LAURENTIAN BAKERIES

The 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 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
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.
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.
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 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 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.
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 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.
 EXHIBIT 1
INCOME STATEMENT
For The Year Ending March 31
($ millions)

1993 1994 1995

Revenues $91.2 95.8 101.5

Cost of goods sold 27.4 28.7 30.5
Gross income 63.8 67.1 71.0

Operating expenses 52.0 55.0 58.4

Operating income 11.8 12.1 12.6

Interest 0.9 1.0 1.6

Income before tax 10.9 11.1 11.0

Income tax 4.2 4.3 4.2

Net income 6.7 6.8 6.8

EXHIBIT 2

BALANCE SHEET
For The Year Ending March 31
($ millions)

1993 1994 1995

Assets:
Cash $6.2 9.4 13.1
Accounts Receivable 11.3 11.8 12.5
Inventory 6.2 6.6 7.0
Prepaid expenses 0.3 0.6 2.2
Other current 0.9 0.9
Total current 24.0 29.3 35.7
Fixed assets: 35.3 36.1 36.4
TOTAL 59.3 65.4 72.1

Liabilities and Shareholder’s Equity:

Accounts payable 7.5 7.9 8.3
Other payable 0.7 1.3 2.2
Total current 8.2 9.2 10.5
Long-term debt 16.8 20.4 24.3

Shareholder’s equity 34.3 35.8 37.3

TOTAL 59.3 65.4 72.1
 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 no
Corporate: yes no
 EXHIBIT 4
CAPITAL EXPENDITURE APPROVAL PROCESS

Start

Project Submit
AFE

Application
For
Quarterly Committed No Emergency
To C.I. spending
Funds available for emergency only
Yes (Dollar value ??)

In No less No
Annually Strategy than
$300
Yes yes

On No Less No Present
Quarterly Profit than revised
Plan $1000 plan
Yes
Yes

Exec.
Less No Committee
Project Than Review &
$1000 Approval

Yes

Divisional
Review & Approved Finish Track Result
Approval AFE Class
1&2 Spending
Savings
3&4 Spending
 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
 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 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%