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LAURENT IAN BAKERIESThe decisi on-maker mustmake arecommenda tion ona largeexpansi onprojec t.Discounted cashflowanalysis isrequired.In lateMay,1995,Danielle Knowles,vice-president ofoperations forLaurentian BakeriesInc.,was preparinga capital expenditure proposalto expand the company s frozen pizza plantin Winnipeg Manitoba.If theopportunity toexpand into the U.S.frozen pizza market wastaken,the companywould needextra capacity.A detailedanalysis,including anet presentvaluecalculation,was requiredby the company,s Capital Allocation Policyfor allcapitalexpenditures inorder to ensure thatprojects wereboth profitableand consistent withcorporate strategies.COMPANY BACKGROUHDEstablishedin1984,Laurentian BakeriesInc.Laurentian manufactureda varietyof frozenbakedfood productsat plantsin Winnipegpizzas,Toronto cakesand Montrealpies.Whileeach plantoperated as a profitcenter,they shareda commonsales forcelocated at the companyheadoffice inMontreal.Although the Toronto plant was responsible for over40%of corporaterevenuesin fiscal1994,and theother plantswas accounted for about30%each,all threedivisionscontributed equallyto profits.The companyenjoyed strongcompetitive positionsinall threemarkets andit was the low cost producer in thepizza market.Income StatementsandBalance Sheetsfor the1993to1995fiscal yearsare inExhibits1and2,respectively.Laurentian soldmost of its productsto largegrocery chains,and infact,supplying severalCanadianchains withprivate labelbrand pizzasgenerated muchof thesales growth.Othersales weremade toinstitutional foodservices.The company s successwas,in part,the productof itsmanagement sphilosophies.Thecornerstone ofLaurentian,s operationswas itsincluding acommitment to a business strategypromoting continuous improvement;for exampleall employeeswere empoweredto thinkaboutand makesuggestions forways ofreducing waste.As DanielleKnowles sawit:Continuousimprovement isa wayof lifeat Lauremtian.Also,the companywas knownfor itsabove-averageconsideration for the human resource and environmental impactofitsbusiness decisions.Thesephilosophies droveall policy-making,including thosepolicies governingcapital allocation.Danielle KnowlesDanielleKnowles scareer,which spanned13years in the foodindustry,had includedpositionsin otherfunctional areassuch asmarketing andfinance.She hadreceived anundergraduatedegree inmechanical engineeringfrom Queens Universityin Kingston,Ontario,and amasterof businessadministration fromthe WesternBusiness School.THE PIZZAINDUSTRYReviewApprovedFinish TrackResultApproval AFEClass12SpendingSavings34SpendingEXHIBIT5BUSINESS REVIEWCRITERIAUsed toAssess DivisionalCommitment toContinuous ImprovementSafety•Lost timeaccidents per200,000employee hoursworkedProduct Quality•Number ofcustomer complaintsFinancial•Return ofinvestmentLost Sales•Market share%-where dataavailableManufacturing Effectiveness•People costtotal compensation$including fringeasa percentage ofnew sales•Plant scrapkg asapercentageof totalproduction kgManagerialEffectiveness/Employee Empowerment•Employee survey•Training providedvs.Training planned•Number ofemployee grievancesSanitation•Sanitation auditratingsOther ContinuousImprovement Measurements•Number ofcontinuous improvementprojects directedagainst identifiedpiles ofwaste/lostopportunity completedand in-progressEXHIBIT6ELIGIBLE CCADEDUCTIONYear Deduction$434,0001996$768,0001997$593,000$461,0001998$361,000$286,0001999$229,0002000$185,000$152,000$1731,0002001200220032004EXHIBIT72005MARKET INTERESTRATESON MAY18,19961-Year Government of CanadaBond
7.37%5-Year Governmentof CanadaBond
7.66%10-Year Governmentof CanadaBond
8.06%20-Year Governmentof CanadaBond
8.30%30-Year Governmentof CanadaBond
8.35%Major segmentsin thepizzamarketwere frozen pizza,deli-fresh chilledpizza,restaurantpizza andtake-out pizza.Of thesefour,restaurant andtake-out werethe largest.While thesesegmentsconsisted ofthousands ofsmall-owned establishments,a fewlarge North Americanchains,which includedDomino s,Pizza Hutand LittleCaesar,s,dominated.Although12firms manufactured frozen pizzasin Canada,the fivelargest firms,includingLaurentian,accountedfor95%of production.McCain Foodswas themarket leaderwith44%marketshare,while Laurentian had21%.Per capitaconsumption of frozen productsin Canadawasone-third of the levelin U.S.where retailprices werelower.ECONOMIC CONDITIONSTheNorth Americaneconomy hadenjoyed stronggrowth since1993,after havingsuffered asevererecession for the twoprevious years.Interest ratesbottomed-out inmid-1994,after whichthe U.S.Federal Reserveslowly increasedrates untilearly1995in anattempt tofightinflationary pressures.Nevertheless,North Americaninflation was expected toaverage3%to5%annually for the foreseeablefuture.The Bankof Canadafollowed theU.S.Federal Reserveslead and increased interestrates,in partto protectthe Canadiandollar svalue relativeto the valueof theU.S.dollar.The resultwas aNorthAmericangrowth rate of grossdomesticproduct that was showingsigns ofslowing down.LAURRENTIAN SPROJECT REVIEWPROCESSAll capital projects atLaurentian weresubject toreview basedon the company s CapitalAllocation Policy.The latestpolicy,which had been developedin1989when the company beganconsideringfactors otherthan simplythe calculatednet present value forproject evaluation,was strictlyenforced andmanagers evaluatedeach yearpartially bytheir divisions returnon investment.The purpose of thepolicy wasto reinforcethe managementphilosophies byachievingcertain objectives:that allprojects beconsistentwithbusiness strategies,support continuous improvement,consider thehuman resourceandenvironmentalimpact,andprovide asufficient returnoninvestment.Prior to the approvalof anycapital allocation,each operatingdivision wasrequired todevelopboth aStrategic andan Operating Plan.The StrategicPlan had to identifyand quantifyeitherinefficiencies orlost opportunitiesand establishtargets fortheir elimination,include athree-year planof capitalrequirements,link capitalspending tobusinessstrategies andcontinuousimprovementeffort,and achievethe company-wide hurdle rates.The firstyear of the StrategicPlan became the AnnualOperatingPlan.This wassupportedby adetailed listof proposedcapital projectswhich becamethe basis for capitalallocation.In additionto meetingall StrategicPlan criteria,the OperatingPlan hadto identifymajorcontinuous improvementinitiatives andbudget forthe associatedbenefits,as wellas developa training planidentifying specifictraining objectivesfortheyear.These criteriawere usedby headoffice tokeep thebehavior ofdivisional managersconsistentwith corporateobjectives.For example,the requirementto developatrainingplan aspartof theoperational planforced managersto beefficient withemployee trainingand tokeepcontinuous improvementas theultimate objective.All proposedprojects weresubmitted onan Authorizationfor ExpenditureAFE Formfor reviewand approval seeExhibit
3.The AFEhadtopresent the projects linkagetothebusinessstrategies.In addition,it hadto includespecific detailsof economicsand engineering,involvement andempowerment,humanresource,and theenvironment.This requirementensuredthat projects had beencarefully thoughtthrough byforcing managersto listthe itemspurchased,the employeesinvolved inthe project,the employeesadversely affectedby theproject,andtheeffect of the projecton theenvironment.Approval of a capitalexpenditure proposalwas contingenton threerequirements which areillustrated inExhibit
4.The firstof theserequirements was the operatingdivision sdemonstratedcommitment to continuousimprovementC.I.,the criteriaof whichare describedinExhibit
5.The second requirement wasthat allprojects ofmore than$300,000be includedinthe StrategicPlan.The finalrequirement wasthat forprojects greaterthan$1million,the operatingdivision hadto achieveits profittarget.However,if a project failedto meetanyof theserequirements,there wasa mechanismthrough whichemergency fundsmight beallocatedsubject tothe corporateexecutive committees review andapproval.If the projectwas lessthan$1million andit metall threerequirements,only divisionalreviewandapprovalwas necessary.Otherwise,approval wasneeded fromthe executivecommittee.The proposedWinnipeg plantproject wasconsidered aclass2project asthe expendituresweremeant toincrease capacityfor existingproducts orto establisha facilityfor newproducts.Capital projectscould fallinto oneof three other classes:cost reductionClass1;equipment orfacility replacementClass3;or othernecessary expendituresfor RD,productimprovements,quality controland concurrencewith legal,government,health,safety orinsurancerequirements includingpollution controlClass
4.A projectspending audit wasrequired for all expenditures;however,a savingsauditwasalso neededif the project wasconsideredeither1or
2.Each classof projecthad adifferent hurdle rate reflectingdifferentlevels ofrisk.Class1projects wereconsidered themost riskyand hada hurdlerateof20%.Class2and Class3projectshadhurdleratesof18%and15%,respectively.Knowles wasresponsiblefordeveloping the Winnipeg divisions CapitalPlan andcompletingall AFEforms.WINNIPEG PLANTS EXPANSIONOPTIONSLaurentian hadmanufacturedfrozen pizzas attheTorontoplant until
1992.However,afterthe companybecamethesole supplierof private-label frozenpizzas fora largegrocery chainandwas forcedto secureadditional capacity,it acquiredthe Winnipegfrozenpizzaplantfrom acompetitor.A programof regularmaintenance andequipment replacementmade the newplant the lowcost producerinthe industry,with anoperating marginthat averaged15%.The plan,with itsproven commitmenttocontinuousimprovement,had successfullymet itsprofitobjective forthe pastthree years.After theshortage ofcapacity had been identifiedasthe plant s largestsource oflost opportunity,management waseager torectify thisproblemas targetedfor inthe StrategicPlan.Because thefacility hadalso includedthe proposedplantexpansion inits StrategicPlan,it metall threerequirements forconsideration ofapprovalfora capitalproject.Annual saleshad matchedplant capacityof
10.9million frozenpizzas whenLauentian concludedthatopportunities similar to thosein Canadaexisted intheU.S.An opportunitysurfacedwhereby Laurentian could havean exclusivearrangement tosupply alarge U.S.-based grocerychainwith itsprivate-label-brand frozenpizzas beginningin April,
1996.As a result ofthisarrangement,frozenpizzasales wou1d increaserapidly,adding
2.2million unitsinfiscal1996,another
1.8million unitsin fiscal1997,and then
1.3million additionalunitsto reacha totalof
5.3million additionalunits byfiscal
1998.However,the termsof theagreementwould onlyprovide Laurentianwith guaranteedsales ofhalf thisamount.Knowlesexpected that there wasa50%chance thatthe grocerychain wou1d orderonly theguaranteedamount.Laurentian soldfrozenpizzasto itscustomers for$
1.7in1995and priceswere expectedtoincrease justenough tokeep pacewith inflation.Production costswere expectedto increaseata similarrate.Laurentianhadconsidered,but rejected,threeotheralternatives toincrease itsfrozen pizzacapacity.First,the acquisitionofacompetitor,s facilityin Canadahadbeen rejectedbecause theequipment wouldnot satisfythe immediatecapacity needsnor achievethe costreductionpossible withexpansion of the Winnipeg plant.Second,the acquisitionof acompetitorintheU.S.hadbeenrejected becausethe availableplant wouldrequire acapitalinfusion doublethat requiredinWinnipeg.As well,there wererisks thatthe productqualitywould beinferior.Last,the expansionof theToronto cakeplant hadbeenrejectedas itwouldrequire acapital outlaysimilartothat inthe secondalternative.The onlyremainingalternative wasthe expansionof the Winnipegplant.By keepingthe frozenpizza inWinnipeg,Laurentiancouldbetter exploiteconomies ofscale andassure consistentlyhigh productquality.The ProposalTheexpansion proposal,to complete,would recommendinwhich wou1drequiresix monthsfourmain expenditures:expanding theexisting buildingWinnipeg by60%wou1d cost$
1.3million;adding aspiral freezer,$
1.6million;installing anew highspeedpizza processingline,$
1.3million;and acquiringadditional warehousespace,$600,
000.Including$400,000for contingencyneeds,the totalcash outlayfortheprojectwould be$
5.2million.The equipmentwasexpectedto beuseful for10years,at whichpointits salvagevalue would be zero.The landon whichtheWinnipegplantwasbuilt valuedat250,000and noadditional landwouldbe necessaryfortheproject.While theexpansion wouldnot requireLaurentian toincreasethe sizeof theplantsadministrative staff,Knowles wonderedwhat portion,if any,ofthe$223,000in fixedsalaries shouldbe includedwhen evaluatingtheproject.Likewise,sheestimated thatit costLaurentian approximately$40,000in salesstaff timeand expansestosecure theU.S.contract thathad createdthe needfor extracapacity.Last,net workingcapitalneeds wou1dincreasewith additionalsales.Working capitalwasthesum ofinventoryand accountsreceivable lessaccounts payable,all ofwhich werea functionof sales.Knowlesestimated,however,thatthe new high-speed linewould allowthecompanyto cuttwo daysfromaverage inventoryage.Added tothe benefitderived fromincreased sales,theprojectwould reduceproduction costsintwo ways.First,thenewhigh-speed linewould reduceplant-wide unitcost by$
0.009,though only70%of thisincreased efficiencywould berealized inthe firstyear.There wasanequal chance,however,that only50%of thesesavings couldactually beachieved.Second,“other〃savings totaling$138,000per yearwould alsoresult fromthenewline andwouldincrease eachyear atthe rateof inflation.Each year,acapitalcost allowanceCCA,akin todepreciation,wouldbededucted fromoperatingincome asaresultofthecapitalexpenditure.This deduction,in turn,would reducetheamount ofcorporate taxpaid byLaurentian.In theevent thatthecompanydid nothavepositive earningsin anyyear,the CCAdeduction couldbe transferredtoasubsequent year.However,corporate earningswere projectedto bepositive forthe foreseeablefuture.Knowlescompiled theeligible CCAdeduction for10years seeExhibit
6.For thepurposeofheranalysis,she assumedthat allcash flowswould occurattheappropriate year-end.Three areasof environmentalconcern hadto beaddressed inthe proposaltoensurebothconformity withLaurentian policyand compliancewith regulatorybodies andlocal by-laws.First,design andinstallation ofsanitary drainsystems,including re-routing ofexistingdrains,would improvesanitation practicesof effluent/wastewater discharge.Second,theprovision ofwater-flow recordingmeters wouldquantify watervolumes consumedinmanufacturing andhelp toreduce itsusage.Last,the refrigerationplant woulduse ammoniaasthe coolantas opposedto chloro-fluro-carbons.These initiativeswere consideredsufficientto satisfythe criteriaoftheCapitalAllocation Policy.THE DECISIONKnowlesbelieved thattheprojectwas consistentwith thecompanysbusinessstrategysinceit wouldensure thattheWinnipegplant continuedto bethelowcostproduceroffrozenpizzasin Canada.However,she knewthat heranalysis mustconsider allfactors,including theproject,s netpresentvalue.The plants capitalallocation reviewcommittee wouldbe followingtheprocedures setout inthecompanysCapitalAllocationPolicyasthebasisforreviewingher recommendation.Knowles consideredthe implicationsif theproject didnot providesufficient benefitto covertheClass2hurdlerateof18%.Entering theU.S.grocery chainsmarket wasa tremendousopportunityand sheconsidered whatother businesscould resultfrom Laurentian,s increasedpresence.She alsowondered ifthe hurdlerate foraprojectthatwasmeant toincrease capacityforan existingproduct shouldbe similartothecompanyscost ofcapital,since theriskof theproject shouldbe similartotheoverall riskofthefirm.She knewthat Laurentian,s boardof directorsestablished atarget capitalstructure thatincluded40%debt.She alsoreviewedthe currentCanadian marketbond yields,whicharelisted inExhibit
7.The spreadbetweenGovernmentofCanada bondsand thoseof corporationswith bondratings ofBBB,suchas Laurentian,had recentlybeen about200basis points2%for mostlong-term maturities.Finally,she discoveredthat Laurentian,s stockbeta was
0.85,and that,historically,theToronto stockmarket returnsoutperformed long-term governmentbonds byabout6%annually.EXHIBIT1INCOME STATEMENTForThe YearEnding March31$millions199319941995Revenues$
91.
295.
8101.Cost ofgoods sold5Gross income
27.
428.
730.5Operating expenses
52.
055.
058.4Operating income
11.
812.
112.6Interest
0.9L
01.6Income beforetax
10.
911.
111.0Income tax4,
24.34,2Net income
6.
76.
86.8EXHIBIT2BALANCE SHEETForThe YearEnding March31$millions199319941995Assets:$
6.
29.4Cash
13.1Accounts Receivable
11.
311.
812.5Inventory
6.
26.
67.0Prepaid expenses
0.
30.
62.2Other current
0.
90.9Total current
24.
029.
335.7Fixed assets:
35.
336.136,4TOTAL
59.
365.
472.1Liabilities andShareholder,s Equity:Accounts payable
7.
57.
98.3Other payable
0.
71.
32.2Total current
8.
29.
210.5Long-term debt
16.
820.
424.3Shareholder,s equity34,
335.
837.3TOTAL
59.
365.
472.1EXHIBIT3AUTHORIZATION FOREXPENDITURE FORMCompanyname:___________________________________________________businesssegment;Project title:Project costAFEamount:Project costgrossinvestment amount:Net presentvalue at___________%j_Internal rateof return:years paybackBriefproject description:Estimated completiondate:approvalsProject contactname:Name SignatureDatePhone:Fax:Currency used:CDN USOtherPostaudit:Company:yes noCorporate:yes noEXHIBIT4CAPITAL EXPENDITUREAPPROVAL PROCESSStartProjectSubmitAFEQuarterly CommittedNoTo C.I.Fundsonly availableforvalueemergencyNo lessNoInAnnually Yesthan DollarStrategy$300yesYesOn NoLess NoPresentQuarterlyProfitthanrevisedPlan$1000planYesYesExec.Less NoCommitteeProjectThanReview$1000ApprovalYesDivisional。
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