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1、LAURENTIAN BAKERIESThe decision-maker must make a recommendation on a large expansion project. Discounted cash flow analysis is required.In late May, 1995, Danielle Knowles, vice-president of operations for Laurentian Bakeries Inc., was preparing a capital expenditure proposal to expand the companys
2、 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 companys Capital Allocation Policy for all capital expenditur
3、es in order to ensure that projects were both profitable and consistent with corporate strategies.COMPANY BACKGROUHDEstablished in 1984, Laurentian Bakeries Inc. (Laurentian) manufactured a variety of frozen baked food products at plants in Winnipeg (pizzas), Toronto (cakes) and Montreal (pies). Whi
4、le 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 contrib
5、uted 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 la
6、rge 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 companys success was, in part, the product of its managements philosophies. The cornerstone of Laurentians o
7、perations 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 co
8、mpany 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 KnowlesDanielle Knowless career, which spanned 13 years in the foo
9、d industry, had included positions in other functional areas such as marketing and finance. She had received an undergraduate degree in mechanical engineering from Queens University in Kingston, Ontario, and a master of business administration from the Western Business School.THE PIZZA INDUSTRYMajor
10、 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
11、s, Pizza Hut and Little Caesars, 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 produ
12、cts in Canada was one-third of the level in U.S. where retail prices were lower.ECONOMIC CONDITIONSThe 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. Feder
13、al 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 Reserves lead and increased interest rates, in pa
14、rt to protect the Canadian dollars 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.LAURRENTIANS PROJECT REVIEW PROCESSAll capital projects at Laurentian were subject to review based on the co
15、mpanys 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 divisions return on in
16、vestment. 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 investm
17、ent.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 p
18、lan 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 becam
19、e 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 c
20、riteria 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
21、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 projects linkage to the business strategies. In addition, it had to include specific details of economics and engineering, involv
22、ement 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
23、 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 divisions demonstrated commitment to continuous improvement (C.I.), the criteria of which are described in Exhibit
24、 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, ther
25、e was a mechanism through which emergency funds might be allocated subject to the corporate executive committees 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
26、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); equip
27、ment 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; h
28、owever, 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 1
29、8% and 15%, respectively.Knowles was responsible for developing the Winnipeg divisions Capital Plan and completing all AFE forms.WINNIPEG PLANTS EXPANSION OPTIONSLaurentian had manufactured frozen pizzas at the Toronto plant until 1992. However, after the company became the sole supplier of private-
30、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 tha
31、t 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 plants largest source of lost opportunity, management was eager to rectify this problem as targ
32、eted 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 Lauentian concluded
33、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 piz
34、za 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
35、 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
36、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 competitors facility in Canada had been rejected because the equipment would not satisfy the immediate capacity needs nor achiev
37、e 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 inferio
38、r. 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 economie
39、s 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; installi
40、ng 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 w
41、ould 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 plants administrative staff, Knowles wondered what portion, if any, of the $223,000 in
42、 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 additio
43、nal 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 incr
44、eased 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 a
45、ctually 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 expend
46、iture. 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 forese
47、eable 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 Lau
48、rentian 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 q
49、uantify 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 DECISIONKnowles believed that the project was consistent with the companys business strategy since it would ensure that the Winnipeg plant continued to be the low cost producer of frozen pizzas in Canada. However, she