This report is written by Knowles. This report is written for project review team of Laurentian Bakeries Inc. This report projects a new expansion strategy for the Winnipeg plant to meet the demand of the new deal. Founded in 1984 Laurentian Bakeries Inc. operates in the industry of manufacturing a vast variety of frozen baked products within their three operating plants in Montreal, Winnipeg and Toronto. The operating plants produce items such as frozen pizza in Winnipeg, Manitoba, pies in Montreal, Quebec and Cakes in Toronto, Ontario – with each representing 30%, 30% and 40% of the total revenue stream respectively. The buyers for this company include large institutional clients such domino’s pizza, etc. which have a significantly higher level of power whereas the seller of the products consists of several food producers which have a relatively low level of power.
With the cost of setting up a plant of this scale being high, substitute products will also remain high in the market causing the overall profit margin to be low. With the company’s ongoing effort for continuous improvement Danielle Knowles (VP of operations) proposed to expand one of the operating plants in Winnipeg – which was based on the opportunity if the company expanded into the U.S. market. We have analyzed the project in terms of NPV based on the expected sales and cost figures. The NPV calculation is done to determine if undertaking the project would bring profit or loss to the firm.
Various scenarios were taken to project the NPV at those cases. This report also covers the Quantitative risks associated with exchange rate as Laurentian will be exporting to US grocery chain and will earn in dollars. The tools to mitigate those risks are also mentioned. We have identified risks related to variance in units sold. Any decrease in number of units sold can affect the profitability of project. We have devised tools to mitigate those risks also. We have also analyzed the non-quantitative risks associated and mitigation risks are also considered.
Net Present Value
Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows. It is used in capital budgeting to analyze the profitability of an investment or project. In case of Laurentian Bakeries Inc. the NPV for a particular expansion project needed to be calculated. For the base-case scenario, best-case scenario and the worst-case scenario all cash inflows and outflows have been considered. The present value of all the capital costs incurred (including depreciation) such as land, expansion of building, additional warehouse space, spiral freezer and pizza processing line have been computed. We have taken certain assumptions for the calculation of the Net Present Value. Assumptions
Inflation Adjustment: Inflation affects all the factors of production and revenue. Thus all the factors will change in a similar way. Thus we neglect this as they will cancel each other out.
Expansion of staff $223,000 for expansion of staff will not be considered as a part of this calculation since these employees would have been hired even if this project were not undertaken. This is a sunk cost.
Capacity of the plant and goods sold
In 2009, the capacity of the new plant is 5.3 million units and the number of units sold is 5.3 million as well.
No additional fixed costs were incurred in 2005.
15% operating margin cost includes all costs incurred.
Savings of $138,000 per year due to new facility is reduced from fixed cost
All the plants of Laurentian bakeries have equal profit margin and cost of goods sold is distributed as per ratio.
At the end of 4 years, the goods to be sold at UCC.
Current Capacity of the plant is 10.9 million and the expansion of the plant by 60 % will increase the capacity by 6.54 million
No further land is required which makes the current usage of land = 10.9/(10.9+6.54) = 62.5%. After the expansion, the land available for use will increase by 37.5%
Land prices in Winnipeg increase by 1.5% per year. The land price at end of 4th year is $99542.
Other savings also vary from 70% to 130% and hence adjustments are made to fixed cost.
Laurentian has transaction exposure since it has cash flows in US dollars whose value is subject to unanticipated changes in the exchange rate. Thus the Laurentian Bakery faces a risk of changes in exchange rate between the foreign and domestic currencies. Economic Exposure Laurentian also has economic exposure to the degree to which the market value is influenced by unexpected exchange rate exposure fluctuations. This can affect the firm’s market share position and its value. Overall revenues for Laurentian will depend heavily on CAD to USD ratio. If this rate increases, revenues obtained from US grocery chains will be worth less in CAD. Thus any increase in the ratio decreases the value of firm. The risk profile can be drawn as below Laurentian needs to mitigate these foreign exchange rate risk and it can do so by using any of the below tools. 1. Foreign Exchange Forward Contract
Here the Laurentian can buy future contracts to offset the currency exchange risk; the bakery should enter into a Foreign Exchange Forward Contract to agree on a set price of the asset today to be paid for at some future date. These are legally binding and can be tailored to meet both party requirements. Currently there was a fall in ratio of CAD to US but there are positive signs and the ratio has shown positive signs towards improvement. This increase needs to be mitigated and it can do so by buying a forward for a certain exchange rate at a certain time in future. Δ Exchange Rate CAD to USD
It can be observed that by buying a forward on a certain exchange price, we can hedge the firm against rise in CAD to USD ratio. The issue with this strategy is that, if CAD gets weaker with respect to USD, we won’t be able to earn benefit from it. 2. Future Contract Futures are a form of forwards with the difference that the gains and losses are realized each day instead of only the settlement date. Future contracts are traded on organized security exchange, and require an upfront payment called “margin”. Future contracts are credit risk free, compared to the forward contracts, since the clearinghouse guarantees the performance of these Future contracts. Here the Laurentian can opt for currency futures of the USD. The strategy should be same as that of forwards and the resulting profile will also be same as Forwards. 3. Foreign currency Options
Options give the Laurentian the right but not the obligation to buy (sell) an asset for a set price on or before a fixed date. This is one of the best derivatives because it gives the chance to hedge the loss of the bakery due to exchange rate fluctuation while at the same time it assures that the bakery can participate in the upside potential. Options are of two types i.e. Call Option and Put option. Laurentian bakery needs to mitigate the decrease in value of company due to increase in value of CAD w.r.t to USD. Buying a Call option can do this. As shown in the figure below, if there is increase in value of CAD w.r.t to USD, Laurentian can exercise the call and buy CAD at a certain fixed lower than current exchange rate. This will help me mitigate the risk. If the value of CAD falls in comparison to USD, we can still earn profit but a small factor due to price associated with will reduce the profits buy price of Call. Δ Exchange Rate CAD to USD
The risk profile is shown below:
4. Spot Contract Laurentian can also hedge the foreign currency exchange risk by buying a spot contract. These contracts fix exchange rates against fluctuations. Laurentian might not be able to benefit from positive swings, but a negative swing won’t hurt it. The downside to these contracts is that Laurentian will have to pay for them, thus it will effectively be guaranteed to lose a little money. Other suggestions for the Laurentian: Also it is suggested to diversify the risk across different currencies since different currencies move differently, thus the loss due to one currency could be mitigated with gain in another currency. Even if we enter into forwards contracts with the grocery stores in the US to sell our goods at set prices in the near future, we would still run into significant exchange rate risk.
To hedge against the short-term exchange rate risk, we choose to consider the scenario wherein the exchange rate of Canadian dollar to US dollar increases. If the exchange rate increases, Laurentian bakery as sellers would face a loss in value since the USD would be worth less when converted to CAD. If the exchange rate decreases Thus in a position like this, the best option to mitigate the losses by exchange rate risk, would be to buy currency call options which would offset the losses if the exchange rate rises. Exercising call on CAD would increase in value if exchange rates rise. Commodity Futures Trading
Hedging against Units Sold
The expansion strategy is based on expectation of a four-year exclusive agreement with one of the US grocery chains. It creates an opportunity of selling a total of 16.8 million is four years. There is a 50 % probability that the actual demand will be half of this amount. As per our calculation, we show that in this case, we have a negative NPV and in this scenario taking up the project will lead to loss to the firm. The risk profile for change in quantity with change in value is as below.
We can mitigate the risk by selling a future contract, which will make the buyer buy certain units from us a certain price. The exercise price might be lesser than the actual market price but it will help us mitigate most of the risk due to low demand of Frozen pizza from the grocery chain. We can create a forward, which will make the buyer buy the quantities expected which is the difference between the guaranteed amount by the grocery Chain and expected quantity from the agreement. The exercise of per unit can be set at $1.7 as per the present price. The payoff profile for the above risk is shown below.
These factors are those that cannot be reflected by quantitative methods. These are very important for the project and if not paid attention to might lead to failure of the project. Managers need to pay attention to these non-quantitative factors and must try to mitigate these risks by different means. Negative Factors: Change in Management at Laurentian: An organization wide changes might result in stress related issues of the employees. The following reasons could be responsible for the stress related issues, perceived injustice or unfairness, lack of timely communication of future changes, and loss of loyalty. This might also lead to lower employee morale and loss of productivity might be very harmful to the company.
Stricter environmental regulations by government: The Company must take care of all the environmental concerns related to the project and also take care of any new regulations that the government is expected to pass in the coming years. Thus the company must take care to ensure that any bi-product or effluent is properly treated and disposed so that they do not cause any negative effect to the environment. Thus is very crucial for the progress of our project. Stricter food safety regulations by FDA: Food safety has become a very important concern not only for the people who consume it but also to the company itself. The government also regulates it heavily, thus the company needs to pay special attention in order to meet all the regulations. If these are neglected the project might get delayed or even be cancelled Other Factors: Strategic factor: The managers must make sure that the new project is aligned to the firm’s short term and long term strategy and that there is continuous improvement in the new project so that it adds some value to the firm as well.
This is one of the most important factors since if not addressed properly it might lead to the rejection of the project straightaway. Cold supply chain in the industry: Supply chain is very important for the company and determines the success and failure of the project. The company needs to work with all the supply chain partners specially the cold storage warehouses and the transportation partners. The managers must determine if the current partners can do the work or is it required to sign new partners especially for this project. Also the advancement in technology in this field is going on at a very fast pace and might led to decrease in time and also maybe cost of the supply chain cycle. We can also use Porter’s Five Competitive Forces framework to describe some non-quantitative factors. 1) Threat of new Entrant: The new project would make Laurentian a low cost produce and would help it maintain or even grow its market share.
This will make it hard for any new entrants to take a pie of Laurentian’s market share. 2) Bargaining power of the Buyer: Laurentian will have to offset the buying power of the USA based grocery chain in order to maintain the profit margins. The company must make sure that it is not forced to sell at a lower profit margin. 3) Threat of substitutes: A shift in the preference of the people to burgers and other foods might hurt the pizza industry and Laurentian badly. The managers must do their due diligence before going for the long-term investment of this project. 4) Competition from the existing competitors: McCain food is the leader of the and thus this project becomes even more imperative to Laurentian, by this they will be able to capture a new market in the USA and thus increase their share of the market. Moreover by economies of scale of productions they will be able to get larger profits by maintaining same profit margins. 5) Bargaining power of supplier: Though the prices of the underlying products required to make pizza bases have kept constant over the years, but in the wake of a sudden change in the prices the suppliers might get upper hand and demand a larger profit.
The Laurentian bakery management realized that the Winnipeg plant’s largest source of lost opportunity was the shortage of capacity. The new capacity proposed provides the following benefits – reduced cost of manufacturing, increase in sales from 10.9 million to 16.54 million in 4 years, and hence increased profits. From the data provided by Knowles, the Net Present Value of the cash flows for the given base case is positive. The pessimistic case (worst case) which has a negative NPV. This risk of the project failing can be mitigated by selling future on commodity to the US based grocery which ensures that Laurentian does not entail a contractual loss. A scenario risk profile indicates that, for the base case Laurentian can earn a positive Net Income throughout the four years. A further study of break-even analysis shows that Laurentian will have to sell a minimum of 3.07 million units to achieve financial break even and sell 8.74 million units to achieve cash break even and Laurentian can achieve these numbers within the 2 years and 4 years respectively. Considering the assumptions Laurentian bakery will make a profit all three years.