COKE vs.

PEPSI
Finance Case Write-up

NGUYEN VIET CUONG CFVG 10TH INTAKE Email: cvn@cnson.com

April 8, 2003

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In this writing, we will discuss about WACC, EVA, their uses in evaluate a firms performance and apply into a particular case of comparing performance of Coca Cola and Pepsi based on the past and forecasted data. 1. Definitions of EVA and its strengths and limitations Economic value added (EVA) has been getting plenty of attention in recent years as a new form of performance measurement. An increasing number of companies are relying heavily upon EVA to evaluate and reward managers from all functional departments. So what is EVA? 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). Quite simply, 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). (1) EVA is a dollar amount. If the dollar amount is positive, the company has earned more net operating profit after taxes than the cost of the assets used to generate that profit, in other words, the company has created wealth. If the EVA dollar amount is negative, the company is consuming capital, rather than generating wealth. A company's goal is to have positive and increasing EVA. However, as companies introduce new tools for managing their businesses, it is required that each manager also develops a working knowledge of those tools by discussing not only their definitions but also their strengths and limitations. Strengths In order to understand the strengths of EVA, the limitations of a predecessor called return on investment (ROI) must be discussed first. The intent of ROI is to evaluate the success of a company or division by comparing its operating income to its invested capital. ROI can be measured with the following formula: ROI = Operating Income / Investment The appeal of ROI is that it controls for size differences across plants or divisions. For example, assume the managers of divisions A and B earned $1,000,000 and $800,000 in operating income respectively. A naive interpretation of that difference would be that the manager of division A outperformed the manager of division B. This viewpoint is naive because the cause of division A's higher income may be its greater size relative to division B. To control this problem, ROI is used to measure each division's income relative to the asset base deployed, thereby standardizing the computation into a ratio while de-emphasizing the absolute amount.
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The primary limitation of ROI is that it can encourage managers, who are evaluated and rewarded based solely on this measure, to make investment divisions that are in their own best interests, while not being in the best interests of the company as a whole. We see the following example: A division has received a proposal from headquarters expand its activities into alternatives A and B. The company has enough funds to finance both projects and has a 10% weightedaverage cost of capital. Projected earning and investment for the division are: Current activities Operating Income Investment ROI $2,250,000 $15,000,000 15% Alternative A $342,000 $2,500,000 13.68% Alternative B $750,000 $4,000,000 18.75%

Assuming the division manager is compensated based solely on ROI, he will be motivated to proceed with only the alternative B because it would increase the projected ROI of 15% currently being earned in the traditional activities. He would not accept the alternative A because it would lower his projected ROI and negatively affect his performance evaluation and compensation. Conversely, the company would prefer that he accepts both alternatives because each exceeds the 10% cost of capital. Should the division manager be blamed for not being a team player? Well, think about the frustration of making investment choices in the best interests of the company and being "rewarded" with a pay cut because ROI declined from the prior year! EVA helps overcome the goal conflict that exists between the manager and the firm in this situation. Using EVA instead of ROI to reward the division manager would motivate him to accept any investment alternatives that generate a return greater than the company's 10% cost of capital. With the data given in the above example, we can calculate the EVA as follows: Current Activities: Alternative A: Alternative B: EVA Current Activities = 2,250,000 (15,000,000 x 0.10) = $750,000 EVA Alternative A = 342,000 (2,500,000 x 0.10) = $192,000 EVA Alternative B = 750,000 (4,000,000 x 0.10) = $350,000

Since EVA is positive for both proposals, the divisions current EVA would improve by $542,000 and therefore both proposals would be accepted. The decision is also in the best interest of the company. So with EVA, division managers' goals and corporate goals align. Any investment opportunity with an EVA greater than zero (or a return greater than the cost of capital) will be viewed favorably by division managers and the company. Investment options with an EVA less than zero (or a return less than the cost of capital) will be viewed unfavorably by division managers and the company. Thus, the primary strength of EVA is that it provides a measure of wealth creation that aligns the goals of divisional or plant managers with the goals of the entire company.

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Limitations Despite EVA's advantage over ROI, this measure has some limitations that are: size differences, financial orientation and short-term orientation. Size Difference. EVA does not control for size differences across organizational units like ROI does. A larger plant or division will tend to have a higher EVA relative to its smaller counterparts. Financial Orientation. EVA is a computed number that relies on accounting data. If motivated to do so, managers can manipulate these numbers by altering their decision making processes. Three examples will help illustrate this point: First, managers can manipulate the revenue recognized during an accounting period by choosing to fulfill first the highly profitable orders before the end of the current accounting period and postponed the less profitable ones until the next period. The end result of this scenario is a boost to current period EVA and an adverse blow to customer satisfaction and retention. Second, necessary expenditures can be terminated to boost EVA. For example, an employee training program conducted by an outside consulting firm can be terminated towards the end of an accounting period. The savings in consulting fees reduce the expenses recognized during the current period, thereby increasing EVA, but dropping commitment to workforce training. Third, managers may decide not to replace completely depreciated assets. Keeping the outdated equipment on the accountant's books lowers the asset base and ensures that no depreciation expense charges are recognized, thereby increasing EVA; however, product quality and customer satisfaction may suffer as the outdated manufacturing equipment continues to be used. Each of these examples reflects a choice on the part of managers for personal gain over corporate welfare. Short-Term Orientation. EVA overemphasizes the need to generate immediate results; therefore, it creates a disincentive for managers to invest in innovative product or process technologies. The costs or expenses associated with the project are recognized, by the accountants immediately while benefits or revenues associated with the initiatives are not recognized by the accountants until a few years. The net effect for managers investing in innovation is a lower EVA in the current period accompanied by an unsatisfactory pay raise. Granted, innovative ideas possibly may lead to greater pay raises in the future; however, all managers understand "time value of money" concepts and the notion of risk. Money in the pocket today is a certainty and is worth more than the prospect of money earned in the future, which is worth less and is more uncertain. So EVA forces managers to put undue emphasis on the short-term target. In conclusion, EVA can provide a valuable measure of wealth creation and can be used to help align managerial decision making with firm preferences; however, it is only one piece of the performance measurement puzzle and it must be used in conjunction with a balanced set of measures that provide a complete picture of performance.

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2. Now, have a look at the data for the historical EVAs of Coca Cola and Pepsi. What we can observe is that Coca Colas seems to be more stable, but Pepsis, which although was negative from 1994 to 1997, is increasing rapidly and passed Coca Colas in 2000.

Coca Cola EVA vs. Pepsi EVA

2,000 1,500 1,000 $MM 500 (500) (1,000) (1,500) Years 1994 1995 1996 1997 1998 1999 2000 Coca Cola Pepsi

The dramatic change starting in 1997 of Pepsis and Coca Colas EVAs were probably explained by Pepsis 1997 sale of KFC, Taco Bell and Pizza Hut, and the 1997-1999 mistake-ridden reign of Douglas Ivester as CEO of Coca-Cola. Also in 1999, Pepsis CEO Roger Enrinco spun off its bottling operations allowing Pepsi to focus on selling concentrates to bottlers, which can have up to twice the margin of bottling (that is 80% margin of the concentrate business in comparison with 35-40% for bottling). In order to determine what are the key drivers of EVA, we come back to formula (1) and rewrite it as: EVA = (Return on Invested Capital WACC) x Invested Capital (1)

In which the Return on Invested Capital (ROIC) can be calculated by dividing NOPAT by Invested capital. This alternative form of the EVA formula shows us that earning beyond a companys cost of capital results in value creation. See Exhibit 1, the WACC of both Coca Cola and Pepsi is almost the same. During 19941998, Coca Cola had less invested capital then Pepsi did but the ROICs of Coca Cola were much higher than those of Pepsi, consequently Coca Cola defeated Pepsi in term of value created as measured by EVAs. The situation was reverted at the year 2000. So we can conclude that ROIC is where Coca Cola and Pepsi beat each other, as recorded data. 3. We have mentioned above the term of Weighted Average Cost of Capital when discussing the way to calculate EVA but still did not have a change to discuss about it. According to Investorwords.com, Weighted Average Cost of Capital (WACC) is an average representing the expected return on all of a company's securities. Each source of capital, such as stocks, bonds, and other debt, is assigned a required rate of return, and then these required rates of return are weighted in proportion to the share each source of capital contributes to the company's capital structure, which is the permanent long-term financing of
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a company, including long-term debt, common stock and preferred stock, and retained earnings, differing from financial structure, which includes short-term debt and accounts payable. The resulting rate is what the firm would use as a minimum for evaluating a capital project or investment. Broadly, the assets of a company are financed by either debt or equity. WACC is the average of the cost of each of these sources of financing weighted by their respective usage in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it borrows. Thus WACC can be calculated by using the following formula: WACC = [Kd(1-Tc)*D/(D+E)] + Ke*E/(D+E) (2)

Unless you are a fortune 500 company with an excellent credit rating, this rate should be at least 12% to 25%. For small businesses that rate can be much higher. The weighted average cost of capital is an important component of any EVA calculation, as also of capital budgeting and project evaluation decisions, in which it is used as the discount rate in determining the value of projects being evaluated by the firm. WACC is a vital input to decision making at the corporate level. From its definition we realize that the weighted average cost of capital is dependent upon the firms capital structure as well as the valuation of the market on the firms rickiness, which reflects the cost of capital sources, provided that the corporate tax rate are constant and fair to every firm. It is the management decision in changing the percentage of debt to equity in the firms structure, therefore changing in WACC. So theoretically, the manager can try to reduce WACC by changing the capital structure. As we are aware, debt is cheaper than equity as bondholders require lower rates of return than stockholders based on the fact that bonds are a less risky investment (because it has a contractual first claim to specific future payments of interest and principal), so by using more debt, it seems that the manager can reduce WACC. But consider the fact that using more debt financing increases riskiness of both debt and equity, pushing Kd and Ke up, thus increasing WACC. So this means that it is not simple to influence the value of WACC just by altering the capital structure. And the task of the financial manager is to define a combination of debt and equity that minimizes the firms WACC. That combination is called the optimal capital structure. The example below will illustrate the statement:

Debt %

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Due to the importance of estimating WACC, a good mathematical understanding and application of the concept is essential for any financial analyst. It also helps understand the implication of a firms financial structure and, when used with EVA, can assist managers in maximizing shareholder value. A mathematical method in calculating WACC will be described in the next section. 4 and 5. Come back to the case of Coca Cola and Pepsi. In order to decide which of the two companies will be more beneficial investment over the coming years, we need to perform an EVA analysis for Coca Cola and Pepsi for 2001-2003 based on the past data as well as the future projections provided in Exhibits 6 and 7. Performing an EVA measurement is a complex process that requires us to look into many other costs before determining the overall measurement. But actually, the key component to calculating EVA is the computation of the WACC. Below is an illustration of calculating WACC of Coca Cola based on projected data for the year 2001. The same manner will be used to find WACC of both Coca Cola and Pepsi for the years during 2001-2003. In the last section we have mentioned about the formula of WACC: WACC = [Kd(1-Tc)*D/(D+E)] + Ke*E/(D+E) This formula can be rewritten as: WACC = Kd(1-Tc)*wd + Ke*we Where: Kd = Before-tax cost of debt Tc = Effective marginal tax rate Ke = Cost of equity D, wd = Total debt and weight of debt E, we = Total equity and weight of equity (2) (2)

The first step in calculating the WACC is to decide the before-tax cost of debt K d, which is able to be calculated as follows: $I ---------------(1 + Kd)t $M + -------------(1 + Kd)n (3)

NPd =

t =1

To calculate this, we use the information on publicly traded debt in exhibit 8. The provided current price $91.54, which is in a value of $100 as usual, gives us $915.4 as the NPd corresponding with the par value of $1,000. The coupon will be paid semiannually with the coupon rate of 5.75% per annum. Assuming the first payment would be 30 Apr 2001, thus number of payments would be 17. Substituting NPd = $915.4; $I = (5.75%/2)*1000 = $28.75; $M = $1000, n=17 into the equation (2), we will come up with the before-tax cost of debt for Coca Cola is Kd = 7.09%. In this case, we calculate Kd through IRR. As we are aware, the cost of debt can be obtained
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by calculating the Internal Rate of Return (IRR) of the cash flow from debt. Thus the IRR is easily determined using the IRR function of MS Excel.

C o c a C o la
The interest paid on debt is deductible, so given the corporate tax rate of 35%, the after-tax cost of debt for Coca Cola is: Kd(1-T) = 7.03*(1-0.35) = 4.57% Next, it is crucial to find the cost of equity. There are three ways to calculate the cost of equity that are Capital Asset Pricing Model (CAPM), Dividend Discount Model and Equity Capital Model. CAPM is considered to be the most complete model taking into account the firms beta, the risk-free rate and the market-risk premium. The Dividend Discount Model compares dividends forecasted for the next period with the current share price of the firm and then adds the firms growth rate. Lastly, the Equity Capital Model compares forecasted earnings for the next period over the current share price. It is clear that why CAPM is the preferred model as the others are dependent on the forecasts of dividends or earnings and disregards the impact on the market. Therefore we will use the capital-asset-pricing model for estimating the cost of equity. The formula to be used is:

2 0 0 0 3 0 -A p r-0 1

30

-9 1 5 .4
Ke = Kf + beta(Km-Kf)

2 8 .7 5 2 8 .7 5
(4)

Where

IR R =

Kf = the risk-free rate Km - Kf = market-risk premium

3 .5 4 6 %

an

The risk-free rate Kf is the required rate of return, or discount rate, for riskiless investment and typically is measured by the rate of return on a US government security. Therefore we can give Kf the amount of the 10-year yields on US treasuries given in Exhibit 8, that is 5.73%. The market risk premium represents the reward for investors for taking the risk of putting their money in stocks generally. Market risk premium is determined for the economy as a whole. This represents the margin by which the market as a whole has surpassed the performance of risk-free securities over a long period of time. Referring to the footnotes of Exhibit 9, we see that the arithmetic average of annual market returns over the Treasury bill rate over 1926-1998 is 7.5% and the compound average of market returns over Treasury bond for the same period is 5.9%, we use the latter one since it includes compounding. So the risk premium for the market (Km Kf) is 5.9%.)

Pepsi

2 0 0 0 1 5 - J u l-1 5 - J a n - 0 01
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The market-risk premium discussed above is a very broad measure, which considers the stock market as a whole. However not all the companies are equally risky, therefore the beta coefficient is used to adjust the market-risk premium based upon the risk perception for the concerned company. If a company is perceived to be no more or no less risky than the stock market as a whole, its beta coefficient would be 1. Similarly, firms that are more risky than the average will have a beta coefficient of greater than 1 and firms with less risk than the average will have a beta coefficient of less than 1. For Coca Cola, the beta is given in Exhibit 8 as 0.88, the average of the period 1994-2000. We must use the historical number of beta because of the fact that there is no forecast given for the later years. So, Ke = 5.73% + 0.88*5.9% = 10.92% Now we need to find the current market value of the debt and equity, then their weights. One thing that is very important in doing any calculation and analysis is that for WACC purposes, both debt and equity must be valued at market prices and not at the face values at which they have been recorded in the books. It should be the price at which each of these stakeholders should be able to sell their stake in the firm. The market value of debt can be calculated by using data given in Exhibit 6 (for Coca Cola) and Exhibit 7 (for Pepsi), that are the total long-term debt (booked value), the par value of the coupon and the current price of the debt traded, for Coca Cola they are $681,000,000; $1,000 and $915.4 respectively. D (Coca Cola) = ($681,000,000 / $1,000) *$915.4 = $623,387,400 The calculation of market value of equity can be done by looking at the current share price of the firms on 4 Dec 2000 and the diluted outstanding shares in Exhibit 8. For a more conservative view, we will use diluted shares instead of basic shares to account for unknown situations such us convertible debt and preferred stocks, warranties, stock options held by management and stock options held by investment banks. For Coca Cola, the current market price per share on 4 Dec 2000 is $62.75 and the number of diluted shares is 2,487,000,000. So: E (Coca Cola) = $62.75 * 2,487,000,000 = $156,059,000,000 By knowing the current market value of debt and equity, we can easily define their weights: wd = $623,387,400 / ($623,387,400 + $156,059,000,000) = 0.004 we = $156,059,000,000 / ($623,387,400 + $156,059,000,000) = 0.996 Finally, the WACC now can be found by substituting the above-defined values into the formula (2): WACC = 7.09%* (1-0.35)*0.004 + 10.92% * 0.996 = 10.8969% The calculation results of WACC for both Coca Cola and Pepsi at the years 2001 to 2003 is shown as the below tables:

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C o c a C o la W A

B e fo re -ta x c o s

D o lla r a m o u M a tu r ity v a lu
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Pepsi W AC C

B e fo re -ta x c o

D o lla r a m o u M a tu r ity v a lu
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From the calculations we can see that WACC of both Coca Cola and Pepsi is quite stable and the values are almost the same during the period even though Coca Colas WACC is slightly greater than Pepsis (provided that the forecasted data are accurate). This means that based on their relative proportions of debt and equity, they both incur costs of capital of nearly 11%. Even though Pepsi has significantly more debt, their cost of debt offsets the WACC to equate with Cokes WACC. The total equity values for Coke and Pepsi differ significantly, however their cost of equity is consistent at 10.92%. This is reflected in Cokes higher WACC. 6 and 7. With WACC calculated, the final step in finding EVA of the firms is to determine the Return on Invested Capital (ROIC). It is found by dividing the firms net-operating profits after tax (NOPAT) by its invested capital. The invested capital is defined as total assets less excess cash minus non-interest-bearing liabilities (investorwords.com) and can be calculated through the data given in Exhibit 6 (for Coca Cola) and Exhibit 7 (for Pepsi). The invested capital is calculated by abstracting A/P and other current liabilities from the total assets. We also use data in the same exhibits to calculate the NOPAT. NOPAT can be found by taking the operating income less the income tax and adjusted by adding back the accumulated goodwill amortization. We have left out the additions of the accumulated goodwill amortizations due to the lack of information thus cannot be forecasted for those at the end of the year 2001 and 2002. Please be noted that NOPAT cannot be computed by taking the operating income multiplied with the difference of 1 and the given marginal tax rate (1-T). This is explained by looking into the definition of the marginal rate, according to which marginal rate is the tax rate paid on the last dollar of one's income. In a graduated tax system (which most countries use), this rate will be equal to or higher than the tax rate paid on the one's entire income, since the tax rate is lower for the first dollars of income than for subsequent dollars of income. Therefore by multiplying the operating income with (1-T), we may receive a figure that is smaller than the real NOPAT. For Coca Cola in 2001, we have: NOPAT = $5,399,000,000 - $1,682,000,000 = $3,717,000,000 Invested Capital = $21,434,000,000 - $3,796,000,000 = $17,638,000,000 and: ROIC = $3,717,000,000/ $17,638,000,000 = 21.07%

Basing the above calculation s, we are now able to obtain the EVA for the firms according to the formula (1) above: EVA = (ROIC WACC) x Invested Capital EVA = (21.07% - 10.897%) $17,638,000,000 = $1,795,000,000 With the same manner, we can calculate projected EVA for the years 2001-2003 for both Coca Cola and Pepsi. The result can be found in the tables bellow:

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NOPAT ($MM)
Based on the given EVA for the past years 1994-2000 and the forecasted EVA for 20012003, we can build up a chart in order to better see the trend of EVAs. According to the chart, Coca Cola EVA will continue increasing while Pepsis will be unstable. The high value of Pepsi EVA in 2001 can be explained by adding a big amount of the accumulated goodwill amortization at the end of 2000 into that years NOPAT. Otherwise, Pepsis EVA of 2001 would be reduced lower than that of the year 2000.

Invested Capita NOPAT ($MM) ROIC (%)

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Coca Cola EVA vs. Pepsi EVA (1994-2003)

3,000 2,500 2,000 1,500 1,000 500 (500) (1,000) (1,500)

EVA ($MM)

Coca Cola Pepsi

From the analysis we see that Coca Cola will continue defeat Pepsi Co. in term of the value created as measured by EVA. Once again we recognize that the difference can be demonstrated using the ROIC. While, as above-judged, WACC of both firms are almost the same during the period, Coca Cola has its invested capital less than Pepsis. So the Coca Colas EVAs are higher due to its higher ROICs. So we can conclude that ROIC is where Coca Cola beat Pepsi. In conclusion, assuming the projected data is reasonable accurate, we can answer the above question that the firm most capable creating value is Coca Cola. This makes it a more attractive investment over the next few years.

19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03

Years

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