.1 7.5 0.7 8.2 7.9 1.3 9.2 8.3 2.2 10.5 Long-Term Debt 16.8 20.4 24.3 Shareholders' Equity 34.3 35.8 37.3 59.3 65.4 72.1 $ Fixed Assets Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F249205 TOTAL $ Liabilities and Shareholders' Equity: Accounts Payable Other Current Total Current TOTAL $ Purchased for use on the Corporate Finance, at Manchester Business School Worldwide Ltd.. Taught by Arif Khurshed, from 1-May-2015 to 31-Oct-2015. Order ref F249205. Usage permitted only within these parameters otherwise contact info@thecasecentre.org 1993 Assets: Cash Accounts Receivable Inventory Prepaid Expenses Other Current Total Current Page 10 9A95B029 Exhibit 3 AUTHORIZATION FOR EXPENDITURE FORM Company Name: ____________________________ Business Segment: __________________________________ Project Title: __________________________________________________________________________________ Project Cost (AFE Amount): ____________________________ Net Present Value at ___________%: __________________ Internal Rate of Return: ________% Years Payback: _________ Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F249205 Brief Project Description: Approvals Estimated Completion Date: _________________________ Signature Date __________________ __________________ __________________ __________________ __________________ __________________ __________________ __________________ __________________ __________________ __________________ __________________ _______________________ Name __________________ Project Contact Person: __________________ __________________ __________________ __________________ __________________ Phone: _________________ Fax: ___________________ Currency Used: CDN _______ US _______ Other __________________ Post Audit: Company: Yes _____ No_____ Corporate: Yes _____ No_____ Purchased for use on the Corporate Finance, at Manchester Business School Worldwide Ltd.. Taught by Arif Khurshed, from 1-May-2015 to 31-Oct-2015. Order ref F249205. Usage permitted only within these parameters otherwise contact info@thecasecentre.org Project Cost (Gross Investment Amount): __________________ Purchased for use on the Corporate Finance, at Manchester Business School Worldwide Ltd.. Taught by Arif Khurshed, from 1-May-2015 to 31-Oct-2015. Order ref F249205. Usage permitted only within these parameters otherwise contact info@thecasecentre.org Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F249205 Page 11 9A95B029 Exhibit 4 CAPITAL EXPENDITURE APPROVAL PROCESS Page 12 9A95B029 Exhibit 5 BUSINESS REVIEW CRITERIA Used To Assess Divisional Commitment To Continuous Improvement Safety Lost time accidents per 200,000 employee hours worked Financial Return on Investment Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F249205 Lost Sales Market share % where data available Manufacturing Effectiveness People cost (total compensation $ including fringe) as a percentage of new sales Plant scrap (kg) as a percentage of total production (kg) Managerial Effectiveness/Employee Empowerment Employee Survey Training provided vs. training planned Number of employee grievances Sanitation Sanitation audit ratings Other Continuous Improvement Measurements Number of continuous improvement projects directed against identified piles of waste/lost opportunity completed and in-progress Purchased for use on the Corporate Finance, at Manchester Business School Worldwide Ltd.. Taught by Arif Khurshed, from 1-May-2015 to 31-Oct-2015. Order ref F249205. Usage permitted only within these parameters otherwise contact info@thecasecentre.org Product Quality Number of customer complaints Year Deduction 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 $ 434,000 $ 768,000 $ 593,000 $ 461,000 $ 361,000 $ 286,000 $ 229,000 $ 185,000 $ 152,000 $1,731,000 Purchased for use on the Corporate Finance, at Manchester Business School Worldwide Ltd.. Taught by Arif Khurshed, from 1-May-2015 to 31-Oct-2015. Order ref F249205. Usage permitted only within these parameters otherwise contact info@thecasecentre.org Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F249205 Page 13 9A95B029 Exhibit 6 ELIGIBLE CCA DEDUCTION Source: Bloomberg L.P. Purchased for use on the Corporate Finance, at Manchester Business School Worldwide Ltd.. Taught by Arif Khurshed, from 1-May-2015 to 31-Oct-2015. Order ref F249205. Usage permitted only within these parameters otherwise contact info@thecasecentre.org Educational material supplied by The Case Centre Copyright encoded A76HM-JUJ9K-PJMN9I Order reference F249205 Page 14 9A95B029 Exhibit 7 MARKET INTEREST RATES On May 18, 1995 1-Year Government of Canada Bond 7.37% 5-Year Government of Canada Bond 7.66% 10-Year Government of Canada Bond 8.06% 20-Year Government of Canada Bond 8.30% 30-Year Government of Canada Bond 8.35%