14th March, 2013

Coke vs PepsiCo, 2001

Strategic Corporate Finance Case Analysis

ADITYA GHOSE (7) | ATHUL GEORGE (31) | BIBHU PRASAD BISWAL (40) | SOHINI BHATTACHARYYA (145) | SOMYA SHARMA (146) XIME, BANGALORE

Coke vs PepsiCo, 2001 | 14th March, 2014

WHAT IS EVA? WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF USING EVA AS A MEASURE OF COMPANY PERFORMANCE? EVA is a value-based financial performance measure based on Net Operating Profit after Taxes (NOPAT), the Invested Capital required to generate that income, and the Weighted Average Cost of Capital (WACC). EVA is the after-tax cash flow a firm derives from its invested capital less the cost of that capital. EVA represents the owners' earnings, as opposed to paper profits. The formula to measure EVA is: EVA = NOPAT - (Invested Capital x WACC) or EVA = (ROIC WACC) x Invested Capital ADVANTAGES EVA allows a good way for companies to set a reward system that is not overly expensive to implement because is not too difficult for top management to monitor. EVA makes the cost of capital visible to operating managers. EVA is better than conventional ways because it takes into account the total cost of the operating capital. EVA allows a good way for companies to set a reward system that is not overly expensive to implement because is not too difficult for top management to monitor. Stock prices track EVA more closely than they track other popular measures. Ways to improve EVA Increase earnings Reduce capital employed Invest capital in high-return projects DISADVANTAGES EVA does not involve forecasts of future cash flows and does not measure present value. EVA therefore rewards managers who take on projects with quick paybacks and penalize those who invest in projects with long gestation period. Need to make changes in income statements and the balance sheet to measure economic value.

Coke vs PepsiCo, 2001 | 14th March, 2014

EXAMINE THE HISTORICAL PERFORMANCE OF COCA-COLA AND PEPSICO IN TERMS OF EVA. WHAT TRENDS DO YOU OBSERVE? WHAT ARE THE FACTORS BEHIND THOSE TRENDS? WHAT DO YOU THINK ARE THE KEY DRIVERS OF EVA? Coca-Cola's EVA has been slowly decreasing while PepsiCo's EVA has been increasing. REASONS Coca-Cola's NOPAT has decreased in recent years as a result of slowing sales growth and worsening profit margins If it were not for Coca-Cola's decreasing WACC, its EVA would decrease more rapidly. If Coca-Cola used a WACC of 12%, about the average of the past seven years, its EVA would have been $445,000,000 in 2000. PepsiCo was able to more than double their EVA in 2000 due to higher NOPAT and lower WACC. The higher NOPAT, was mainly a result of improved margins which lead to a higher ROI. THE KEY DRIVERS OF EVA The key to EVA is the spread between ROI and WACC. It is important to invest capital at a higher rate than the capital is obtained at. In theory, as long as there are enough projects that produce ROI > WACC and enough capital supplied, EVA can grow indefinitely. WHAT IS WEIGHTED AVERAGE COST OF CAPITAL (WACC) AND WHY IS IT IMPORTANT TO ESTIMATE IT? IS THE COST OF CAPITAL SOMETHING THAT MANAGERS SET? WHO SETS IT? Firms must use capital for operations. We want to know what the cost of that capital is to that firm. Therefore we look at the cost of the companies debt, the companies equity, and other costs when applicable such as preferred. Once we determine these costs we calculate the weighted average of them so that they reflect the true structure of the company. IMPORTANCE It is the opportunity cost of capital It is what the owners would expect to earn on their money in an equally risky project elsewhere. It is the financial managers who usually set the WACC. They do so with the aid of published sources, financial advisors, and other sources to estimate values for Beta, risk free rate, and market premium. A new company that faces potential bankruptcy will often take that cost into account and will be much more equity financed. A company that is relatively certain of profits will lean toward more debt to take advantage of the tax shields available.

Coke vs PepsiCo, 2001 | 14th March, 2014

CALCULATE EVA FOR 2001 TO 2003 USING THE FORECASTS GIVEN IN THE CASE AND THE WACCS YOU HAVE ESTIMATED. WACC CALCULATION

Coke
2001 % Debt % Equity Beta Risk free rate Market risk premium Cost of Debt Cost of Equity Tax Rate WACC
32.50% 67.50% 0.88 6.15% 7.50% 7.10% 12.75% 35.00% 10.11%

PepsiCo
2003
28.45% 71.55% 0.88 6.15% 7.50% 7.10% 12.75% 35.00% 10.44%

2002
30.30% 69.70% 0.88 6.15% 7.50% 7.10% 12.75% 35.00% 10.29%

2001
42.40% 57.60% 0.88 6.15% 7.50% 6.97% 12.75% 35.00% 9.26%

2002
36.89% 63.11% 0.88 6.15% 7.50% 6.97% 12.75% 35.00% 9.72%

2003
35.64% 64.36% 0.88 6.15% 7.50% 6.97% 12.75% 35.00% 9.82%

Source: Exhibit 6 & 7 => D/E Structure.

Exhibit 8 => Beta, Risk Free Rate, Market Risk Premium & Cost of Debt (Bond Yield to Maturity) Cost of Equity = CAPM, Tax Rate = 35% (Assumption)

EVA CALCULATION

Coke
2001 Pre-Tax Income Equity Income Goodwill Cash Taxes Interest Income Interest Expense NOPAT Debt Equity Acc. Goodwill Cash and Equivalents Invested Capital
5605 -197 295 -1738 -295 310 3980 5426 11267 487 -2238 14942

PepsiCo
2003
6874 -261 295 -2131 -254 264 4787 4919 12368 1077 -2432 15932 30.05% 10.44% 19.61% 3124

2002
6313 -227 295 -1957 -244 280 4460 5172 11898 782 -2406 15446 28.87% 10.29% 18.59% 2871

2001
4394 -157 236 -1142 0 148 3479 6833 9282 987 -2241 14861 23.41% 9.26% 14.15% 2102

2002
4979 -186 295 -1245 0 92 3935 6810 11648 1282 -4143 15597 25.23% 9.72% 15.51% 2419

2003
5571 -239 295 -1504 0 37 4160 6304 11382 1577 -2923 16340 25.46% 9.82% 15.64% 2555

ROI 26.64% WACC 10.11% Spread 16.53% EVA

2470

Source: Exhibit 7 => Income Details.

Coke vs PepsiCo, 2001 | 14th March, 2014

INTERPRET THE RESULTS OF YOUR EVA CALCULATION. IF YOU HAD TO CHOOSE BETWEEN COCA-COLA AND PEPSICO, WHICH ONE WOULD YOU CHOOSE? WHY? Both Firms EVAs are increasing from 2001 to 2003 EVAs of Coca Cola is significantly higher than those of PepsiCo. EVAs insures that management perspective and objective is to maximize shareholders wealth, as such we would choose Coca Cola. The reason is because EVA is a measure of added value, and since Coca Colas EVA is obviously greater than that of PepsiCo, it would be a good investment to choose Coca Cola as it has a higher potential. In the long run, Coca Cola can survive more efficiently than PepsiCo, as PepsiCo didnt face any near bankruptcy cases, while Coca Cola did and succeeded in recovering from them.