STUDY CASE CAPITAL BUDGET ALLOCATION: EUROLAND FOODS S.A. (1988)
Financial Management Course Study Program of Economics
Sent by: Acwin Hendra S. - 1993/IV-3/11 Eko Wicaksono - 1973/IV-3/11 Martin HL Tobing -1975/IV-3/11 Supriyasruri Supriyasruri - 1992/IV-3/11
MASTER OF SCIENCE PROGRAM FACULTY OF ECONOMICS AND BUSINESS YOGYAKARTA November, 2011
Euroland Foods S.A. Senior manager’s of euroland was challenged to allocate limited spending on capital project for only 120 million imposed by the boards of directors, in early January 2001. There were 11 major projects that totaled 316 million and investment in this rate would represent a major increase in firm’s current asset base of 965 million. Euroland a Belgium multinational firms are the producer of high quality ice cream, yogurt, bottled water, and fruit juice. Scandinavia, Britain, Belgium, the Netherlands, Luxembourg, western Germany, and northern France are the market area for its products. Ice cream leading on 60 percent of firm revenue; yogurt contributed approximately 20% and the remaining 20% else divided equally between bottled water and fruit juice. Ice cream the company’s leading product had a loyal based of customers. But since 1998 the Euroland Food’s sales had been static. Management argued that low population growth in northern Europe and market saturation caused this static sale. From outside views faulted recent failures in new product introductions. Most members of management wanted to expand the company’s presence introduce more new products to boost sales that would improved the company’s market value. Euroland Foods stock was currently 14 times earnings, just below book value. T his price/earnings ratio was below the trading multiples of comparable company, and it gave little value to company’s brands. Source Allocation
Capital budget at Euroland Foods was prepared annually by a committee of senior managers, who then presented it for approval to the board directors. As a matter of policy, investment proposals wre subject to two financial test; payback and internal rate of return (IRR). Minimum Type of Project
Acceptable IRR
Maximum Acceptable Payback Year
1. New product or new markets
12%
6 year
2. Product or market extension
10%
5 years
3. Efficiency improvements
8%
4 years
4. Safety or environmental
No test
No test
Test or hurdles had been published in 1999 by the management committee and variate among type of project.
The estimated weighted-average cost of capital (WACC) of Euroland was 10.6 percent published in January 2001.
Ownership and The Sentiment Of Creditors and Investors
125 percent debt-equity-ratio of Euroland Foods was leveraged much more highly than its peer in the European consumers-foods-industry. Management had relied on debt financing significantly in the past few years to sustain firms capital spending and dividends during a period of price war. And with the end of price war Eouroland bankers strongly urged an aggressive program of debt reduction. in any event they were not prepared to finance increase in leverage beyond the current level. 14 times of price earnings ratio, indicate shares of euroland Foods common stock were priced below the average multiples of peer companies and the average multiples of all companies on the exchanges where Euroland Foods was traded. At the conclusion of the most recent meeting of the board directors, the board voted unanimously to limit capital spending in 2001 to 120 M. Members of The Senior-Management Committee Heinz Klink Profile
Position
: Managing Director for Distribution
Job Desk
: Oversaw transportation, warehousing, and order-fulfillment
Main Concern
: Spoilage, transport cost, stock-outs, and control system
Project a. Replacement and expansion of truck fleet
Brief description:
Buy 100 refrigerated tractor-trailer trucks, 50 each in 2001 and 2002. Objective:
Efficiency Advantage:
-
New trucks capacity 15% larger
-
New Tractors will be more fuel and maintenance efficient
-
More flexible scheduling and more efficient routing and servicing of the fleets.
-
More frequent delivery to the company’s major market.
-
Delivery change will be shorter
-
Would reduce he loss of sales caused by stock-outs
b. Networked, computer-based inventory control system for warehouses, and field representatives Brief description
Setup networked, computer-based inventory control system to support supply chain management. Objective:
Efficiency Advantages:
-
Short term delay in ordering and order processing.
-
Better control of inventory
-
Reduction of spoilage
-
Faster recognition of changes in demand at the customer level
Maarten Leyden Profile Position Job Desk
: Managing Director for Production Purchasing : Managed production operation at the company’s 14 plants
Main Concern
: Production cost control
Project a. New plant Brief description: Build new plant to produce ice cream and yoghurt in south eastern region to meet the market demand. Objective: Market extension Advantages: - Increase sales - Reduce delivery cost
b. Expansion of a plant Brief description: Expand plant to produce mineral water and fruit juice in southeastern region to increase production capacity. Objective: Market extension Advantages: - Increase production
Scheduling of routine equipment maintenance become easier. c. Plant Automation and conveyor systems Brief description: Automation production line Objective : Efficiency Advantages : - Improve Speed in production - Reduce Accident - In turn will reduce potential cost related to compensation of injury
-
d. Effluent-water treatment at four plants Brief description: Set up the water treatment equipment to reduce poisonous chemical. Objective : Society and Environment/meet legal requirement Advantages:
-
Potential cost reduction Maintain the company reputation
Fabienne Morin Profile
Position
: Managing Director for Marketing
Job Desk
: Marketing research, new-product development, advertising, and brand management
Main
: Production cost control
Concern Project
a. Development and roll-out of snack foods Brief description: Utilizing the excess capacity to prudoce dried fruit Objective : New market/product Advantages
:
-
Utilize the excess capacity
-
Creating new market
-
The plan based on experience of other companies
b. Development and introduction of new artificially sweetened yoghurt and ice cream Brief description: Objective : New product and efficiency Advantages
:
-
Cost saving
-
Stimulating demand for low-calorie products.
-
Protecting market share
Marco Ponti Profile
Position
: Managing Director for Sales
Job Desk
: Oversaw the field sales force of 250 representatives and planned changes in geographical sales coverage
Main
: Rapid expansion and geographical positioning
Concern Project
a. Market expansion in southward/eastward Brief description:
The Company expanded its market southward including France, Switzerland, Italy, and Spain and/or Eastward to include eastern Germany, Poland, Czechoslovakia, and Austria. Objective :
Market extension Advantages
-
:
The time is right to expand yoghurt and ice cream geographically
Nigel Humbolt Profile
Position
:
Managing Director for Strategic Planning
Job Desk
: Set up strategic planning staff
Main
: Growth and Market share
Concern Project
a. Acquisition of a leading schnapps brand and associated facilities
Brief description: Making diversifying acquisitions in an effort to move beyond
company’s mature core business Objective : New product category Advantages
-
:
Cordial and liqueurs offered unusual opportunities for real growth and market protection through branding
POINT OF VIEW OF EACH MANAGER Wilhelmina Verdin
As a PDG, Verdin is responsible for the whole company values. She concerns mainly on company’s long term growth. The recent compan y’s difficulties are become her concern as well. The previous three years financial reports show the Euroland’s low growth, earning per share, and market value of the company. It is a bad sign for the company’s future operation continuity and current performance. To increase the values, company must develop strategies by increasing the growth. Company’s growth had been static since 1998 because of the static sales. Either management have a reason that the market saturation in a low population in northern Europe or the outside observer have different reason that failures of new-product introduction are the causes of the static sales and growth, it gives the same sign that Euroland must expand their main products sales to increase the company’s growth. Geographically, it is the right time for company to expand yoghurt and ice cream sales outside the existing saturated market, especially to southward and eastward. To fulfill the market demand resulted from the increasing sales, it must be supported with the increasing production which can only be reached by developing new plants. The development of new plants will also result in a decreasing delivery cost which is in line with the company’s growth objectives. Company should also give an attention to expand of the plants in southeastern region to produce mineral water and fruit juice because the existing plants had reached the full capacity production. By doing so, the company could increase the production capacity. To support the whole objectives of the company and to maximize the stakeholder values, the following capital budget proposal must be held by the company:
No
Investment Project’s Name
(in €)
1
Expand Southward
30M
2
Expand Eastward
30M
3
New Plant
45M
4
Expanded Plant
15M
Trudi Lauf
As a Finance Director, Lauf is responsible for managing the modernization of financial control and systems. Lauf had also been a vocal proponent of reducing company’s leverage and voiced the stakeholder’s concerns and frustrations. By expanding the market southward and eastward, it is support the company’s profitability, which in turn increases the assets and equity balance and reduces the company’s leverage. Company must aware of the cost efficiencies. The use of arti ficial sweetener for company’s products will result in cost reduction. To reach the cost efficiencies, company must aware of the supply chain management including short term delay in ordering and order processing, better control of inventory, reduction of spoilage, and faster recognition of changes in demand at the customer level. European Community directives called for any waste-water containing even slight traces of poisonous chemicals to be treated at the resources and gives company four years to comply. Company needs effluent-water treatment at four plant to comply the the directives and to reduce cost reduction. Euroland must keep the company’s image in the eyes of stakeholders, otherwise company will receive bad image in the eye of consumer and at last reduce the stakeholder trust which is feared to decrease the company’s market value. To maintain the financial sustainability and to satisfy the stakeholder’s interests, the capital budget would be as follow: No
Investment Project’s Name
(in €)
1
Expand Southward
30M
2
Expand Eastward
30M
3
Artificial Sweetener
27M
4
Inventory-Control System
22,5M
5
Effluent water
6M
Heinz Klink
Klink concerned with the product distribution of Euroland Foods. That's why he proposed some projects that could improve the distribution process, such as replacement of the old truck fleet and inventory-control system. The two projects proposed by him would help him to improve his performance as managing director for Distribution in the company. We would like to try to make an alternative capital budget that would be supported by Heinz Klink regarding his position as managing director for Distribution. First, Klink would place the replacement of the old truck fleets as the first choice. The replacement could give some advantages for the company. Those advantages came from cost efficiency and market expansion supported by the new fleets. Those advantages are as follow: 1. The new fleets would be more fuel and maintenance efficient 2. The new fleets could load more goods on each trip (15% increase) 3. More flexible scheduling and more efficient routing and servicing of the fleets 4. Shorter delivery times and cut inventories 5. More deliveries to company's major markets. Those advantages could be used by Klink to defend his proposal on the board meeting. He would reason that the project would be in line with the company's strategy, because it would improve both cost efficiency and market expansion to support the growth of the company. The project required 33M initial outlay with the yield of 11.6 M over the next seven years that would come from cost saving and added sales potential. Second, there was another project that was proposed by Klink. It is Networked, computer-based control inventory-control system for warehouses and field representatives. The project would support the distribution system of the company. There were several advantages of the project, such as shorter delays in ordering and order processing, better control of inventory, reduction of spoilage, and faster recognition of changes in demand at the customer level. The investment required 22.5 initial outlay, with the benefit for the next three years, IRR of 16.2% , NPV at WACC of 1.75 and NPV at Minimum RoR of 2.67.ß Third, the total projects proposed by Klink was 55.5 M. Regarding the capital budget of 120M, so the remaining budget would be 64.5 M, then Klink would support some projects that could also improve the distribution system for the companies so that he could also get some benefit from those projects because they would also support the improvement of his performance
as managing director for Distribution. One of the remaining nine projects that could support him could be The New Plant in Dijon proposed by Leyden. The new plant could support the distribution system in southeastern region by reducing shipping cost and lost of sales in the region. The other project that would be supported by Klink would be the expansion of plant in Nurenberg, Germany. The reason is because the expansion would improve the production schedule then the improvement would also improve the schedule for distributing the product as well. No
Project's Name
Investment
1
Replacement and expansion of new truck fleet
33 M
2
Networked,
22.5 M
computer-based
control
inventory-control system for warehouses and field representatives 3
A New Plant in Dijon
45 M
4
Expansion Plant in Nuremberg
15 M
Maarten Leyden
As managing director for producing and purchasing, Maarten Leyden concerned with the cost of production in Euroland Foods. He is tough negotiator with unions and suppliers, his style occurs because as producing and purchasing director and managed production operations at the company’s 14 plants he gained a long life experienced about how to manage the cost of production effective and efficient. We are not surprised when he proposed 4 projects that all related in cost efficiency, the project are A new plant, Expansion of a plant , Plant automation and conveyor systems, Effluent-water treatment at four plants. Considering the position of Maarten Leyden as managing director for producing and purchasing we are trying to explain why Maarten Leyden supported the project. A new plant – as noted by him there a exceed the capacity of its Melun, France, manufacturing
and packaging plant for producing yogurt and ice-cream sales in the southeastern region. This conditions induce the existing demand was being met by the newest plant located in Strasbourg, it lead the additional cost of production because the shipping cost over that distance were high. To take off this burden of shipping cost that will be disturbing the marketing effort because there
is no supporting from delivery Maarten Leyden proposed a new plant of manufacturing and packaging be built in Dijon, France just at current southern edge of Euroland Food’s marketing region. The cost of new plant would be 37.5 M and would entail 7.5 M for working Capital. The new plant also would expected to yield after-tax cash flows 35.5 M and IRR 11.3 percent over the next 10 years for gained from increasing sales and depreciation and also the decrease in delivery cost. Maarten Leyden would defend this project for three main reasons; reducing the delivery cost that means less in cost of production and the new plant would increase the company sales in southeastern region and the last this project has 11.3% IRR above 10% of minimum acceptable IRR. But southeastern region would be facing problems with the test or hurdles had been published in 1999 by the management committee that just allow maximum acceptable Payback period 5 years but a new plant project has Payback period 6 years. Expansion of a plant - Considering full capacity of its Nuremberg, Germany plant and the need
of greater production capacity in Euroland Food's southeastern region Maarten Leyden proposed expansion of plant project to eliminate production scheduling and deadline problems. The plant's estimated would be expanded by 20% for 15 M and would be resulting additional production up to 2.25 M a year, and yielding IRR 11.2 percent above 10% of minimum acceptable IRR. From the calculation we found that this project resulting Profitability Index 1 that would be used by Maarten Leyden to defend this project although it’s not meet the minimum acceptable payback years of the project. Plant automation and conveyor systems - To increase automation that would have a benefit of
cost production reduction Maarten Leyden also requested 21 M for plant automation and conveyer systems. This projects benefit from improving production, reducing employee accidents, spillage and production tie-ups. The conveyer systems would eliminated the need for any heavy lifting by employees that will be giving the company cost savings and depreciation totaling 4.13 M a year from average hourly total compensation 150,000 a year. The plant automation and conveyer systems also increasing productivity by reduce the chance of injury by employees. As stated that minimum efficiency acceptable IRR 8% this project is met by resulting 8.7 IRR, this is may be the reason that will be used by Maarten Leyden to defend this project. Effluent-water treatment at four plants - As the environmental project would not be tested by
financial test this project proposed by Maarten Leyden tends to be speculated for preventing 15 M cost of equipment when immediate conversion became mandatory for the current cost of 6 M.
This project would be defending by Leyden by stated that in the intervening time, the company would run the risks that European Community regulators would shorten the compliance time or that the company pollution record would become public and impair the image of the company in the eyes of the consumers. Bad branding is a sign to reducing in sales and would affect revenue would not covering the production cost. Computer-Based Inventory-Control System - the last project that would be supported by
Maarten Leyden was computer-based inventory-control system for the ware house. This project would be met with Maarten Leyden main concern, reduction cost control because with this computer-based inventory-control system the field of sales representatives, distributors, drivers, warehouses, and possibly even retailers would be linked in one single system that means more effective and efficient by shorter delays in ordering and order processing, better control of inventory, reduction spoilage, and faster recognition of changes in demand at the customer level. From the cash-flow forecast, it’s reflected an initial outlay of 18 M for the system, followed by 5.5 M in the next for ancillary equipment but Maarten Leyden must be careful to support this project because there is the possibility of additional cost of system implementation and mitigation costs for the system implementation failure due it will take time for workers to understand and be able to operate the new system well.
Marco Ponti
Marco Ponti was managing director for Sales at Euroland Foods. He was one of the proponent of the rapid expansion of the company which was in line with his responsibility as managing director for Sales. Ponti proposed two projects that could improve the sales of the company, they are market expansion southward and market expansion northward. Both of the projects would support his performance as managing director for Sales if they were succesfully implemented. Ponti would be the proponent of some other projects that would support the sales of the company. Ponti, of course, would support the two projects proposed by him. They would increase the sales of the company which is the thing that he put more concerns because it was the indicator of his performance. The greater the sales the better Ponti's performance as managing director for Sales. Thus, both of the market expansions would be defended by Ponti in the
meeting. The two projects would have a total 60 M of initial outlay with a total of 105.1 M after-tax cash flows. However, Ponti pointed out that, it would hard for the sales and distribution organizations to expand in both directions simultaneously. The southward expansion was riskier than the eastward expansion though the IRR is higher than eastward expansion. But there were still some other projects that could improve the distribution system that would indirectly support the market extention. Those projects could also be supported by Ponti in the meeting. The remaining budget would be 60 M if the two Ponti's projects were accepted. Then Ponti would use the remaining budget for other projects that could support the sales improvement. Some of those projects would be the two projects proposed by Henry Klink which were the replacement of truck fleets and the inventory-control system. The two projects would also support the sales expansion as well as distribution, therefore they would reduce the lost of sales caused by the costly distribution costs and weak inventory control. Therefore, the alternative capital budget proposed by Ponti would be as follow: No
Project's Name
Investment
1
Market Expansion Southward
30 M
2
Market Expansion Northward
30 M
3
Replacement and expansion of new truck fleet
33 M
4
Networked,
22.5 M
computer-based
control
inventory-control system for warehouses and field representatives
Fabienne Morin
With believe of “window of opportunity” for product expansion, Morin Introduce two projects proposing new product. He proposed to Develop and roll out of snack foods and develop and introduction of new artificially sweetened yogurt and ice cream With Following Financial Performance calculation.
Indicator
New Snack
New Artificial Sweetened
Total Disbursement Net Present ValueWACC Net Present Value-ROR Internal Rate of Return Equity annuity Payback Profitability Index
27
27
3.74 1.79 13.4 0.32 7 0.64
13.43 10.97 20.5 1.94 5 1.66
From the financial analysis above, she argued that both of those projects offered positive NPV as well as IRR spread and profitability index. Thus, based on financial point of view, these projects are feasible even though there is weakness in the payback period for the snack. In addition, she also will argue from the view of non qualitative perspective. She believed that by developing and rolling out of snack foods there will be some advantages as follows: -
Utilize the excess capacity at Antwerp spice and nut processing facility
-
Creating new market
-
The market has been tested by other companies
While by applying the development and introduction of new artificially sweetened yogurt and ice cream she proposed following advantages: -
Cost saving with low cost sweetened yogurt
-
Stimulating demand for low-calorie products.
-
Protecting market share
She also remind the other manager that this innovative sweetened yoghurt can repeat the success of the low fat dairy product that had been developed and introduced by the Company. In order to support her marketing of the two new product, she also will support the project that will expand the geographical market area of the company. Based on the information in article, it have been explained that the most dairy product consumer were spread out in southward area, while the market for frozen products were located in eartward area. Thus Morin will support the Market expansions for southward and eastward proposed by Pontii with expenditure of 30
million Euro each. This project also parallel with Fabienne Morin tendetion to support growth oriented project. In addition, as a Marketing managing director, she also cares about image of the company in the eyes of the consumer. Based on this opinion, most likely she will support the Fluent water treatment at four plants that will give positive contribution for the environment as well as the image of the company and retrench of budget. So as conclussion, Fabianne Morine will support 5 prjocets as follow: No
Project's Name
Investment
1
Development and roll out of snack foods and
27 M
2
development
27 M
and
introduction
of
new
artificially sweetened yogurt and ice cream 3
Market Expansion Southward
30 M
4
Market Expansion Northward
30 M
5
Fluent water treatment
6M
Nigel Humbolt
In the article, Nigel Humbolt described as a managing director for Strategic Planning that supported Initiatives aimed at growth as well as market share and he also known for asking difficult and challenging question about Euroland’s core business, its maturity and profitability. From this description, we can say that Humbolt realize the importance of growth and from his point of view, in the 2000s the company already on the peak of its business cycle curve. His opinion can be supported by reported gross sales and net income. As been shown in Exhibit 2, we can see that the growth of gross sales almost stagnant from 1999 until 2000. Worse condition happened on Net income where the amount of Net Income constantly decreases from 1999 until 2000. This situation show that the product of this company already worn out, its market already saturated and can not create better profit anymore. Based on this argument, Humbolt suggested that the company should take an action to “recycle” its business cycle by acquiring another growing profitable company with different industry and of course different product. Based on his analysis, he proposed to Company to buy leading schnapps brand. Depart from his opinion about recent company condition, He believe that, combined with proven company’s branding skill, this diversification acquisition will
increase the profitability of the company, refresh the business cycle and finally will increase the growth as well as the market share of the company. He also prepared a financial performance analysis on this project as follow: Indicator
Value
Total Disbursement Net Present Value-WACC Net Present Value-ROR Internal Rate of Return Equity annuity Payback Profitability Index
60 69.45 59.65 27.5 10.56 5 1.82
From the financial calculation He also was able to show that even though this project need high initial investment, around €60 million but this amount will be compensated by high cash inflow that together will result in high positive NPV, Internal Rate of Return and also good profitability index (69.45, 27.5, and 1.82, respectively). This project also will be paid back in the shorter time compared to maximum payback accepted. Given this analysis, He believe that this is the most suitable project for the Euroland Foods. In addition, since this project only required €60 million of Fund, so there will be idle fund around 60 million that can be allocated to other projects. Recall his conviction that the business and its products already on the peak of business cycle and product cycle, He will dismiss all of the project that concern with efficiency as well as expansion of market for old product. In his opinion, these kind of projects will give very small impact on the growth of the company. In addition, given his concern on the market share, instead of those kind of projects, he will choose the project that introduce new product with new product cycle and new opportunity of market share. Based on that explanation, he will support the Development and introduction of new artificially sweetened yogurt and ice cream and Development and roll out of snack food with expenditure €27 million each. Given this decision, Nigel Humbolt proposes 3 kinds of project: acquisition, new artificial sweetened yogurt and ice cream, and development snack food with total expenditure amounting to €114 million.
