Coke versus Pepsi, 2001: WACC & EVA Analysis
Set in December 2000, immediately following the merger announcement between PepsiCo Inc. and the Quaker Oats Company, this case seeks to examine the implications of the merger for the rivalry between Coca-Cola Co. and PepsiCo, and for value creation by each firm. Because the merger would allow PepsiCo to control Gatorade, which held an 83% share in the sports drink market, PepsiCo would further strengthen its already-wide lead over Coca-Cola Co. in the non-carbonated drinks segment. Will the merger threaten Coca-Cola's historically stellar performance in terms of value creation?
Economic Value Added (EVA); Advantages and Disadvantages
The Economic Value Added (EVA) measures the true economic value of an investment based on residual capital. It is calculated by subtracting the opportunity cost of capital from the company’s net operating profit after tax. In a sense, EVA is the net present value of a project in capital budgeting.
The concept behind EVA is to measure performance based on the value added during the period. It measures how a shareholder’s capital is performing based on other potential investment and is thus directly linked to shareholder’s wealth.
Advantages of EVA
- In theory, EVA is almost tantamount to NPV. It is closest in essence to corporate finance theory that suggests that positive NPV projects will increase the value of a firm.
- It prevents percentage spreads problem as those between ROE and Cost of Equity and ROC and Cost of Capital. Such approaches tend to dissuade firms from taking viable projects with high ROE and ROC to avoid lowering their percentage spreads.
- It allows the firm’s decision makers to make financially sound judgement based on factors within their control—i.e. the return on capital and the cost of capital, rather than on factors beyond their control like the market price per share.
- It hinges on the results that the firm’s decision makers take—i.e. making investment decisions, and likewise, dividend decisions affect the return on capital while the financing decisions affect the cost of capital.
Disadvantages of EVA
- Computing for EVA requires several adjustments to profit and capital figures.
- Because EVA is an absolute measure, it fails to capture comparisons between divisions.
- Calculating WACC entails many assumptions.
EVA is based on historical data, which is not a clear indicator that the same will perform as such in the future.
Coca-Cola and Pepsi Co. EVA [1994-2000]
Exhibit 1 shows that between 1994 to 2000, Coca-Cola has a relatively stable EVA as compared to Pepsi Co. despite the fact that Coca-Cola’s EVA is declining from the said period. On the other hand, Pepsi Co. has acquired negative EVA in the past but has been steadily increasing and surpassed Coca-Cola’s EVA in 2000.
The trend in Pepsi Co,’s EVA was the direct impact of its CEO, Roger’s Enrico’s decision to sell off KFC, Taco Bell and Pizza Hut in 1997 as part of a move to overhaul the company and focus on snack and beverage. Business mistakes of its CEO, Doug Ivester, largely contributed Coca-Cola’s low EVA more than the global economic environment during that period.
The formula for EVA:
ROIC = Return on Invested Capital = NOPAT/ Invested Capital
Exhibit 1 shows that between 1994 and 1998, both Coca-Cola and Pepsi have similar WACC values but Coca-Cola had lesser capital investment with higher ROICs than Pepsi and thus has higher EVAs. By 2000, the situation is almost revers where Pepsi Co. now has higher EVA. Based on these observations, it can be assumed that Return on Investment Capital (ROIC) is the deciding factor for EVA analysis.
Weighted Average Cost of Capital (WACC)
The Weighted Average Cost of Capital (WACC) is the average of the costs of all sources of financing used by a firm. By calculating WACC, we can see how much interest the company has to pay for every dollar it finances. A firm's WACC is the firm’s overall required return. It is considered the appropriate discount rate to use for cash flows with risk that is similar to that of the firm. A firm’s WACC is computed using the formula:
WACC is a valuable tool to assess the soundness of a company’s financial position. When considering a new project, merger, or acquisition, WACC is used to discount the cash flows to get the NPV of the project. By calculating WACC of an investment option, the firm can have an idea of what level of returns are required to remain profitable in the future. Thus, WACC is an important tool in making sound financial decision at the corporate level.
From the definition of WACC, it can be deduced that WACC is dependent on the firm’s capital structure and the market’s valuation of the firm’s riskiness as reflected in the sources of the cost of capital, this is assuming that the corporate tax rate is constant. It is within the prerogative of the firm’s decision makers to change the percentage of debt to equity ration of the firm. Thus, changing the firm’s capital structure can decrease WACC. In general, debt is cheaper than equity but at the same time, increasing debt means higher riskiness and could lead to higher Kd and Ke.
The following were calculated to get the WACC for Pepsi Co. and Coke:
Cost of Debt (Kd)
Since both Coca-Cola and Pepsi Co. have publicly traded debt, we believe that the most appropriate approach is to calculate the yield to maturity on this debt, which can then be used as a measure for cost of debt. As shown in Appendix 1, Coca-Cola has a before tax cost of debt of 7.09% whereas Pepsi Co. has a value of 6.92%. Assuming a tax rate of 35%, the after-tax cost of debt of Coca-Cola would be 4.61% and 4.50% for Pepsi Co.
Cost of Equity (Ke)
There are three main techniques that analysts use to calculate the Cost of Equity, the Capital Asset Pricing Model (CAPM), the Dividend Discount Model (DDM) and Equity Capital Model. We used CAPM in computing the cost of equity because it is considered to be the most appropriate model as it incorporates the firm’s beta—the risk-free rate and the market risk premium. To compute for CAPM:
How to Compute for WACC
As we have stated, the first step in calculating the Economic Value Added (EVA) is to calculate the firm’s WACC. The next step is to calculate the Invested Capital. Using the data provided in the balance sheet in Exhibit 6(for Coca-Cola) and Exhibit 7(for Pepsi), we calculated the Invested Capital by adding the total debt, equity and accumulated goodwill amortization. As shown in Appendix 2, CocaCola has a consistently higher Invested Capital as compared to Pepsi Co. The third step in estimating EVA is to calculate the firm’s Net Operating Profit after Taxes (NOPAT). Using the data from Exhibit 6 & 7, we computed the NOPAT by subtracting the cash taxes and adding goodwill amortization from the Operating Income. Appendix 2 shows that in terms of NOPAT, Coca-Cola consistently outperforms Pepsi Co. The last step is to calculate the Return on Invested Capital (ROIC), which we did by dividing the NOPAT by the Invested Capital. Appendix 2 shows that, as expected, Coca-Cola consistently outperforms Pepsi Co. in terms of ROIC.
Based from the above calculations, and using the formula:
EVA=(ROIC-WACC) * Invested Capital
we were able to compute for Coca-Cola and Pepsi Co.’s EVA for the next three years, 2001-2003.
Appendix 2 shows that the forecast data on the Economic Value Added (EVA) on Coca-Cola is consistently higher than Pepsi Co. Once again, this can be due to Coca-Cola’s ROIC, which is higher than Pepsi Co.’s and thus further strengthens the argument that ROIC is the key driver of EVA.
The above graph shows that based on EVA, Coca-Cola will significantly outperform Pepsi Co. between the years 2001-2003. Thus, Coca-Cola is a better financial choice that would create more value.
To have a more robust view of the situation, we looked at the EVA figures for both companies from 1994-2003 together. It is important to note that in the long run, Coca-Cola can survive more efficiently since it has faced near bankruptcy cases and recovered from them whereas Pepsi Co. has not.
In conclusion, based on the EVA analysis, Coca-Cola is a better financial option in the foreseeable future. It should also be noted that Coca-Cola and Pepsi Co.’s recent attempts to enter other market segments is likely to be highly profitable given the changes in customer orientations from carbonated drinks to non-carbonated drinks.
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