Case Overview

This case talks about a capital budgeting decision of PepsiCo regarding a joint venture which
they are going to start in Peoples Republic of China (PRC). PepsiCo entered into China in 1994.
PepsiCo is in the proposal process of investing into an equity joint venture in the city of
Changchun and is currently involved in 7 Joint ventures in Peoples Republic of China (PRC).
This proposal would be one of the first two green field equity joint venture with PepsiCo having
control over both the board and day-to-day management. PepsiCo uses capital budgeting tools
such as NPV and IRR to systematically evaluate their investment project. Using this evaluation
method Mr Hawaux, vice president of Finance for PepsiCo East Asia, was wondering whether
this project would be profitable and if PepsiCo should proceed with the Changchun Joint
Venture.
But for the protection of local manufacturers the Central Government of PRC had made it
difficult for foreign companies to enter the PRC market. The only acceptable method of entry
was through a joint venture with a local Chinese firm. To attract foreign investors, the equity
joint venture was established. This meant that the foreign company would invest a maximum of
60% ownership share into the entity, while the remaining 40% would be invested by the local
Chinese company. PepsiCos equity joint venture is proposed to be with two local Chinese
companies. PepsiCo would hold 57.5% interest in the joint venture, while 37.5% by Second
Food Factory and the remaining 5% by Beijing Chong Yin Industrial & Trading Company. Mr.
Hawaux needs to determine the attractiveness of the projects risk and return prospects.

Financial estimates
Keeping in line with its previous financial practices, 12 year cash flow projections were
calculated for the proposed new venture in PRC. These financial projections accounted for the
country risk premium of investing in a relatively closed off economy like China. PepsiCo
estimated that a WAC of 13% would be suitable for this investment whereas the Chinese
counterparts eyed a 20% return from this venture.
As the sales would grow in the proposed JV, the company would need increased investment in
working capital and fixed assets and the financial projection calculated by PepsiCo accounted for
these factors. This venture required a substantial capital investment in the early years by the
partners to jump start the business. Consistent with its experience in other bottling operation in
China, PepsiCo estimated that half of their sales would be cash on delivery and other half would
be on 120 days credit period. Days sales in receivables was estimated at 45 days. The JV would
have 1.3 months of raw material and 7.5 days of finished product in the inventory.

Sensitivity Analysis
Growth

Discount Rate

($4,747.54)

3%

12%

4,501.12

14%

5%

7%

9%

11%

8,976.12

17,031.14

35,826.17

129,801.34

(1,962.14)

300.27

3,855.48

10,254.85

25,186.73

16%

(5,996.87)

(4,747.54)

(2,942.94)

(107.15)

4,997.27

18%

(8,623.27)

(7,889.65)

(6,889.27)

(5,444.27)

(3,173.56)

20%

(10,374.60)

(9,923.71)

(9,334.08)

(8,530.04)

(7,368.65)

Decision
Since PepsiCo has set a hurdle rate of 16% for its investment in China, their current growth rate
estimates of 5% is very conservative and at this rate this project would yield a negative NPV.
Thus the decision of moving forward with this project is very subjective in nature. We believe
that their growth rate can be higher in the future compared to their current estimate. According to
our sensitivity analysis, if this JV achieves a growth rate of 11% in the future then this project is
feasible for the company. however we have to take into account the possibility that the hurdle
rate for this type of an investment might be higher than 16% as originally proposed and this
would yield a negative NPV even with a growth rate of 11%.