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 Sols 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?

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Will the demand estimated by the consultant be the actual demand

and more importantly the sustenance of the demand?

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 semiautomating the whole process. The ROI will be shown after the final
calculation
Net present values of all future cash flow will give a better picture
whether the project is worth taking or not as a high negative NPV
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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) 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. Accounts
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 companys 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

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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).
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

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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%.

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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 find
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.

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