2. Memorandum
To: Danielle Knowles
Vice President of Operations
From: Yifan Lin
Project Analyst
Date: November 10th
, 2014
Subject: Winnipeg Expansion Project Analysis
This memorandum is to explain the current financial situation of Laurentian Bakeries
Inc. based on a comprehensive ratio analysis of year 1993, 1994 and 1995. Also,
project analysis will be conducted so that NPV, IRR, Payback Period and Discounted
Payback Period are calculated using hurdle rate and WACC rate respectively.
Current Ratio, Quick Ratio, and Net Working Capital Ratio are calculated in order to
analyze company’s solvency. Solvency is a company’s ability to meet short-term
obligation. According to the ratio shown in Appendix A, the short-term liquidity of
Laurentian Bakeries Inc. has increased from 1993 to 1995.
Activity ratios measure a firm's ability to convert different accounts within its balance
sheets into cash or sales. Total Assets Turnover, Accounts Receivable Turnover and
Inventory Turnover have increased during year 1993 to 1995, resulting from more
efficient management of company’s assets.
Interest coverage ratio is used to determine how easily a company can pay interest on
outstanding debt. The larger the interest coverage ratio, the more easily the company
pays interest to the bank. Based on the calculation shown in Appendix A, Laurentian
Bakeries Inc.’ s ability to pay interest has dropped largely due to the increased
long-term debt.
Profitability ratio including Return on Assets, Return on Equity and Profit Margin can
assess a business's ability to generate earnings. Profitability ratio has been decreased
from 1993 to 1995, which means Laurentian Bakeries Inc.’s ability to make money
has decreased.
3. Project Analysis
Laurentian Bakeries Inc. is faced with a project proposal requiring the company to invest $5.2
million for building, equipment and warehouse at first as initial investment. In terms of sales,
there is 0.5 chance customer will order full guaranteed amount, 0.5 chance will order only 50%
of guaranteed amount. Based on this assumption, thus, the unit amount in 1996-1998 are
9.825, 11.175 and 12.15 (million) as shown in Appendix B, and the revenue in each year are
17.203575 20.15444775 and 22.57027619 million (the price in 1995 is $1.7, the inflation rate
is assumed as 3% based on the referred inflation rate from US)
The total operating cash flow from 1995-1998 are 0, 1.741746813, 2.109795906 and
2.276112958 (million) as shown in Appendix C OCF row (in million). We assume that this
company need 30% of next year’s revenue as its working capital, then changing working
capital cash flow (NWC) can be found out in Appendix B Working Capital table which are
-0.55125, -0.34125 and 4.2525 million from 1996 to 1998.
We also assume that this company’s CCA rate for PPE is 20% which is most common CCA
ratio, thus we have got the ending UCC for PPE in 1998 is 2.9952 million; and we assume
that the salvage value of PPE decrease 10% from original price each year so the salvage value
for PPE in 1998 is 3.64 million; thus, the after tax salvage value for PPE is 0.41912 million
(seen Appendix B Residual value (PPE) table & CCA table). Those figures result in the
total investment cash flow from 1995-1998 are -5.41, -0.55125, -0.34125 and 4.67162
(million) which are shown in Appendix C Total Investment CF row.
So the total net cash flow from 1995-1998 are the sum of operating cash flow and investment
cash flow which are -5.41, 1.190496813, 1.768545906 and 6.947732958 million. The risk
free rate is 7.66%, and cost of equity is 12.76% (beta is 8%, risk premium is 5%), cost of debt
is 9.66%, so the WACC rate is 10.17%. Based on the WACC rate, we have got the following
results: NPV is around 2.11 million, IRR is 27% which is bigger than the WACC (10.17%
), Payback period is around 2.35 years and Discounted payback period is 2.55 years.
And based on the hurdle which is 18%, and those analysis results are: NPV is around 0.93
million, IRR is 27% which is bigger than the hurdle rate, Payback period is around 2.35 years
and Discounted payback period is 2.74 years.
Thus, our conclusion is that since the NPVs based on the WACC rate and the hurdle rate are
both positive, and the IRR rates under two rate are bigger than both WACC and hurdle rate,
this project is acceptable because it can help company to create more value. After
implementing this project, the company can get back its investment in 2.35 years based on the
WACC rate and in 2.55 years based on the discounted cash flow under the WACC rate. For
hurdle rate is 18%, the company can cover its investment in 2.35 years and 2.74 years based
on the discounted cash flow.
4. Recommendations
Based on the previous analysis, our recommendation is to take this project
because NPVs based on the WACC rate and the hurdle rate are both positive, and
the IRR rates under two rates are bigger than both WACC and hurdle rate, this
project is acceptable because it can help company to create more value
Company should consider to utilize leverage such as issuing bonds for tax saving
purpose and reducing relieving financing pressure.
Company can utilize purchased equipment after the project for other production
purpose for achieving more benefits instead of selling them since the assumed
usage life of both equipment, warehouse and building are 10 years, this project
just keep 3 years.
Company can look for other potential customers in the market for selling them
the left amount of products if our target customer just order 50% of guaranteed
amount, and company can gain more revenue based on the diversified strategy.
Company can consider to utilize the recovered initial investment (after Payback
period) to repurchase stocks or to claim dividends for increasing shareholder
value.
Company can also keep working capital for future production which can help
company to create continuous revenue after finishing the project in three years
instead of selling all working capital
Since there is a great amount of cash out flow for the project in 1995, the
company should prepare more cash as its current assets for supporting this project
by issuing bonds or stocks.
Company can also utilize the recovered initial investment to purchase risk free
financing assets due to the high risk free rate which is 7.66%.
5. Appendix A
1993 1994 1995 1993-1995 Average
Short-term solvency
Current Ratio 2.926829 3.184783 3.4 3.170537292
Quick Ratio 2.170732 2.467391 2.733333 2.457152115
NWC Ratio 0.266442 0.307339 0.349515 0.307765278
Activity Ratio
Total Assets Turnover 2.675978 2.8 2.737988827
Receivable Turnover 8.294372 8.353909 8.32414088
Average Collection Period 44.00574 43.69212 43.84892968
Inventory Turnover 4.484375 4.485294 4.484834559
Days in Inventory 81.39373 81.37705 81.3853887
Financial leverage ratios
Interest Coverage 15.22222 14.4 9.5 13.04074074
Profitability Ratio
Return on Assets 0.065758 0.061091 0.063424364
Return on Equity 0.116976 0.114911 0.115943415
Profit Margin 0.094298 0.085595 0.082759 0.087550619
