Laurentian

Overview: Laurentian bakeries manufacture a variety of frozen baked food products such as pizzas (Winnipeg Plant), cakes (Toronto Plant) and pies (Montreal Plant). Laurentian currently enjoys 21% market share of frozen pizza in Canada and is planning to expand its frozen pizza plant in Winnipeg, Manitabo in order to meet the production capacity required for expanding into the U.S frozen Pizza market. The objective of this literature is to analyze the financial implications of the expansion of the Winnipeg plant on Laurentian Bakeries Inc. and justify our recommendations based on the analysis. Roadmap: The financial study conducted on behalf of the Laurentian Bakeries involves an analysis of the proposed expansion project of its Winnipeg plant. We start our analysis by calculating the required return that an investor will want from the firm as a whole – the weighted average cost of capital (WACC). Since the Winnipeg project is in-line with the Laurentian’s main business, we found this approach appropriate to compute the appropriate rate to use its cash flows. But risks are involved as their target market will be in United States and factors like exchange rates, supply chain management and government regulations can affect the business. We then proceeded to the next logical step – the computation of the Net Present Value – that is used in capital budgeting to analyze the profitability of the expansion of Winnipeg plant. Using realistic assumptions, we did scenario and sensitivity analysis to understand their corresponding effects on the NPV. We have stated our key assumptions that drive the computation and form the basis of our analysis. Graphical illustrations of the various variables that affect NPV are included in the exhibit to bring attention to factors that need to be thought about before the project is taken up. We have also included the analysis of non-quantitative factors that are relevant to the decision on this project. The conclusion of this report is the recommendations concerning the Winnipeg plant expansion which is based on the analysis carried out. Cost of Capital: Weighted Average Cost of Capital is the appropriate discount rate to use for cash flows similar in risk to the overall firm. It reflects the risk and target capital structure of the firm’s existing assets as a whole (both debt and equity). Investments must offer this return to be worth using the capital providers’ money. For Laurentian Bakeries Winnipeg expansion, we have calculated the cost of capital based upon the balance sheet (1995) of the firm. We used Capital asset pricing model to estimate the cost of equity and used weighted average cost of long term bonds to estimate the cost of debt. Weighted average cost of capital (WACC) was used to estimate the overall cost of capital for Laurentian Bakeries. For cost of equity calculations we have used CAPM since Laurentian is a private firm and is not listed on stock exchange and is not liable for paying dividends to the share holders (ruling out use of dividend growth model). From the cost of capital, we have tried to develop individual project hurdle rate using a subjectively determined risk premium based on the characteristic of the new project. Assumptions taken for computational purposes of the WACC are: 1. We have assumed that all the long term debt component of the company is from issuance of bonds. 2. The market risk premium equals the equity risk premium minus the risk free rate. The equity risk premium is the amount of return an investor expects from equity investments. Knowles discovered using historical information that the Toronto market returns outperforms long term government bonds by about 6% annually. Therefore we would put the market risk premium around 6% (Rm-Rf=6%). 3. The cost of debt has been calculated using the spread between Government of Canada bonds and those of corporations with bond ratings of BBB, such as Laurentian, which is about 200 basis points for most long term maturities(10 years in this case). 4. Beta measures the expected future risk of the company compared to the overall stock market in general. We assumed that the Beta value provided by Knowles is correct and have used it for our calculations. B=0.85. 5. The 10-Year Government of Canada bond with 8.06% is assumed as risk free rate. 6. The values of equity and debts have been taken from the previous year (1995) balance sheet. Based on our calculations (Refer Exhibit 1), WACC of Laurentian =10.42% .Knowles considered the implications if the project did not provide sufficient benefit to cover the class 2 hurdle rate of 18 per cent. Having a hurdle rate of 18% has to be justified. It reflects that the risk involved in this particular project as stated by the management is much higher (about 800 basis points higher) than the risk of the overall firm itself. Since we don’t have additional data for subjective analysis of the appropriate hurdle rate we have used both the WACC and hurdle rate for our NPV analysis. ‘Net present Value’ (NPV): The difference between an investment’s market value and its cost is known as the Net present value of the investment. NPV is the measure of how much value is created or added today by undertaking an investment. It is used in a capital budgeting process in order to analyze the profitability of an investment or project. An investment is considered profitable and is accepted when its Net present Value is positive. The NPV method of valuation is used here since it adjusts cash flows for both the time value of money and the risk. The figure itself tells us how much value will be created with the investment. Scenario Analysis: The alternative scenarios were studied with the help of a scenario analysis. The analysis is designed to allow improved decision-making by allowing consideration of outcomes and their implications. In this case two cases (Best and worst) are considered in order to provide us confidence with respect to accepting or rejecting the expansion plan for Laurentian Bakeries. Table: | Best Case | Worst Case | Base Case | Units Sold | 100% | 50% | 75% | Unit Price (Sales Price/unit) | +10 % | -10% | NA | Operating expenses | 80% of revenue | 90% of revenue | 85% of revenue | Inflation rate | 3% | 5% | 4% | NPV (With Discount Rate of 10.42 %) | 5179908.29 | -874718.71 | 1962259.64 | IRR | 22.60% | 7.09% | 13.65% | NPV (With discount rate of 18 %) | 1390174.18 | -2172877.36 | -598261.62 | * With respect to base case Scenario analysis examines several possible situations, usually worst case, most likely case and best case. It provides a range of possible outcomes. In our case we have seen that with a discount rate of 10.42% NPV for worst, base and best case are $ -874718.71, $ 1962259.64 and $ 5179908.29 respectively (Refer exhibit 2, 3 and 4). It should be noted that in worst case we have assumed that the NWC recovery will only be 50% of the total account which is very pessimistic that’s why we are getting a small negative NPV. However, with discount rate of 18% (Hurdle rate) NPV for worst, base and best case are $ -2172877.366, $ -598261.62 and $ 1390174.18 respectively (Refer appendix 5, 6 and 7). The NPV post all the assumptions mentioned below with operating margin of 15% is about $1.96 million (discount rate 10.42%) , however, a further analysis of various scenarios was essential to detect any forecasting risks. For the Optimistic (Best) Case, taking inflation at the lower end of 3%, assumption of 100% sales, increasing operating margin to 20%and full savings on the units produced (a result of expansion), the NPV increases to around $5 million (with 10.42% as discount rate). For the Pessimistic (Worst) Case, taking the expected inflation at the higher end of 5%, 50% of sales realization, decreasing the operating margin by 5%, NWC recoverable only 50% of total and savings of only 50% of the units produced the resulting NPV is $ -0.8 million. Our recommendation in this case is to go for the project only after reassessing the hurdle rate. If the discount rate can be adjusted upto 14 % the expansion project will give positive NPV. Sensitivity Analysis: Sensitivity analysis is a technique that indicates how much NPV will change in response to a given change in an input variable. The steeper the slope, the more sensitive the NPV is to a change in the variable. The basic idea with a sensitivity analysis is to freeze all the variables except one and see how sensitive our estimate of NPV is to changes in that one variable. For the graphical representation, we place NPV on Vertical axis and variables on the horizontal axis. 1. Changing Units Sold: The variations in NPV due to the variations in the number of units sold, while keeping every other variable constant, is as shown in the Exhibit 8. From the table, the NPV changes by 0.4% when the number of unit sold changes by 1%. As seen from this graphical representation (Exhibit 9), the line is moderately inclined, demonstrating that the NPV for Laurentian is sensitive to the small changes in the no. of units sold. 2.Changes in Price/unit: When the selling price of the units is changed, while keeping every other variable constant, the pattern observed in the changes in NPV is as shown in the Exhibit 8, The line is steeper (refer Exhibit 9), which shows that the NPV is very much sensitive to the changes in selling price of each unit. Moreover, the NPV is zero when the selling price is around 0.35. Here if we change price per unit by 10 cents, NPV shows deflection of almost 7.3% 3. Changes in Savings per unit: As seen from the Exhibit 8, the variation in NPV w.r.t to changes in savings per unit yields slightly inclined line. Even if saving per unit is zero, graph in Exhibit 9 shows high positive NPV i.e. 1950623.This implies that the NPV is not much susceptible to the changes in savings per unit. 4. Changes in other Savings: Similarly, as seen from Exhibit 8, the change in the amount of saving does not result in a substantial change in the NPV. Even here if we have zero other savings project yields a high positive NPV of 1363622. Therefore, change in other savings does not affect the estimation of NPV substantially. As per the aforementioned sensitivity analysis, the NPV for Laurentian expansion project is highly sensitive to the variable Price/Unit. So while making estimation, more attention should be given to the estimation of selling price. The plot of variable price is much steeper than that of other parameters, indicating that NPV is more sensitive to variable price than other parameters. Steeper sensitivity line indicates greater risk. Thus we are able to find those variables which potentially have the greatest impact on profitability which will help the management to focus on most important variables. Also the projected IRR for this project is 22% for the best case and around 14% for the base case, at which NPV for project is zero. So the required rate of return should be somewhere around 15%. Since the hurdle rate of 18% appears to be unrealistic in the given scenario Knowles should reassess the discount rate to be considered. Anything between 11 and 15 % will make this project a go as our recommendation. Key assumption while calculating NPV: 1. We are assuming that the operating expense of 85% will also be applicable for the new project .(Given in case : Operating margin as 15 % for Winnipeg ). Operating cost = Fixed cost + Variable Cost * No of Units. As it is not clearly mentioned what are the fixed cost for Winnipeg Unit we are in no position to calculate the variable cost. It is clearly mentioned that Winnipeg plant is most cost effective plant , so we can’t assume the Company standard of around 30% as cost of sales (based on Income statement) to be proportionate for each plant. So we have not considered any variable cost in our calculations. 2. The saving per unit is 70% of $0.019 in the first year and subsequently $0.019 per unit per year. 3. Contingency budget of $400000 has been used up through the life of the project for safety and environmental concerns 4. $40,000 spent on securing the deal with the US grocery chain is considered to be a sunk cost, because Ms. Knowles would have spent this in order to secure any deal. Sunk costs are costs that an organization would compulsorily incur irrespective of go or no-go decision for a project. 5. $223000 of fixed salary of the administrative workers has not been considered as an operating expense and is excluded from the figure under “Operating Expenses”. This has been done because no staff is being added as a result of this expansion 6. The cost of the land (Land value of $250,000) is not included in the opportunity cost, as the land forms the part of existing plant. This land if not used for this expansion project cannot be sold and hence we cannot realize its cost to the project cost. This doesn’t cause any huge impact on the NPV value even if considered. 7. The ratios and figures in the balance sheet are a reflection of each division in the company and can be used as a benchmark to calculate returns for the expansion/new projects 8. The unit production capacity on expansion of 5.3million units is the maximum capacity, and therefore stays constant after the third year 9. The CCA deductions are eligible for the new expansions in the equipment only. 10. The sales figure are given till 1998, we are assuming that the sales will not fall in the subsequent years. A major assumption since the sales figure affects the NPV calculation a lot. This assumption is a reasonable one, and gives us a reasonable base for calculation of NPV. 11. As stated in the case the working capital is the sum of the inventory and accounts receivable less account payable, all of which were a function of sales. Taking this into consideration ratio of the NWC /Revenue is calculated for the previous year data (1993-95) and the average of the same is taken for calculation in the year 1996 and onwards. Refer to Exhibit 1A 12. The above point also makes the NWC a dependent variable (dependent on Revenue); hence in best case and worst case scenario we don’t increase/decrease NWC. 13. For worst case possible, we assume the NWC may not be fully recovered. We have assumed that only 50% of the NWC recoverable will be recovered at the end of the project in the worst case scenario. 14. Tax rates for the year 1996 onwards, are taken are the same from the previous year, 38% Non-quantitative factors that may influence the decision on this project are enlisted as under: 1. Government Regulations and Taxes: Government regulation and tax norms in USA may change over a period of time and since the project is of 10 years these factors need to be addressed and looked upon. The Federal or Provincial government may impose new industry, safety, labor, environment or export laws that might affect the operation of the company significantly. The increase of tax rates can also affect the business profitability in a significant way. 2. Exchange rates fluctuations: In our calculations, we have assumed that the exchange rates of US and Canadian currencies will remain constant throughout the ten years. We have not incorporated the volatility of the exchange rates and the eventually strengthening Canadian dollar. If the value of US dollar decreases as compared to the Canadian dollar or vice versa, then the value of money Laurentian receives from the US retailer could significantly be lower when converted into Canadian dollars. The fluctuations in exchange rates of US dollar to Canadian dollar have not been considered in the studies of the project. 3. Strategic Plan: A visionary document prepared with three-years of horizon that mentions a hurdle rate of 18% for this Class 2 project as it may be more risky.However, these guidelines may not be strictly followed in our projects. For instance, this project, being the first venture of the company in US market, may come with long-term benefits that may not be acknowledged and accounted for in the time frame of three-years. So, the hurdle rate for the project may be relaxed to a certain extent to appreciate the overall business prospects of the project. 4. Obsolete Technology: Over the period of ten years, competitors may implement newer technologies to manufacture pizza at lower costs. To remain competitive, Laurentian’s Winnipeg project will need a strategy restructure, which will differ significantly from the picture we are portraying based on Laurentian’s current expansion plans. Our calculations, and consequently our analysis, have not incorporated competitor move to newer technology that might revolutionize the industry. 5. Transportation & Energy cost: Efficient and cost effective transportation of pizza from Winnipeg to the various locations in the United States is a cause for concern in the current markets. In our calculation of the feasibility of the project, the transportation costs are not factored in. If the transportation costs are high, it could lead to significant reduction from the expected gains of the project. Volatility of oil prices poses a high influence on transportation costs and accordingly storage after production needs to be taken into account. Warehousing and energy requirements for refrigeration and cold storage add to the rapidly increasing energy costs. This could significantly affect the performance of the company. 6. Health conscious customer: The preference of US citizens is gradually shifting from unhealthy, fattening food to healthy and nutritious food. In light of this, the demand for pizza over the 10 years we have considered cannot be accurately predicted. This uncertainty could lead to decreased production and possible loss of capital in the Winnipeg project. 7. Product appeal and quality standards of Laurentian bakery in Canada should be acceptable to FDA and attractive to US customers. Failing to address these constraints and concerns may have negative influence on the projected sales figures. 8. Three areas of environment concern that need to be addressed in the proposal are: a. Design and installation of sanitary drain systems, b. Provisioning of water-flow recording meters, c. Using ammonia as the coolant, rather than using chloro-fluro-carbons. The company needs to implement these in accordance with regulatory bodies and local by-laws. Recommendation: In addition to this, the Laurentian Bakeries’ requirement of 18% return for projects in risk class II, and the condition to meet the sales targets appears to be a bit impractical, especially when the cost of capital is 10.42%. If the company’s requirements are to be met, then the expansion of the Winnipeg plant is not recommended, however, if the company is willing to compromise on the required discount rate, then, expansion may be a viable option purely from the financial calculations. If the Winnipeg plant were to be expand and ensure success, strong retailer tie-ups and product innovation (healthier, nutritious pizzas) will have to be considered. Once the expansion of the plant and extra production capacity is achieved, the business will be exposed to following risks. 1. Factoring the Exchange rate fluctuations: If the US dollar grows weaker as compared to Canadian dollar, it will directly impact the profitability of Laurentian bakeries. We recommend hedging for exchange rate fluctuations.. Entering a forward contract with the retailer by which Laurentian agrees to deliver the predetermined number of pizzas and the retailer agrees to pay Laurentian the amount of money in Canadian dollars. Otherwise, hedging on currency rates by buying put options on US dollar can be done. Here, if the US dollar decreases in value as compared to Canadian dollars, Laurentian can exercise the put and the profit from the option can be used to negate the reduction of profit from business. 2. Exposure to energy and costs variations due to volatility of oil prices Volatility of the world oil prices can affect the production, storage and transportation costs (logistics) and might reduce the profitability of the company. Hence, the company can hedge against increasing crude oil prices by buying option calls from oil companies. If the oil prices do increase in the given period, Laurentian can exercise the option and the profit obtained can be used to offset the reduction of profits due to sudden surges in energy costs. 3. Loss of market share to healthier and nutritious food: The behavioral shift of people from unhealthy junk food to healthy and nutritious food is a cause of concern for Laurentian. As the project seems profitable and the calculations are based on demand estimates, no sharp decline in demand is envisaged. But there is always a risk of declining demand and therefore, declining profit. Hence hedging the risk by investing in other healthier and nutritional food industries in the form of option calls or futures can be done to offset decrease of profitability due to customers migrating from pizza to healthy foods. 4. Exposure of the invested capital to natural or other calamities : The invested capital is an asset and there is always the risk of the asset being ruined by natural catastrophes such as flood, storms, earth quakes etc. or by other causes such as fires, explosion etc. The equipment and machinery should be insured properly against any of the scenarios mentioned above.