Case Laurentian Bakeries, NPV Calculation, and other Analysis in this case

LAURENTIAN BAKERIES The decision-maker must make a recommendation on a large expansion project. Discounted cash flow analysis is required. In addition to the assumptions and scenarios in the case, assume that, due to increased competition, the U.S grocery chain can only guarantee 33% of the increased sales unless they receive a $0.20 per pizza reduction in price. With this deduction, they will be able to guarantee 50% of the original increased sales. Should you reduce the price? Explain. In late May, 1995, Danielle Knowles, vice-president of operations for Laurentian Bakeries Inc., was preparing a capital 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 BACKGROUHD 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' head office in Montreal. Although the Toronto plant was responsible for over 40% of corporate revenues in fiscal 1994, and the other plants was accounted for about 30% 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. Laurentian sold most of its products to large grocery chains, and in fact, supplying several Canadian chains with private label brand pizzas generated much of the sales growth. Other sales were made to institutional food services. The company's success was, in part, the product of its management's philosophies. The cornerstone of Laurentian's operations was its including a commitment to a business strategy promoting 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 Lauremtian.\" 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. Danielle Knowles Danielle Knowles's 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 master of business administration from the Western Business School. THE PIZZA INDUSTRY 1 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-owned establishments, a few 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% of production. McCain Foods was the market leader with 44% market share, while Laurentian had 21%. Per capita consumption of frozen products in Canada was one-third of the level in U.S. where retail prices were lower. ECONOMIC CONDITIONS The North American economy had enjoyed strong 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 3% to 5%annually 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. LAURRENTIAN'S PROJECT REVIEW PROCESS 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 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 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 behavior 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. 2 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 involved in the project, the employees adversely affected by the project, and the effect of the project on the environment. 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 improvements, 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 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%. Class 2 and Class 3 projects had hurdle rates of 18% and 15%, 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%. The plan, 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, 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. 3 Annual sales had matched plant capacity of 10.9 million frozen pizzas when Lauentian concluded that opportunities similar to those in Canada existed in the U.S. An opportunity surfaced whereby Laurentian could have an exclusive arrangement to supply a large U.S.-based grocery chain with its private-label-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% chance that the grocery chain would order only the guaranteed amount. Laurentian sold frozen pizzas to its customers for $1.7 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 U.S. 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 frozen pizza 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% 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. The land on which the Winnipeg plant was built 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 expanses 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 highspeed line would allow the company to cut two days from average inventory age. 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 plant-wide unit cost by $0.009, though only 70% of this increased efficiency would be realized in the first year. There was an equal chance, however, that only 50% 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. 4 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-flurocarbons. 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 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. Knowles considered the implications if the project did not provide sufficient benefit to cover the Class 2 hurdle rate of 18%. Entering the U.S. grocery chains 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% 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 (2%) 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 6% annually. 5 EXHIBIT 1 INCOME STATEMENT For The Year Ending March 31 ($ millions) 1993 1994 $91.2 27.4 63.8 95.8 28.7 67.1 101.5 30.5 71.0 Operating expenses Operating income 52.0 11.8 55.0 12.1 58.4 12.6 Interest Income before tax 0.9 10.9 1.0 11.1 1.6 11.0 4.2 6.7 4.3 6.8 4.2 6.8 Revenues Cost of goods sold Gross income Income tax Net income 1995 EXHIBIT 2 BALANCE SHEET For The Year Ending March 31 ($ millions) 1993 1994 1995 $6.2 11.3 6.2 0.3 9.4 11.8 6.6 0.6 0.9 29.3 36.1 65.4 13.1 12.5 7.0 2.2 0.9 35.7 36.4 72.1 Liabilities and Shareholder's Equity: Accounts payable 7.5 7.9 Other payable 0.7 1.3 Total current 8.2 9.2 Long-term debt 16.8 20.4 8.3 2.2 10.5 24.3 Shareholder's equity TOTAL 37.3 72.1 Assets: Cash Accounts Receivable Inventory Prepaid expenses Other current Total current Fixed assets: TOTAL 24.0 35.3 59.3 34.3 59.3 35.8 65.4 6 EXHIBIT 3 AUTHORIZATION FOR EXPENDITURE FORM Company name: business segment: Project title: Project cost(AFE amount): Project cost(gross investment amount): Net present value at %: Internal rate of return: years payback Brief project description: Estimated completion date: approvals Project contact name: Name Signature Date Phone: Fax: Currency used: CDN US Other Post audit: Company: yes Corporate: yes no no 7 EXHIBIT 4 CAPITAL EXPENDITURE APPROVAL PROCESS Start Project Quarterly Submit AFE Committed To C.I. Yes Annually In Strategy No Funds available for emergency only (Dollar value ??) No Yes Quarterly On Profit Plan No less than $300 yes Less than $1000 Yes Application For Emergency spending No No Present revised plan Yes Project Less Than $1000 Exec. Committee Review & Approval No Yes Divisional Review & Approval Approved AFE Finish Track Result Class 1&2 Spending Savings 3&4 Spending 8 EXHIBIT 5 BUSINESS REVIEW CRITERIA Used to Assess Divisional Commitment to Continuous Improvement Safety Lost time accidents per 200,000 employee hours worked Product Quality Number of customer complaints Financial Return of investment 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 9 EXHIBIT 6 ELIGIBLE CCA DEDUCTION Year Deduction 1996 $434,000 1997 $768,000 1998 $593,000 1999 $461,000 2000 $361,000 2001 $286,000 2002 $229,000 2003 $185,000 2004 $152,000 2005 $1731,000 EXHIBIT 7 MARKET INTEREST RATES ON MAY 18,1996 1-Year Government of Canada Bond 5-Year Government of Canada Bond 10-Year Government of Canada Bond 20-Year Government of Canada Bond 30-Year Government of Canada Bond 7.37% 7.66% 8.06% 8.30% 8.35% 10