HOLA-KOLA – THE CAPITAL BUDGETING DECISION ABHINANDAN SINGH MP15003 XLRI PGDM 2015-18
Financial Management 2
Executive Summary Mexico with an increasing fascination of Soft drinks among the people is having the highest consumption of carbonated soft-drinks per capita in the world. But this also lead to health problems such as obesity which forced the government to impose a 20% tax on soft-drinks to reduce the consumption and also generate revenue which may be used for fighting public health problems. Major players in this segment were Coca-Cola, Pepsi-Cola, Dr. Pepper Snapple and Grupo Penafiel who together accounted for more than 90% share. Bebida Sol’s being a
local company provided a low price carbonated soft-drink having similar taste at about half the price which was sold mainly in small independent grocery stores and convenience stores. The company products were mainly targeted for middle to low income families and product promotion was mainly through incentives to the small retailers. During the recession in 2008-09 the company benefited as demand increased for low priced soda-business and sales increased by 60% from 2008 to 2009. Also return on sales had also seen an increasing trend in last few years. Antonio Ortega, owner of Bebida Sol was thinking of launching a zero-calorie product line with the rising health problem such as Obesity in Mexico. Certain consideration that he was supposed to take into account was the demand for these types of products and also people who demanded these products. So they hired a consultant to do market research and got the estimate that they could sell a total of 600,000 liters of these zero-calorie carbonates a month. Now the management had to take a final decision whether to invest in this project.
Problem Identification Hola Kola being a small company in the soft drinks business was launching a new product line. Certain question that were to be answered are
Whether there will be demand for their product?
Who all will be the potential customers?
Will the low income group opt for these products as they might not be much concern about health problems caused by soft-drinks?
What if the big players enter into the market?
Will the demand estimated by the consultant be the actual demand and more importantly the sustenance of the demand?
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Financial Management 2
The above problems are more of market related issues, now coming to the finance related issues there were certain questions that were to be answered.
What will be initial investment? Considering that market study is to be done for the next 5 years what would be the return on this investment?
What would be the NPV of all these returns?
What would be the effective IRR during this tenure?
Cost analysis of producing a unit and final price that the company would charge from its customer. What if inflation increases in the next 2-3 years?
How to calculate the depreciation of the new bottling plant that is to be setup for these ranges of products?
Whether the initial consultant cost is to be taken into account when analyzing the business decision?
Will the annexure be used for storing inventory and whether this cost is to be taken as an opportunity cost in the financial analysis?
How to calculate the working capital for this venture?
What would be average cost of capital? The value at which the future cash flows would be discounted to get NPV.
How to take into account the cannibalization of existing product lines because of this new product?
These are some of the problems that have been identified and need to be answered before deciding on the final decision to go ahead with the project.
Solutions
Initial investment for the project is assumed to be 50 million pesos which was needed for a new fleet of semi-automated bottling and kegging machines and this also include the cost of installation. This in turn would help the company to reduce its labour cost by semi-automating the whole process. The ROI will be shown after the f inal calculation
Net present values of all future cash flow will give a better picture whether the p roject is worth taking or not as a high negative NPV means that it is better to not invest than to suffer loss. The figures have been shown in the final analysis.
IRR is that rate at which negative NPV becomes zero. For any company there is an option to invest in a project or in the market. A high IRR(greater than market rate)
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Financial Management 2
shows that it is better to invest in project while a lower value in general suggest that investing in market is a more lucrative option (but at its own risk).
Some costs that are to be taken into account are raw material costs (1.8 pesos per liter) while labour costs and energy costs were estimated to be 180,000 and 50,000 pesos per month (for production of 600,000 units per month). Administrative and selling expenses were estimated to be 300,000 a year as the product is to be sold by current sales work force and also the existing distribution channels. Account’s department in Bebida sol
charged 1% of sales as overhead cost for any project. As there has not been any mention of inflation in the next few years, for simplicity we will assume that all costs are to remain in the next 5 years and also the selling price for the product (5 pesos per liter)
As the company expected that the new machinery will have a life of 5 years and after that it can be sold at a salvage value of 4 million pesos, so we will use the straight line depreciation method to calculate the depreciation per year which comes to be 9.2 million pesos per year. Also the company though that if the product is a success then they can introduce a fully automated bottling plant after 5 years and in case it is a failure then they can close the plant and thus the project.
As the company has already paid for the consultation cost (5 million pesos) and there was no way to recover this sunk cost so it will not be taken into account. This cost has no bearing on the company’s decision to go ahead with the project.
The annexure was built the first owner of the company and it was planned for storing inventory for mineral water business project that was planned years ago. All these years it was vacant but a few days back Antonio received an offer to lease out this space for 60,000 pesos a year. With the starting of zero-calorie soft drinks this revenue would not be added to be the company so this fall in the category of opportunity cost. As with any opportunity costs this cost is to be taken into account for any financial analysis.
The company had made huge financial gains in the last 2-3 years and thus had a huge amount of cash to be invested into any new venture. As the General manager estimated that they would require a loan of 20% of the initial investment (50 million pesos) which comes out to be 10 million pesos that the banker had agreed to pay at an interest rate of 16%. With a 20-80 debt equity structure WACC for the project was estimated to be 18.2%. This was the average cost of capital and also the value at which future cash flows are to be discounted to get net present value (NPV).
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Financial Management 2
The company also realized that with the introduction of this new product line their existing products might suffer as many of the existing customers will switch between products of the same company. It was estimated that it will cause a potential erosion of 800,000 pesos (i.e. 0.8 million pesos) of after tax cash flow each year.
After taking into account the above facts and figures we will be doing a financial analysis to find whether venturing into the new project would be ideal for the company.
Calculation
Monthly Demand Yearly Demand
600,000 Total Months
7200000 Unit Selling Price
Conversion Ratio Raw material Cost/Unit
1000000 Annexure rentRevenue( 1 Yr)
1.8
Total raw Material Cost(1 Yr)
12960000
Labour Cost (per month) Enregy Cost (per month) Total Labour and Enregy Cost(1 Yr) COGS
180000 50000
Account Receivable(million Pesos) Average Account Receivable(Days) Account payable (Days) Average Account Payable(million Pesos) Inventory
WACC
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12
2760000 15.72
4.44 45 36
1.28 1.08 18.20%
5
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Financial Management 2
Year by Year analysis of Cash flow for the Project (All figures are in million of pesos) Year 1 Sales
Year 2
Year 3
Year 4
Year 5
36
36
36
36
36
0.06
0.06
0.06
0.06
0.06
COGS
15.72
15.72
15.72
15.72
15.72
Gross Margin
20.34
20.34
20.34
20.34
20.34
0.3
0.3
0.3
0.3
0.3
0.36
0.36
0.36
0.36
0.36
19.68
19.68
19.68
19.68
19.68
9.2
9.2
9.2
9.2
9.2
10.48
10.48
10.48
10.48
10.48
Pesos
1.60
1.37
1.09
0.78
0.42
EBT
8.88
9.11
9.39
9.70
10.06
2.664
2.733
2.817
2.91
3.018
6.22
6.38
6.57
6.79
7.04
9.2
9.2
9.2
9.2
9.2
15.42
15.58
15.77
15.99
16.24
Receivable
4.44
4.44
4.44
4.44
4.44
Account payable
1.28
1.28
1.28
1.28
1.28
Inventory
1.08
1.08
1.08
1.08
1.08
Working Capital
4.24
4.24
4.24
4.24
4.24
-4.24
0
0
0
0
0.8
0.8
0.8
0.8
0.8
1.12
0.959
0.763
0.546
0.294
50
0
0
0
0
FCFF
-38.50
15.74
15.74
15.74
15.74
NPV
3.10
IRR
23%
Income from Other Sources
Administrative & Selling expenses Accounting department Expense EBITDA Depreciation EBIT Interest @16% for Loan of 10 million
Tax @30% Net Income Depreciation Operating Cash Flow Accounts
Change in Working Capital(WC Investment) Cannibalization Interest(1-t) FC (Investment)
From the above analysis we find that the NPV has a positive value of 3.10 million Pesos and the IRR for the corresponding period comes out to be 23%. 5|Page
Financial Management 2
How Free Cash Flow has been calculated Net Income for each year NCC (Depreciation) Interest*(1-t) where t is tax rate WC (Investment) – It is negative for 1st year and then 0 for other years FC (Investment) – It is 50 million Pesos for 1st year and 0 for other years
Now FCFF = NI + NCC + Interest*(1-t) – WC (Investment) – FC (Investment) Other data that has been used for calculation has been mentioned in Fig 1
Conclusion On the basis of above analysis we can conclude that the project is a viable one and Bebida Sol can go for the project. The NPV for the next 5 years is a positive value which comes out to be 3.10 million Pesos. As NPV is greater than zero and also has a high positive value i.e. 3.10 million, so the project will supposedly give a positive ROI even after some approximation or estimation error. Also if we find the discounted payback period then we find that the payback period comes out to be (3 years and 5 months) which also indicates that the project is a feasible one. The Weighted Average Cost of Capital is estimated to be 18.2%. The IRR from the calculation comes out to be 23%. So from that perspective also we f ind that investment in this project looks a more lucrative option. Apart from all these financial analysis considering the market situation where major players have already suffered setbacks this is a good time to invest and capture some share from the big players. The government has also taken many initiatives to de-promote the consumption of carbonated soft drinks. The market of high calorie soft-drinks is already going to be affected with the increase in taxes and more people becoming health conscious. Thus it is a good time to get the first mover advantage in the zero-calorie carbonated drink market. Thus I would recommend to go for the project as it look viable in market as well as financial sense.
