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This document is one of the 63 authorised copies to be used in the Corporate Finance course, Manchester Business School Worldwide Ltd, from 01/12/09...

An analysis / report on attached case study (Laurentian Bakery) will help.
9A95B029.pdf

This document is one of the 63 authorised copies to be used in the Corporate Finance course, Manchester Business School Worldwide Ltd, from 01/12/09 to 30/04/10. Order number 64048 S w
9A95B029 LAURENTIAN BAKERIES 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 [email protected]
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. This document is one of the 63 authorised copies to be used in the Corporate Finance course, Manchester Business School Worldwide Ltd, from 01/12/09 to 30/04/10. Order number 64048 Page 2 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.
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.
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 9A95B029 This document is one of the 63 authorised copies to be used in the Corporate Finance course, Manchester Business School Worldwide Ltd, from 01/12/09 to 30/04/10. Order number 64048 Page 3 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.
LAURENTIAN’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 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 9A95B029 This document is one of the 63 authorised copies to be used in the Corporate Finance course, Manchester Business School Worldwide Ltd, from 01/12/09 to 30/04/10. Order number 64048 Page 4 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 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, 9A95B029 This document is one of the 63 authorised copies to be used in the Corporate Finance course, Manchester Business School Worldwide Ltd, from 01/12/09 to 30/04/10. Order number 64048 Page 5 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.
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. 9A95B029 This document is one of the 63 authorised copies to be used in the Corporate Finance course, Manchester Business School Worldwide Ltd, from 01/12/09 to 30/04/10. Order number 64048 Page 6 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.
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 9A95B029 This document is one of the 63 authorised copies to be used in the Corporate Finance course, Manchester Business School Worldwide Ltd, from 01/12/09 to 30/04/10. Order number 64048 Page 7 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 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. 9A95B029 This document is one of the 63 authorised copies to be used in the Corporate Finance course, Manchester Business School Worldwide Ltd, from 01/12/09 to 30/04/10. Order number 64048 Page 8 9A95B029 Exhibit 1
INCOME STATEMENT
For The Year Ending March 31
($ millions) 1993 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 4.2
8.6 5.2
8.2 5.2
8.4 Revenues
Cost of Goods Sold
Gross Income Income Tax
Net Income $ $ This document is one of the 63 authorised copies to be used in the Corporate Finance course, Manchester Business School Worldwide Ltd, from 01/12/09 to 30/04/10. Order number 64048 Page 9 9A95B029 Exhibit 2
BALANCE SHEET
For The Year Ending March 31
($ millions) 1993 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 Assets:
Cash
Accounts Receivable
Inventory
Prepaid Expenses
Other Current
Total Current $ Fixed Assets
TOTAL $ Liabilities and Shareholders' Equity:
Accounts Payable
Other Current
Total Current TOTAL $ This document is one of the 63 authorised copies to be used in the Corporate Finance course, Manchester Business School Worldwide Ltd, from 01/12/09 to 30/04/10. Order number 64048 Page 10 9A95B029 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: 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_____ This document is one of the 63 authorised copies to be used in the Corporate Finance course, Manchester Business School Worldwide Ltd, from 01/12/09 to 30/04/10. Order number 64048 Page 11
9A95B029 Exhibit 4 CAPITAL EXPENDITURE APPROVAL PROCESS This document is one of the 63 authorised copies to be used in the Corporate Finance course, Manchester Business School Worldwide Ltd, from 01/12/09 to 30/04/10. Order number 64048 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
Product Quality

Number of customer complaints
Financial

Return on 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 This document is one of the 63 authorised copies to be used in the Corporate Finance course, Manchester Business School Worldwide Ltd, from 01/12/09 to 30/04/10. Order number 64048 Page 13 9A95B029 Exhibit 6
ELIGIBLE CCA DEDUCTION 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 This document is one of the 63 authorised copies to be used in the Corporate Finance course, Manchester Business School Worldwide Ltd, from 01/12/09 to 30/04/10. Order number 64048 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%
Source: Bloomberg L.P.

This question was asked on Mar 22, 2010.

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