Pepsico ChangChun Joint Venture Capital Expenditure Analysis Case Solution

PepsiCo was faced with several difficulties posed by the government of People’s Republic of China for the foreign companies who are willing to do business in China. However, later during the 1990s a few lenient policies were put forth by the government to stimulate the foreign business in People’s Republic of China. Foreign companies were only allowed to do business in China if they make a joint venture with one of the Chinese companies. The policies suggested that PepsiCo should invest at most 60 per cent ownership share of the company, whereas the remaining 40 per cent needs to be invested by the local company operating in China.

PepsiCo was involved in a joint venture with two different local Chinese companies. Through this joint venture, PepsiCo would have to invest 57.5 per cent in the joint venture, Second Food Factory would have to invest around 37.5 per cent of the total ownership, and the remaining five percent would have to be invested by another local Chinese company, Beijing Chong Yin Industrial and Trading Company. The problem at hand for Mr. Hawaux was to calculate the attractiveness of the project in terms of returns and risk associated with the joint venture.

Net Present Value Analysis

Mr. Hawaux calculated the net present value for PepsiCo to assess the feasibility of the joint venture with the Second Food Factory and Beijing Chong Yin Industrial and Trading Company. Mr. Hawaux evaluated the net present value for two different situations. The first set of calculations involved the impact of net present value on the joint venture and the second part revolved around the profitability and feasibility for PepsiCo. This means that the first set of calculations provided the net present value of the joint venture excluding the concentrate sales from joint venture, whereas the second part of analysis took into account the impact of concentrate sales on the joint venture.

1. Assumptions of Net Present Value

Before making any final decision, Mr. Hawaux had to base the calculations of net present value for the joint venture under the premise of the following assumptions:

• He must have assumed that the cash flows generated or incurred throughout the joint venture project must have taken place at the end of the financial year. The assumption is highly unrealistic and very difficult to take place in the real world scenarios. Mainly, because during any project proceedings, cash flows occur throughout a financial year instead of just taking place at the end. However, the main purpose of taking this assumption by Mr. Hawaux was to simplify the overall calculations.

• Secondly, Mr. Hawaux must have assumed that the cash flows generated by this joint venture project were quickly reinvested back into the project. He also assumed that the cash flows were reinvested into the joint venture project at a rate of return which is equal to the discount rate. In this case, the discount rate is 16 per cent. This assumption must have been undertaken to ensure that the overall calculations of the net present value for the joint venture project are accurate and reflects the true picture of the profits and risks associated in the joint venture.

2. Exclusive of Concentrate Sales

The financial analysis excluding the concentrate sales had a direct impact on PepsiCo. The analysis shows that if PepsiCo excludes the effect of concentrate sales than the net present value for the joint venture project turns out to be around $(4,748.10). This means that PepsiCo is making a loss of around $4.748 million if it undertakes this project. Hence, it is recommended to PepsiCo that it should not undertake the joint venture in such a situation.

The analysis and calculations show that PepsiCo is generating negative cash flows for the first three years before it reports a positive cash flow. The company only starts to make profits from the third year in to the joint venture project. Moreover, the negative net present value means that the joint venture’s return is far less than the discount rate applied to calculate the feasibility of the project. This shows that if PepsiCo does not incorporate the concentrate sales, it is hardly able to achieve the minimum level of the required rate of return, which is necessary to cover the costs associated with this joint venture project.

3. Inclusive of Concentrate Sales

The second of calculations done by Mr. Hawaux are established on the idea of incorporating the concentrate sales in the joint venture project. This means that PepsiCo had to take into account the business of the bottling distributor and the profits earned through these business operations. The net present value calculated by Mr. Hawaux turned out to be around a positive of $10.06 million. Therefore, it is recommended to PepsiCo that it should undertake the joint venture project including the sales of concentrate sales. The discount rate used for the calculations was estimated to be around 16 per cent.

The positive net present value of the project shows that the rate of return provided by the joint venture project is higher than the discount rate opted for the calculations. Therefore, it will be easier for PepsiCo to fulfill all the requirement of the joint venture demanded by the other companies. PepsiCo will be able to provide short term dividends to the shareholders, as well. This would enable PepsiCo to expand its business quickly into the Chinese market along with increasing its market share in the carbonated soft drink industry of China. Under the light of this analysis, it is recommended that the PepsiCo should undertake the joint venture project as it provides the highest returns with least possible risk prospects associated.

Internal Rate of Return

Just like the calculations of net present value, Mr. Hawaux developed two separate models which are related to the internal rate of return of the joint venture. If the joint venture does not include the concentrate sales then financial model shows an internal rate of return of 12.9 per cent. On the other hand, the internal rate of return suggested by the calculation for the second set of financial analysis estimated to be around 24.5 per cent. The two internal rates of return have their own significance within the scope of the two different situations. The internal rate of return shows that the PepsiCo needs a minimum required rate of return of 12.9 per cent to cover its costs at a bare minimum level without making any profit. However, if the joint venture involves the concentrate sales than the joint venture would need a higher minimum required rate of return to ensure a no profit no loss position. This is mainly because of the fact that including concentrate sales would result in higher costs associated with the joint venture such as distribution and other costs of goods sold. Lastly, the internal rates of return calculated, show the point where the net present value of the project is zero. This means that the company is not making any extra value from this joint venture project. The internal rate of return also shows the interest rate received on an investment. Therefore, PepsiCo can also benchmark the internal rate of return to compare any other investment opportunity providing a higher, lower or equal rate of return.