HOLA KOLA - THE CAPITAL BUDGTING DECISION

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?
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 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 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 labor 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).

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
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%.

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 going for the project as it look viable in market as well
as financial sense.