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Coke vs. Pepsi, 2001 Case Solution

Solution Id Length Case Author Case Publisher
621 1836 Words (10 Pages) Robert F. Bruner, Jessica Chan Darden School of Business : UV0008
This solution includes: A Word File A Word File and An Excel File An Excel File

This case study solution takes into consideration the post 2001 period in which PepsiCo acquired Quaker Oats Company. The case analyzes the rivalry and competitive relationship between PepsiCo and Coca-Cola. The case puts forward the concepts of EVA, WACC and CAPM. The main goal of the case is to analyze the health of both companies in relation to EVA. As far as past performance is concerned, Coca-Cola is experiencing a decline in its EVA. The cost of debt and the cost of equity for both companies are almost the same. There is only a small difference in their capital structures. The future outlook suggests that Coca-Cola should surpass PepsiCo in value creation, taking into consideration EVA as its measure.

Following questions are answered in this case study solution:

  1. What is EVA? What are the advantages and disadvantages of using EVA as a measure of company performance?  

  2. Examine the historical performances 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?

  3. What is the WACC and why is it important to estimate? Is the cost of capital something that managers set? Who sets it?

  4. Calculate the WACC for Coca-Cola and for PepsiCo. Assume a tax rate of 35%. Be prepared to explain your assumptions for the following components:

  • Cost of debt

  • Cost of equity

  • Risk-free rate of interest

  • Beta

  • Market risk premium

  • Weights of debt and equity capital

  1. Interpret the results of your WACC calculations. What observations can you make?

  2. Calculate the EVA for 2001-2003 using the forecasts given in the case and the WACC you have estimated.

  3. Interpret the results of the EVA calculation. If you had to choose between Coca-Cola and PepsiCo, which one would you choose? why?

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Case Study Questions Answers

1. What is EVA? What are the advantages and disadvantages of using EVA as a measure of company performance?

EVA is a measure of company's financial performance based on the residual wealth concept. EVA is a value based financial performance measure that is calculated as;

EVA= NOPAT-(Cost of Capital*Invested Capital)

In layman terms, EVA represents the after tax cash flow derived from investment less the cost of capital invested. EVA is a dollar amount. If EVA is positive, the company has produced more after tax earnings than the cost of asset used to generate the cash flows.

Advantages
  1. It is an effective tool for wealth generation for companies in comparison with complex ratios that only depict numerical (accounting) figures.

  2. EVA denominates a culture of efficiency where managers are encouraged to accomplish more (money) with as little capital as necessary.

  3. It can also be a diagnostic tool, showing managers the problem areas in the firm.

Disadvantages
  1. EVA does not take into consideration the size differences. Most profitable projects can be small, yet they are ignored because they have relatively less EVA.

  2. Managers are motivated to manipulate the accounting figures.

  3. It may create a disincentive for managers to invest in innovative product or process technologies (they tend to have less EVA).

2. Please examine the historical performances 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?

The historical performance of both PepsiCo and Coca-Cola is depicted in the following graph. There is a dramatic change in PepsiCo's EVA after year 1996. The increase can be attributed to the sale of KFC and Pizza Hut. Meanwhile, PepsiCo CEO, Roger Enrinco boomed the bottling operations which allowed PepsiCo in attaining a high profit margin.

The post 1996 slight gradual decrease in the EVA of Coca-Cola can be attributed to the difficult tenure of Douglas Ivester, in which the performance of Coca-Cola suffered a lot as depicted in the following graph.

In order to find out the drivers of EVA, let's rewrite its equation as;

EVA/(Invested Capital)= NOPAT/(Invested Capital)-((Cost of Capital*Invested Capital)/(Invested Capital))

This equation can be simplified as;

EVA= (ROIC-cost of Capital)* Invested Capital

During 1994 to 1998, Coca-Cola has less invested capital in comparison with Pepsi. However, their ROIC was much high. Therefore, Coke beat Pepsi in EVA or value generation in the specified period. This situation reverted by the start of year 2000. Therefore, Pepsi was able to beat Coke in EVA as its constituent ROIC was much high. At the same time, Coke suffered in relation to this specific criterion.

3. What is the 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?

There are two distinct sources of funding for any company. Each source, such as stocks, bonds and other debt, is assigned a required rate of return. The weighted average cost of capital is calculated taking into consideration the relative contribution of these sources towards company's overall structure. The mathematical formula of WACC can be written as;

WACC= Cost of Debt ((Value of Debt)/(Company Value))+Cost of Equity (((Value of Equity)/(Value of company)))

The average WACC is always in between 15%-25%. Virtually all the companies discount their investment projects using this rate. EVA, NPV and many other crucial financial analysis instruments derive their value from WACC. Therefore, it is vital that the estimated WACC is accurate and reasonable. WACC is mainly dependent on capital structure and riskiness of the firm in relation to market. Therefore, in order to optimize or change WACC, managers can change the capital structure. There are still a lot of other factors that can affect the WACC. These factors include the company's beta, rate on debt and risk free rate.

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