UVA PepsiCo, Inc: Cost of Capital Case Estimates Paper

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Read the PepsiCo, Inc.: Cost of Capital case and complete this assignment, drawing upon what you have studied in this case. Recognize that you are developing cost of capital estimates and that different analysts may come up with different estimates. You want to use the data in the case to develop your inputs and outline the assumptions that you are making and describe the calculations employed to develop your estimates.

You should present your findings in a report to the CFO not to exceed 5 pages of text (typed, double-spaced, 12-point font, one-inch margins) plus one or two exhibits. Your report should contain an introduction, a summary of your analysis, and a conclusion. You should use an Excel spreadsheet to do the analysis for this assignment, uplead the MS word and excel file for the analysis. Use the following questions to focus your analysis, but your report should not be in question-and-answer format.

  1. What is the overall cost of capital for PepsiCo (using beta of 1.1)? Do you agree with the 11% number stated by PepsiCo? If not, why could your number differ from 11%? Use total interest-bearing debt (short-term and long-term) as debt.
  2. What are the costs of capital for the individual business segments? Estimate these using data in the case and the pure-play method.
  3. Do the costs of capital for the business segments add up to the overall cost of capital? Why or why not?
  4. What is the danger of using the overall cost of capital to make decisions at the divisional level? Give examples of the types of errors that could occur. Can you think of some other uses for a divisional cost of capital?

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DardenBusinessPublishing:254065 UVA-F-0981 This document is authorized for use only by kanwal sakhi. Please do not copy or redistribute. Contact permissions@dardenbusinesspublishing.com for questions or additional permissions. Rev. Jan. 30, 2019 PepsiCo, Inc.: Cost of Capital “At PepsiCo Inc., cola was king, but it is quietly being dethroned.” It was this lead sentence of a front-page article in the Wall Street Journal that had caught Michael McCartt’s eye on June 13, 1991, exactly one week ago.1 The timing of the article could not have been more appropriate, because McCartt had just received a call from PepsiCo on the morning of June 13 to schedule an interview for a position on the company’s treasury staff. As McCartt read the article, he decided that, because of PepsiCo’s diversification, he would focus during the interview on the concept of PepsiCo’s cost of capital, so he could display the analytical abilities and knowledge of financial concepts he had just honed in business school. He had spent the past week reading PepsiCo’s annual reports and gathering information on its competitors in preparation for the interview tomorrow afternoon in New York. McCartt’s research had revealed some interesting facts about PepsiCo. For example, he had been surprised to learn that PepsiCo had invested more than 40% of its capital spending over the last two years in fast-food restaurants, opening them at the rate of three per day, and that during the 1991 fiscal year, the restaurant group was expected to surpass beverages as the company’s biggest revenue producer among its three business segments (see Exhibit 1 for a financial summary by business segment). Snack foods, PepsiCo’s third line of business, was the biggest profit generator of the three business segments. These findings had raised a central question that McCartt wanted to be prepared to answer for the interview: How should PepsiCo’s investment dollars be allocated among the three divisions (i.e., what criteria should be used in a diversified company like PepsiCo to evaluate potential investments)? PepsiCo History In its 1990 annual report, PepsiCo described itself as “first and foremost a growth company. Our primary corporate objective is to maximize the value of our shareholders’ investments through a strategy of rapid sales growth, close control of costs, and astute investment of our financial resources.” The company was originally incorporated in 1919 under the name of Loft, Inc. The name was changed to the Pepsi-Cola Co. in 1941 after Loft merged with its Pepsi-Cola subsidiary, which it had acquired some three years earlier. The current name, PepsiCo, was adopted in 1965 after Pepsi-Cola merged with Frito-Lay. Under the name 1 Michael J. McCarthy, “Added Fizz: Pepsi Is Going Better with Its Fast Foods and Frito-Lay Snacks,” Wall Street Journal, June 13, 1991. This is a public-sourced case. Unless otherwise cited, all data and quotations are from publicly available company documents. This public-sourced case was prepared by David Thornhill under the supervision of Professor Kenneth Eades. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright  1991 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an email to sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. Our goal is to publish materials of the highest quality, so please submit any errata to editorial@dardenbusinesspublishing.com. Page 1 of 12 DardenBusinessPublishing:254065 This document is authorized for use only by kanwal sakhi. Please do not copy or redistribute. Contact permissions@dardenbusinesspublishing.com for questions or additional permissions. Page 2 UVA-F-0981 of PepsiCo, the company made several significant acquisitions. In November 1977, the Pizza Hut chain was acquired as a PepsiCo subsidiary, as was Taco Bell some seven months later. In July 1986, PepsiCo purchased Seven Up International for $246 million in cash, and three months and $841 million later, Kentucky Fried Chicken (KFC) joined the corporate fold. In 1988 and 1989, the cash outlays continued as two bottling operations, Grand Metropolitan and General Cinema, were bought for $705 million and $1.77 billion, respectively. PepsiCo expanded internationally in 1989 with the purchase of Smiths Crisps Ltd. and Walkers Crisps Holding Ltd., the leading snackfood companies in the United Kingdom, and in 1990 with the acquisition of Mexico’s number-one cookie manufacturer, Gamesa. The resulting conglomerate was a leader in all three of its business segments. As noted by Wayne Calloway, chairman and CEO of PepsiCo, the soft-drink division generated more revenue than General Mills, Inc.; the restaurant group was bigger than Campbell Soup Co.; and the snack-food business approximated Kellogg Co. “PepsiCo doesn’t have one flagship, it has three flagships,” stated Calloway, “and people would kill to have one of our flagships.”2 Indeed, PepsiCo could boast of having eight different brands—Doritos, Ruffles, KFC Original Recipe, Pizza Hut Pan Pizza, Pepsi, Diet Pepsi, Mountain Dew, and Seven Up—that achieved over $1 billion in retail sales each year. Of its other brands, 25 achieved at least $100 million in annual retail sales. The financial success of PepsiCo is detailed in Exhibits 2, 3, and 4. Between 1985 and 1990, company sales increased at a compound rate of 19%, and income from continuing operations at a compound rate of 21%. In the beverage segment, PepsiCo had Pepsi Cola, the largest-selling food product of any type in US supermarkets and a $13 billion brand worldwide. In the global market, Pepsi Cola was joined on the list of the top 10 selling brands by Diet Pepsi, Caffeine Free Diet Pepsi, and Mountain Dew. With its latest bottling acquisitions, PepsiCo was running the nation’s largest network of soft-drink bottling plants. As for the snack-food division, Frito-Lay had the largest share of the US chip market and was more than four times the size of its nearest competitor. With the purchase of Smiths Crisps and Walkers Crisps, PepsiCo Foods International became the leading chip company in Europe. It was in the restaurant segment, however, that the size and scope of PepsiCo’s accomplishments may have been the most impressive. PepsiCo was running the largest restaurant system in the world, with close to 18,500 units, and the three categories of food served by PepsiCo restaurants (pizza, chicken, and Mexican food) were among the fastestgrowing segments of the quick-service market. PepsiCo’s worldwide sales were greater than $17 billion, and the number of its US restaurants was growing at more than twice the industry average. Pizza Hut not only had a 24% share of the US market as of 1990, but it was also represented in 54 countries internationally and was the leading pizza chain in 46 of those markets. Taco Bell was the leading Mexican-food chain domestically and was just beginning to expand internationally. KFC opened its 3,000th restaurant outside the United States in 1989, making it the largest restaurant chain overseas and the number-one quick-service chicken restaurant in the world. Financial Strategy Some industry analysts believed that Pepsi had obtained Frito-Lay in 1965 partly because chips go well with cola, and had obtained the restaurant franchises as a means of getting new fountain outlets. Over the years, however, the company’s focus had clearly shifted. The Wall Street Journal article asserted that CEO Calloway was not on any sort of “global beverage quest,”3 but was more interested in building a consumer-products company with the best possible return on equity. PepsiCo’s emphasis on performance was clearly stated in the 1990 annual report: “PepsiCo’s principal objective is to increase the value of its shareholders’ investments 2 3 McCarthy. McCarthy. Page 2 of 12 DardenBusinessPublishing:254065 Page 3 UVA-F-0981 This document is authorized for use only by kanwal sakhi. Please do not copy or redistribute. Contact permissions@dardenbusinesspublishing.com for questions or additional permissions. through integrated operating, investing and financing strategies that maximize cash returns on investments and optimize the cost of capital.” Although PepsiCo’s stock price had increased substantially over the past several years, the aggressive investment strategy had also resulted in an increased amount of debt on the books. Regarding the debt financing, PepsiCo management said: We support these investments with financial policies that strive to fund our businesses at the lowest possible cost, while giving us the flexibility to pursue growth. Every company faces the question of how much debt is appropriate. PepsiCo’s philosophy hasn’t changed much over the years, despite leveraged buyouts and the ups and downs of the bond market. We carefully set a corporate leverage target, or a ratio of our net debt4 plus market value of equity. Over time, we strive to achieve a ratio of 20% to 25%. We use market value as a yardstick, rather than the traditional book value, because the market standard reflects the tremendous value of our intangible assets—especially our brands’ reputations—while also taking into account our strong potential for growth. Our leveraged target is set with an eye toward maintaining flexibility, which means we can exceed our target occasionally to take advantage of attractive investment opportunities. The Cost of Capital According to PepsiCo management, “The cost of capital is a weighting of the cost of debt and equity, with the latter representing a measure of expected returns to investors in PepsiCo’s stock. PepsiCo estimates its current cost of capital to be approximately 11%.” It was this statement that McCartt had decided to use as the centerpiece of his interview strategy. He had learned in business school that the true cost of capital depended on how the capital was put to use. For instance, the Wall Street Journal article stated that PepsiCo’s restaurants were a lot “trickier” to manage than soft drinks. They commanded lower margins and were more fragmented, more capital intensive, and more vulnerable to shifts in consumer spending. McCartt concluded that investments in the restaurant division should be evaluated by using not the corporate weighted-average cost of capital (WACC), but a higher cost of capital. He recalled reading an article by Russell Fuller and Halbert Kerr5 that outlined how to estimate the cost of capital of a division in a multidivision firm. Essentially, each division was matched with a publicly traded company having a single line of business that was as similar as possible to the division’s. The cost of capital of such a so-called “pure-play” company served as the best guess of the division’s cost of capital. McCartt knew finding perfect pure-plays would be impossible, but he had succeeded in putting together a list of companies with publicly traded stocks that competed in the same business segments as PepsiCo (Exhibit 5). McCartt assumed that PepsiCo was calculating its cost of equity by using the capital-asset pricing model, the formula for which is given in Equation 1: Ke = Rf + β(Rm – Rf) (1). To choose the appropriate risk-free rate, Rf, he looked up the Treasury bond yields in the Wall Street Journal for December 31, 1990, the date of the latest financial information he had for PepsiCo (Exhibit 6). The market risk premium, Rm – Rf, was more difficult to determine, but once he gathered the information in Exhibit 7, he 4 PepsiCo measured financial leverage net of its large offshore short-term investment portfolios. Because these investments were not required to support the day-to-day operations of the company, PepsiCo considered the funds available to retire debt. 5 Russell J. Fuller and Halbert S. Kerr, “Estimating the Divisional Cost of Capital: An Analysis of the Pure-Play Technique,” Journal of Finance, December 1981. Page 3 of 12 DardenBusinessPublishing:254065 Page 4 UVA-F-0981 This document is authorized for use only by kanwal sakhi. Please do not copy or redistribute. Contact permissions@dardenbusinesspublishing.com for questions or additional permissions. believed he could decide the appropriate risk premium. The betas, β, of the pure-play comparable companies are reported in Exhibit 8. Although the pure-plays exhibited a wide range of financial leverage, Fuller and Kerr had reported that unadjusted pure-play betas were better approximations of the division betas than were adjusted betas. McCartt therefore decided not to worry about adjusting betas for financial leverage. Once he had determined the costs of equity for PepsiCo’s three divisions, McCartt intended to calculate their respective hurdle rates using the WACC formula in Equation 2, WACC = Kd × (1 − τ) × D/(D + E) + Ke × E/(D + E) (2), where Kd is the firm’s cost of debt, τ is the corporate tax rate, D is the amount of debt, and E is the amount of equity. His research had revealed that PepsiCo’s effective marginal tax rate was 38%, which reflected the combined effects of federal, state, and local taxes, and that its cost of publicly traded debt on December 31, 1990, was 9.6%. After computing each business segment’s WACC, McCartt wanted to weight the three costs of capital to see if they summed to 11%, the number given in the annual report. If the individual costs of capital did not prove to be consistent with the corporate cost of capital, McCartt would have difficulty presenting his findings convincingly to his interviewers. McCartt could not remember reading any other company’s annual report that touched on as many financial concepts as PepsiCo’s did: shareholder value creation, the cost of capital, market valuation of equity, targetdebt ratios, and more. The more he read, the more he could understand why PepsiCo had recently been named one of Fortune magazine’s most admired corporations in America, and the more determined he was to make the best of his job interview. Page 4 of 12 DardenBusinessPublishing:254065 Page 5 UVA-F-0981 Exhibit 1 This document is authorized for use only by kanwal sakhi. Please do not copy or redistribute. Contact permissions@dardenbusinesspublishing.com for questions or additional permissions. PepsiCo, Inc.: Cost of Capital Financial Summary by Business Segment (in millions of US dollars) Snack Foods Net sales Operating profit Identifiable assets Depreciation Capital expenditures 1990 1989 1988 1987 $5,054.0 934.4 3,892.4 232.5 381.6 $4,215.0 805.2 3,310.0 189.3 257.9 $3,514.3 632.2 1,608.0 156.8 172.6 $3,202.0 547.6 1,632.5 154.1 195.6 6,523.0 767.6 6,465.2 338.1 334.1 5,776.7 676.2 6,198.1 306.3 267.8 4,638.2 455.3 3,994.1 195.7 198.4 3,975.6 409.6 2,779.8 166.5 202.0 6,225.7 522.4 3,448.9 306.5 460.6 5,250.7 414.3 3,070.6 269.9 424.6 4,380.7 340.3 3,061.0 271.3 344.2 3,840.5 319.4 2,782.9 237.1 370.8 (557.0) 3,336.9 6.9 21.9 (545.2) 2,548.0 6.5 9.2 (300.6) 2,472.2 5.5 14.9 (331.0) 1,827.5 5.3 6.6 17,802.7 1,667.4 17,143.4 884.0 $1,198.2 15,242.4 1,350.5 15,126.7 772.0 $959.5 12,533.2 1,127.2 11,135.3 629.3 $730.1 11,018.1 945.6 9,022.7 563.0 $775.0 Soft Drinks Net sales Operating profit Identifiable assets Depreciation Capital expenditures Restaurants Net sales Operating profit Identifiable assets Depreciation Capital expenditures Corporate Corporate expenses Identifiable assets Depreciation Capital expenditures Totals Net sales Operating profit Identifiable assets Depreciation Capital expenditures Source: Unless otherwise noted, all exhibits created by authors using publicly available company data. Page 5 of 12 DardenBusinessPublishing:254065 Page 6 UVA-F-0981 Exhibit 2 This document is authorized for use only by kanwal sakhi. Please do not copy or redistribute. Contact permissions@dardenbusinesspublishing.com for questions or additional permissions. PepsiCo, Inc.: Cost of Capital Consolidated Statements of Income (in millions, except per-share amounts) 1990 1989 $17,802.7 $15,242.4 8,609.9 6,829.9 189.1 688.5 (182.1) 16,135.3 7,467.7 5,841.4 150.4 609.6 (177.2) 13,891.9 1,667.4 1,350.5 576.8 449.1 1,090.6 901.4 (13.7) ----- $1,076.9 $901.4 Income (charge) per share Continuing operations Discontinued operation Net income per share $1.37 −0.02 $1.35 $1.13 ---$1.13 Average shares outstanding 798.7 796.0 Net sales Costs and expenses Cost of sales Selling, administrative, and other Amortization of goodwill Interest expense Interest income Income from continuing operations before income taxes Provision for income taxes Income from continuing operations Discontinued operation charge Net income Page 6 of 12 PageDardenBusinessPublishing:254065 7 UVA-F-0981 Exhibit 3 PepsiCo, Inc.: Cost of Capital This document is authorized for use only by kanwal sakhi. Please do not copy or redistribute. Contact permissions@dardenbusinesspublishing.com for questions or additional permissions. Consolidated Balance Sheets (in millions, except per-share amounts) Assets Current assets: Cash and cash equivalents Short-term investments Accounts receivable Inventories Prepaid expenses and other current Total current assets 1990 1989 $170.8 1,644.9 1,414.7 585.8 265.2 4,081.4 $76.2 1,457.7 1,239.7 546.1 231.1 3,550.8 1,505.9 5,710.9 5,845.2 17,143.4 970.8 5,130.2 5,474.9 15,126.7 Liabilities and Shareholders’ Equity Current liabilities: Short-term borrowings Accounts payable Income taxes payable Other current liabilities Total current liabilities 1,626.5 1,116.3 443.7 1,584.0 4,770.5 866.3 1,054.5 313.7 1,457.3 3,691.8 Long-term debt Deferred income taxes Other liabilities 5,899.6 942.8 626.3 6,076.5 856.9 610.4 14.4 365.0 4,753.0 (383.2) 5,515.6 (611.4) 4,904.2 4.8 333.5 3,978.4 (66.2) 4,382.9 (491.8) 3,891.1 $17,143.4 $15,126.7 Investments in affiliates Property, plant, and equipment (PP&E), net Goodwill and other intangibles Total assets Shareholders’ equity: Capital stock @ par Capital in excess of par Retained earnings Currency translation adjustment Less: Treasury stock Total shareholders’ equity Total liabilities and shareholders’ equity Page 7 of 12 This document is authorized for use only by kanwal sakhi. Please do not copy or redistribute. Contact permissions@dardenbusinesspublishing.com for questions or additional permis Page 8 UVA-F-0981 Exhibit 4 PepsiCo, Inc.: Cost of Capital Selected Financial Data (in millions except per-share amounts) Summary of Operations: Net sales Cost of sales and operating expenses Gross profit 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 $17,802.7 $15,242.4 $12,533.2 $11,018.1 $9,017.1 $7,584.5 $7,058.6 $6,568.6 $6,232.4 $5,873.3 15,628.9 13,459.5 11,184.0 9,890.5 8,187.9 6,802.4 6,479.3 5,995.7 5,684.7 5,278.8 2,173.8 1,782.9 1,349.2 1,127.6 829.2 782.1 579.3 572.9 547.7 594.5 Interest expense 688.5 609.6 344.2 294.6 261.4 195.2 204.9 175.0 163.5 147.7 Interest income 182.5 177.2 122.2 112.6 122.7 96.4 86.1 53.6 49.1 35.8 1,667.4 1,350.5 1,127.2 945.6 690.5 683.3 460.5 451.5 433.3 482.6 576.8 449.1 365.0 340.5 226.7 256.7 180.5 169.5 229.7 213.7 Earnings from continuing operations before taxes Provision for income taxes Income from continuing operations Net income 1,090.6 901.4 762.2 605.1 463.8 426.6 280.0 282.0 203.6 268.9 $1,076.9 $901.4 $762.2 $594.8 $457.8 $543.7 $212.5 $284.1 $224.3 $297.5 $1.37 $1.13 $0.97 $0.77 $0.59 $0.51 $0.33 $0.33 $0.24 $0.32 1.35 1.13 0.97 0.76 0.58 0.65 0.25 0.33 0.27 0.36 $0.38 $0.32 $0.27 $0.22 $0.21 $0.20 $0.19 $0.18 $0.18 $0.16 Data Per Common Share: Income per share from continuing operations Net income per share Cash dividends declared per share Average shares and equivalents outstanding 798.7 796.00 790.4 798.3 786.5 842.1 862.4 859.3 854.1 837.5 Year-End Position: Total assets $17,143.4 $15,126.7 $11,135.3 $9,022.7 $8,027.1 $5,889.3 Total debt 7,526.1 6,942.8 4,107.0 3,225.0 2,865.3 Shareholders’ equity 4,904.2 3,891.1 3,161.0 2,508.6 2,059.1 Book value per share 6.22 4.92 4.01 3.21 $26.00 $21.38 $13.13 $11.25 Market price per share Shares outstanding 788.4 791.1 788.4 781.2 $4,876.9 $4,446.3 $4,052.2 $3,960.2 1,506.1 948.9 1,073.9 1,033.5 1,214.0 1,837.7 1,853.4 1,794.2 1,650.5 1,556.3 2.64 2.33 2.19 2.13 1.96 1.89 $8.75 $7.88 $4.63 $4.25 $3.75 $4.13 781 789.4 845.2 842 840.4 824.4 Cash-Flow Data: Net cash generated by continuing operations Acquisitions and investments in affiliates $2,110.0 $1,885.9 $1,894.5 $1,334.5 $1,212.2 $817.3 $981.5 $670.2 $661.5 $515.0 630.6 3,296.6 1,415.5 371.5 1,679.9 160.0 ----- ----- 130.3 ----- Purchases of PP&E for cash 1,180.1 943.8 725.8 770.5 858.5 770.3 555.8 503.4 447.4 414.4 Cash dividends paid $293.9 $241.9 $199.0 $172.0 $160.4 $161.1 $154.6 $151.3 $142.5 $126.2 Page 8 of 12 This document is authorized for use only by kanwal sakhi. Please do not copy or redistribute. Contact permissions@dardenbusinesspublishing.com for questions or additional permis Page 9 UVA-F-0981 Exhibit 5 PepsiCo, Inc.: Cost of Capital Description of Snack-Food, Beverage, and Restaurant Companies PepsiCo, Inc. The world’s second-largest producer of soft drinks; controls more than 1,000 bottlers throughout the world. Major soft-drink products include PepsiCola, Diet Pepsi, and Mountain Dew. Operations include: Specialty snack foods: Frito-Lay (major product offerings include Doritos, Ruffles, and Lay’s), Walkers Crisps, Smiths Crisps; Quick-service restaurants: Pizza Hut, Kentucky Fried Chicken, and Taco Bell. A&W Brands Manufactures, markets, and sells softdrink concentrates to licensed bottlers under the A&W Root Beer, A&W Cream Soda, Squirt, Country Time Lemonade, and Vernors trademarks. The company’s brands have the leading US market share in the root beer, cream soda, citrus/grapefruit, and lemonade categories. Coca-Cola The world’s largest soft-drink company. Distributes its major brands through bottlers throughout the world. Foreign operations accounted for about 55% of total sales and 75% of profits in 1989. Food division produces and markets over 100 items including citrus concentrates. 49% owner of Coca-Cola Enterprises. Coca-Cola Bottling Golden Enterprises, Inc. Coca-Cola Enterprises Goodmark Food Inc. One of the largest independent bottlers, with franchises covering 10–12 million people in the Southeast. Has exclusive franchises under which it produces Coca-Cola, Coca-Cola Classic, and all other Coca-Cola soft drinks as well as Dr. Pepper, Canada Dry, Schweppes, Welch’s, Barq’s root beer, and Lipton tea in selected markets. The world’s largest soft-drink bottling company. Flowers Foods, Inc. Fifth-largest producer of bakery and snack-food goods in the United States. Brand names include: Nature’s Own, Cobblestone Mill, Evangeline Maid, Holsum, Dandee, and Beebo. Produces fresh and frozen breads, buns, and specialty rolls, cakes and pies, and frozen vegetables and fruits. General Mills Processes and markets consumer foods, including Big G cereals, Betty Crocker desserts, Gold Medal flour, Gorton’s seafood, and Yoplait yogurt. Operates 785 restaurants in the United States, Canada, and Japan: Red Lobster, Olive Garden. Page 9 of 12 Holding company for Golden Flake Snack Foods, Inc. (Golden Flake and Super Snack brands), Steel City Bolt and Screw, Inc. (specialized metal fasteners), Nall & Associates, Inc. (manufacturer’s representatives), and the Sloan Major Agency, Inc. (advertising). Snack-food operations account for over 95% of sales and profits. National Pizza Corp. Largest franchisee of PepsiCo’s Pizza Hut chain. As of March 1990, operated 354 Pizza Hut restaurants and delivery kitchens. Restaurants offer full table service and feature pizza, Italian pies, pasta, sandwiches, a salad bar, and, in most units, beer. Acquired Skipper’s restaurants in October 1989. Ryan’s Family Steak House Engaged in producing and marketing meat snack products, including Slim Jim, Beef Jerky, pickled meats, and pork skins. Also engaged in producing and marketing grain and potato products, including cheese curls, Andy Capp pretzels, and various other snack foods. Develops, operates, and franchises family-style steak house restaurants featuring cafeteria-style entry; selfservice food bar (the “MegaBar”), soup bar, and ice cream bar; and dinner table service. As of January 1991, had 126 company-owned and 33 franchised restaurants. Lance, Inc. TCBY Manufactures snack foods and bakery products and distributes them through its own sales organization and through brokers to retailers and institutional customers. McDonald’s Corp. Licenses and operates a chain of over 11,400 fast-food restaurants throughout the United States, Canada, and overseas under the name of McDonald’s. Outlets serve standardized menu built around hamburgers. “The Country’s Best Yogurt” is the largest franchisor of soft-serve frozen yogurt stores in the United States. TCBY also sells equipment for use in TCBY stores. As of November 30, 1990, had 1,845 stores, of which 1,677 were franchised. Wendy’s Internatioal, Inc. Licenses and operates the nation’s thirdlargest chain of quick-service hamburger restaurants. Has 3,727 units (71% franchised). DardenBusinessPublishing:254065 Page 10 UVA-F-0981 Exhibit 6 PepsiCo, Inc.: Cost of Capital This document is authorized for use only by kanwal sakhi. Please do not copy or redistribute. Contact permissions@dardenbusinesspublishing.com for questions or additional permissions. Prevailing Interest Rates and Yields as of December 31, 1990 US Government Interest Rates: Maturity Rate 26 weeks 1 year 10 years 30 years 6.57% 6.88 8.16 8.30% Money Rates: Prime rate 6-month certificate of deposit 9.75% 7.47% Moody’s Corporate Bond Yield Averages by Rating Class: Moody’s Rating Rate Aaa Aa A Baa 9.05% 9.39 9.64 10.43% Page 10 of 12 DardenBusinessPublishing:254065 Page 11 UVA-F-0981 Exhibit 7 PepsiCo, Inc.: Cost of Capital This document is authorized for use only by kanwal sakhi. Please do not copy or redistribute. Contact permissions@dardenbusinesspublishing.com for questions or additional permissions. Report of Average Annual Returns, 1926–90 Series Geometric Mean1 Arithmetic Mean1 Standard Deviation S&P 500 10.1% 12.1% 20.8% Small company stocks 11.6 17.1 35.4 Long-term corporate bonds 5.2 5.5 8.4 Long-term government bonds 4.5 4.9 8.5 US Treasury bills 3.7% 3.7% 3.4% ___________________ 1 The arithmetic mean is computed as the sum of the single-year returns from 1926 through 1990 divided by the number of returns (65). The geometric mean accounts for the compound-interest effect such that, when the interest is compounded over 65 years, the final wealth that results is the same as if an investor had invested successively each year to earn a sequence of 65 single-year returns. For example, if an investor earned −20% and +40% over two years, the arithmetic average return would be +10%. The geometric average return (ρ) would be 5.83%—computed as (1 – .2) × (1 + .4) = (1 + ρ)2. Source: Roger Ibbotson and Rex Sinquefield, Stocks, Bonds, Bills and Inflation, 1991 Yearbook (Ibbotson Associates, Inc., 1991). Page 11 of 12 This document is authorized for use only by kanwal sakhi. Please do not copy or redistribute. Contact permissions@dardenbusinesspublishing.com for questions or additional permis Page 12 UVA-F-0981 Exhibit 8 PepsiCo, Inc.: Cost of Capital Financial Information on Snack-Food, Beverage, and Restaurant Companies (December 29, 1990) Company A&W Brands Coca-Cola Coca-Cola Bottling Coca-Cola Enterprises Flowers, Inc. General Mills Golden Ent., Inc. Goodmark Foods Lance, Inc. McDonald’s Corp. National Pizza PepsiCo Ryan’s Family Steak House TCBY Wendy’s (000s) $119,000 10,236,000 431,000 4,034,000 835,000 7,153,000 129,000 139,000 446,000 6,396,000 275,000 17,803,000 273,000 151,000 $1,011,000 (000s) Price per Share Market Book (000s) (000s) (000s) (000s) (000s) Estimated Cost of Debt ___ 9,098 688,239 9,181 114,835 34,425 165,100 12,668 4,302 31,252 359,100 13,849 788,400 52,637 26,162 96,821 $34.75 46.50 19.00 15.50 13.75 49.00 7.25 9.75 21.00 29.13 17.50 26.00 5.63 7.63 $6.38 $7.62 5.65 18.31 11.99 6.27 6.74 4.00 7.02 7.42 11.64 5.88 6.22 2.89 4.06 $4.62 0 $535,861 237,564 1,960,164 91,563 879,000 0 19,873 0 4,428,700 66,397 5,899,600 0 18,973 $123,307 0 $97,272 1,222 576,630 4,857 129,000 0 4,013 0 64,700 628 0 0 2,893 $8,242 0 0 0 0 0 0 0 0 0 0 $6,851 0 0 0 $44,754 $22,345 1,903,611 0 0 0 23,000 2,892 0 0 299,000 0 1,626,500 $26,600 0 0 $22,345 2,536,744 238,786 2,536,794 96,420 1,031,000 2,892 23,886 0 4,792,400 73,876 7,526,100 26,600 21,866 $176,303 10.00% 9.50 12.00 10.00 10.00 9.60 10.00 10.00 10.00 9.50 10.00 9.64 10.00 10.00 12.18% Number of Shares Sales Beta 1.50 1.00 0.75 1.00 0.90 1.05 0.55 1.49 0.70 1.00 1.00 1.10 1.10 1.15 1.10 Long-term Debt Current Portion Capital Leases Notes Payable Sources: S&P Compustat, Value Line Survey (betas), Lotus One Source (Coca-Cola Bottling and Goodmark Foods betas). Estimated Cost of Debt based on author estimates. Page 12 of 12 Total Debt
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Running Head: PepsiCo COST OF CAPITAL

PepsiCo Cost of Capital




The Overall Cost of Capital for PepsiCo Using Beta Of 1.1
Cost of capital refers to the total value of the sources of capital that a company mobilizes
to fiancé sits operations and investments. For the case of PepsiCo, the overall cost of capital
refers to the total cost incurred in generating equity and debt capital for its projects. The cost is
valued in terms of the interests paid for the debt and the dividend paid to the equity shareholders.
The overall cost of capital for PepsiCo can be ascertained using the Capital Asset Pricing Model.
CAPM is used to calculate the cost of capital for PepsiCo by talking into account the risks
associated with its investment (Frank & Shen, 2016). The formula is given by
Ke = Rf + βi(Rm – Rf]
= E(Ri) = Rf + βi * [E(Rm) – Rf]
E(Ri) = Expected return on asset i
Rf = Risk-free rate of return
βi = Beta of asset i
E(Rm) = Expected market return
At a beta value of 1.1, the investment that PepsiCo intends to venture into is more volatile
relative to the market, meaning that it must trade with caution to avoid the possibility of making
huge losses.
From the case of PepsiCo
Rf = 3.7%
βi = 1.1
E(Rm) = 10.1%



Ke = 3.7% + 1.1(10.1% –3.7%]
= 3.7% + 1.1(6.4%) = 10.74%
From the above calculation of the overall costs of capital of PepsiCo using CAMP and a
beta of 1.1, the result is not in agreement with the 11% value given by PepsiCo. This difference
is based on the uncertainties, historical factors, and economic conditions prevailing in the
market. The total interest-bearing debt used in this case comprises of both short-term and longterm debt of the company.
Using the WACC method that combines both the costs of equity and debt, it can be easy
to substantiate whether the cost of capital of PepsiCo is 11% as stated in its books. This is an
average cost of capital of the company after taking into consideration other tax liabilities. For the
case of PepsiCo, the overall cost of capital can be ascertained by the formula;
WACC = (E/V) X Re + (D/V)*Rd*(1-Tc) where E is the market value of the equity of
the company, D is the market value of its debts, and V = E +D. the cost of equity and cost of
capital is given by Re and Rd respectively. On the other hand, Tc is the rate of corporation tax
prevailing in the market.
WACC = (E/V) X Re + (D/V)*Rd*(1-Tc)
From the case of PepsiCo
Rf = 3.7%
βi = 1.1
E(Rm) = 10.1%
Equity = 4,904.2 million
Total debt = 7,526.1 million
Re = 11.6



Rd = long term corporate bonds = 5.2 and long term government bonds = 4.5
Total capita = equity + total debt = 4,904.2 million + 7,526.1 million = 12,430.3
Cost of equity =12,430.3
[(E/V) * Re] = (4,904.2 /12,430.3) * 11.6% = 0.45867838
Cost of debt =
[(D/V) * Rd * (1-Tc)] = (7,526.1 /12,430.3) * 5.2% * (1-35%) = 0.020464685
WACC for PepsiCo can be calculated as: 0.45867838+ 0.020464685= 0.025051469 or 2.5%
This figure can be translated to mean that PepsiCo is incurring an average of 2.5% annually in
terms of the cost of overall cost of its debt and equity capital.
The Costs of Capital for the Individual Business Segments
The pure-play method is used to determine the divisional cost of capital for every
segment of a company with varying risk from that of the overall capital of the company. The
company debt to equity ratio together with the Beta is used to estimate the exact beta and debt to
equity ratio of each segment of the company. Form the case of PepsiCo, the beta is 1.1 and the
D/E ratio is 65.16%. Since all the segments have been financed by the overall capital of the
company, the equivalent equity Beta is given by
(Equity) Beta A = Unlevered Beta of B × (1 + DE A × (1 − Tax RateA))Gbeta X (E/E + D(1-t).
Where Gbeta = the geared beta of the firm
E= the weight of the equity in the capital structure
D = weight of debt on the capital structure
T = tax rate.



The beta coefficient of PepsiCo is 1.1, its debt to equity ratio is 0.65 and the corporation tax rate
is 35%.
The (equity) beta coefficient can be unlevered as follows:
Unlevered Beta = Beta/[1+(1-Tax Rate)(Debt to Equity)]
Unlevered Beta for PepsiCo company is given by
= 1.1 ÷ (1 + 0.65 × (1 − 35%))
= 1.1 / (1 + 0.65 x (0.65)
≈ 1.1/1.4225 = 7.73286467486818
This value can be re-leveraged by
(Equity) Beta for PepsiCo Company as
= 7.73286467486818 × (1 + 1.5 × (1 − 20%))
= 0.66
From the above calculation, it can be concluded that the 0.66 is the appropriate beta coefficient
that should be used in the estimation of the cost of equity for each segment of the company.

Beta = 1.1
Debt to assets ratio = 0.65

381.6 million
Soft drinks
334.1 million



460.6 million
21.9 million
From the calculation above, it is clear that the costs of capital for the business segments
do not add up to the overall cost of capital. This is because of the unleveraged beta of the
company that has been incorporated into the overall costs of capital to ascertain the specific risk
associated with every segment.
The Danger of Using the Overall Cost of Capital to Make Decisions at the Divisional...

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