OCTOBER 23, 2016

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?
Will the demand estimated by the consultant be the actual demand and more
importantly the sustenance of the demand?

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Financial Management 2

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)

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Financial Management 2

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 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).

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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

Monthly Demand 600,000 Total Months 12

Yearly Demand 7200000 Unit Selling Price 5

Conversion Ratio 1000000 Annexure rentRevenue( 1 Yr) 0.06

Raw material Cost/Unit 1.8

Total raw Material Cost(1 Yr) 12960000

Labour Cost (per month) 180000

Enregy Cost (per month) 50000
Total Labour and Enregy Cost(1 Yr) 2760000
COGS 15.72

Account Receivable(million Pesos) 4.44

Average Account Receivable(Days) 45
Account payable (Days) 36
Average Account Payable(million Pesos) 1.28
Inventory 1.08

WACC 18.20%

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Financial Management 2

Year by Year analysis of Cash flow for the Project (All figures are in million of
pesos)
Year 1 Year 2 Year 3 Year 4 Year 5
Sales 36 36 36 36 36
Income from Other
Sources 0.06 0.06 0.06 0.06 0.06
COGS 15.72 15.72 15.72 15.72 15.72
Gross Margin 20.34 20.34 20.34 20.34 20.34

Administrative &
Selling expenses 0.3 0.3 0.3 0.3 0.3
Accounting
department
Expense 0.36 0.36 0.36 0.36 0.36
EBITDA 19.68 19.68 19.68 19.68 19.68
Depreciation 9.2 9.2 9.2 9.2 9.2
EBIT 10.48 10.48 10.48 10.48 10.48
Interest @16% for
Loan of 10 million
Pesos 1.60 1.37 1.09 0.78 0.42
EBT 8.88 9.11 9.39 9.70 10.06
Tax @30% 2.664 2.733 2.817 2.91 3.018
Net Income 6.22 6.38 6.57 6.79 7.04
Depreciation 9.2 9.2 9.2 9.2 9.2
Operating Cash
Flow 15.42 15.58 15.77 15.99 16.24
Accounts
Receivable 4.44 4.44 4.44 4.44 4.44
Account payable 1.28 1.28 1.28 1.28 1.28
Inventory 1.08 1.08 1.08 1.08 1.08
Working Capital 4.24 4.24 4.24 4.24 4.24
Change in Working
Capital(WC
Investment) -4.24 0 0 0 0
Cannibalization 0.8 0.8 0.8 0.8 0.8
Interest(1-t) 1.12 0.959 0.763 0.546 0.294
FC (Investment) 50 0 0 0 0
FCFF -38.50 15.74 15.74 15.74 15.74

NPV 3.10
IRR 23%

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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Financial Management 2

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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