Pepsico. Case Answers

ANSWER 1

PepsiCo. Has performed exceedingly well over the last 10 years of its working. The sales improved considerably from 5873.3 in year 1981 to 17802.7 in year 1990 leading to a 203% increase in period of 10 years. At the corporate level it increased its net income from 297.5 to 1076.9. It is 262% increase in 10 years. The company became a conglomerate in this period by getting diversified into various divisions. The stiff competition in one division was compensated by better performances in the other divisions. The total assets of the company also increased from 3960.2 to 17143.4. The owner funds that stood at 1556.3 were increased to 4904.2 despite paying regular cash dividends. There have been various achievements at the corporate level as all indicators of good competitive performance are indicated in their financials.

The company has certainly created value for the shareholders. The company utilized its debt capacity in order to provide the financial leverage whereby low cost debt funds were used to increase the return for shareholders. The earnings per share accordingly has increased from 0.32 in 1981 to 1.35 in 1990. The market valuation per share has also increased from only 4.125 in 1981 to 25.75 in 1990. It shows increase of 524% in market price per share over a period of 10 years. Even book value per share stands increased from 1.89 per share to 6.22 per share. All these indicate that the company has worked hard towards multiplying the wealth of equity shareholders.

ANSWER 2

Cost shall depend on the respective Beta of every individual business segment. Risk free rate shall be 3.75% (Rate of return on US treasury bills)  and Return on market portfolio shall be (Assumed on geometric average) 10.1 %

Division wise beta implied from industry wise data is

SNACK FOODS = 1 (as in macdonalds)

RESTAURENT = 1.1  (As in wendy’s)

SOFT DRINKS =1 (As in coca cola)

Cost of capital in Snack foods = 3.75 + 1(10.1-3.75) = 10.1%

Cost of capital in restaurent = 3.75 + 1.1(10.1-3.75) = 10.74%

Cost of capital in soft drinks = 3.75 + 1(10.1-3.75) = 10.1%

ANSWER 3

The overall cost of capital shall be based on the weighted average of its cost of equity and cost of debt and the weights should be that of market value.

Cost of equity is computed as Risk free rate + beta (Market risk premium)

Using the geometrical averages , Market risk premium is 10.1% - 3.7% (Return on market portfolio – risk free return)

=  6.4%

Beta is 1.10

Risk free rate is 3.7% ( US TREASURY BILL RATES)

Ke = 3.7 + (1.1*6.4)

=10.74

The cost of debt is given at 9.64 (before tax)..After tax it will become 9.64 (1-0.38)

5.98%

WACC for the company cannot be near 11%. It must be much lesser.

The major reason is their wrong computation of cost of equity and ignoring the tax rate while computing the WACC. The weights that will be applied for computing WACC Shall be market value weights.

ANSWER 4

Whenever a company carries two or more divisions which differ in risk, it will be advisable to avoid using corporate cost of capital in evaluating investment decisions at the divisional level. The cost of capital is also called cutoff rate as it is the minimum required return to be earned for making the project viable. The decision to determine that rate is very crucial and is normally taken at the highest level of management. The corporate rate will represent the average rate for all divisions whereas the divisional rates will rightly represent the requirements of the respective division.