Finc Mgmt Wk 4 Assignment - Reserve for Scofied

Capital Budgeting Assignment –

The Coca Cola Company

I. Introduction

Companies are regularly faced with decisions concerning investments in long-lived assets to promote continuous growth and expansion of business operations. Long-lived assets are expected to return benefits for more than a year (Peterson & Fabozzi, 2002). Capital budgeting is the process of analyzing different investment options and the selection of which identified investment opportunities to pursue (Peterson & Fabozzi, 2002). Having established guidelines and criteria for the selection of projects is crucial for capital budgeting.

The capital budgeting techniques analyzed and used in this paper will be the Net Present Value (NPV), the Internal Rate of Return (IRR), Modified Rate of Return (MIRR) and Profitability Index (PI). The Proposed Capital Budgeting Project – Expansion of Partnership with Keurig Green Mountain, Inc. – will be described and analyzed in an Excel Capital Budgeting Model. The results of the Excel model will be explained and interpreted based on the capital budgeting criteria introduced and a recommendation about the implementation of the proposed capital budgeting project will be discussed.

II. Description of Proposed Capital Budgeting Project

Coca Cola acquired 16% of the Keurig Green Mountain, Inc. (GMCR) in 2014, making it the largest shareholder of the coffee brewer company (Trefis Team, 2014). The Coca Cola Company (KO) purchased these 6.5 million shares for an agreed purchase price of $830 million (Coca Cola, 2015). The announcement of the acquisition raised Coca Cola’s stock by 0.7% (Trefis Team, 2014). The two companies are developing a new brewer system together, the Keurig Cold to be able to tap in the growing demand of ready-to-drink at-home-brewed beverages and expand into the cold drink market (Trefis Team, 2014).

GMCR’s market size has expanded to $19bn and is expected to continue to grow (Trefis Team, 2014). Considering the 16% ownership Coca Cola has of GMCR this is a $3.04bn return for KO on their investment. Considering these impressive numbers an expansion in the partnership between KO and GMCR to a total of 20% of ownership in GMCR should be considered. Based on the purchase price of $830 million for 16% equity, the expansion by another 4% would lead to an initial cash outflow of $207.5 million. Considering the return on the investment of $3bn for 16% equity in GMCR the cash inflows over the next six years after an additional 4% investment is to be estimated at $750 million in Year 1, $700 million in Year 2, $600 million in Year 3, $500 in Year 4, $400 million in Year 5, $300 million in Year 6 and $200 million in Year 7. This estimate is very conservative and considers possible future trends in the beverage market and competitors adapting the new cold brewing mechanism. After a cash inflow of $750 million in the first year, the cash inflows are expected to reduce to $700 million, $600 million, $500 million, $400 million, $300 million and $200 million in the following four years.

Considering Coca Cola’s declining sales in the carbonated drink market due to shifting customer preferences, the investment in GMCR is a strategic approach to diversify KO’s portfolio and benefit from customers’ increasing demand in coffee beverages.

The explanation of the Excel Capital Budgeting Model used follows.

III. Explanation of the Excel Capital Budgeting Model

The Excel Capital Budgeting Model (attachment: Capital Budgeting Model_FINC 430.xls) was developed to analyze the proposed project with multiple capital budgeting techniques – the NPV, IRR, MIRR and PI. The model will provide a framework for further analysis and recommendation regarding the proposed expansion of an additional 4% in GMCR equity to an overall investment of 20% in the coffee brewing company.

In the Model only the yellow cells require input from the company’s Balance Sheet, Income Statement and key financial metrics (e.g. Beta) obtained through Yahoo! Finance (Yahoo! Finance, 2016). The light green cells contain Excel Functions for the calculation of the Discount Rate with WACC [=Cost of Equity*(Equity/Total Value)+Cost of Debt*(Debt/Total Value)*(1-Tax Rate)], NPV, IRR, MIRR and PI.

Changes in the Investment Project Box yellow fields for estimated Cash Inflows will automatically change the value of the NPV, MIRR, IRR and PI. This allows for an analysis of multiple possible outcomes of this investment project. The Model allows a most-likely case, best case and worst case scenario by changing the input data in the yellow cells. The Most-likely Case and the Worst Case are presented in the Model attached to this analysis. The worst case scenario assumes the investment returns the expected revenue in the first year, but then significantly drop to $200 million in Year 2 and $100 million in the following 5 years until it goes in the negative (further investments are necessary, techniques is no longer in demand) in Year 7 to -$100 million.

IV. Explanation and Interpretation of Capital Budgeting Criteria

The four capital budgeting techniques used in this analysis are the NPV, IRR, MIRR and PI as presented in the introduction section. The techniques will be explained and interpreted in detail in the following.

a. Net Present Value (NPV)

The Net Present Value technique considers the Present Value of all future Cash Flows (Peterson & Fabozzi, 2002). A project should be accepted if the NPV is larger than $0, because it increases the value of the firm. The NPV considers all the criteria important in capital budgeting: the future cash flows, the time value of money and riskiness of the project and therefore helps identify the project maximizing the owner’s wealth. When comparing different projects with each other the one with the largest NPV should be selected. The NPV is a very good decision framework as it considers all of the important criteria and allows to compare mutually exclusive and capital rationed projects (Peterson & Fabozzi).

The Excel Model for KO expansion of ownership in GMCR returns a NPV of $2,529 in the most-likely case. This project’s NPV is clearly above $0 and should thus be accepted according to the NPV.

b. Internal Rate of Return

The Internal Rate of Return Technique provides a discount rate, which causes the NPV to equal $0. A project should be accepted if the IRR is larger than the Cost of Capital – provides a larger return (Peterson & Fabozzi, 2002). As the NPV the IRR considers all future cash flows, the time value of money and the riskiness of the project, however, the IRR does not consider the maximization of owner’s wealth. As long as only one project is analyzed and there are no budget limitations the IRR returns the same result as the NPV.

The Excel Model returned an IRR of 353% in the most-likely case scenario for the expansion. Considering the Cost of Capital of 7.72% this is clearly a larger return and should thus be accepted.

c. Modified Internal Rate of Return

The Modified Rate of Return is an adjusted IRR technique that considers a different reinvestment rate for the cash inflows from the project (Peterson & Fabozzi, 2002). A project with a larger MIRR than cost of capita should be accepted. Comparable to the IRR, the MIRR meets the criteria of considering all future cash flows, the time value of money and the riskiness associated with the project. However, as the IRR, the MIRR does not consider the maximization of owner’s wealth. When the MIRR is used for one project without budget limitations it returns the same result as the NPV.

For the MIRR the Excel Model returned a rate of 56% in the most-likely case scenario. The cost of capital is 7.72% and thus, even the rate adjusted for a different re-investment rate for cash flows, the MIRR, is larger and the project should be accepted.

d. Profitability Index

The Profitability Index is the ratio of the Present Value of the change in operating cash inflows to the Present Value of the investment cash outflows (Peterson & Fabozzi, 2002). A project should be accepted if the PI is larger than 1, because it increases the firm’s value. If multiple projects are considered, the one with the larger PI should be selected. The PI considers the following criteria: all future cash flows, the time value of money and the riskiness of the project. However, as the IRR and MIRR, the PI does not consider the maximization of owner’s wealth. When considering one project only, the PI provides the same result as the NPV.

The Excel Model returns a PI of 13.2 for the most-likely case scenario, which clearly indicates that this project should be selected.

The capital budgeting techniques discussed and analyzed provide the framework for an informed and analyzed decision considering the proposed investment project for KO. The recommendation about the implementation of the expansion of ownership by another 4% in GMCR will conclude this analysis.

V. Recommendation About Implementation of Capital Budgeting Project

The proposed capital budgeting project has been analyzed with an Excel Model considering the NPV, MIRR, IRR and PI. As discussed in the above section all of the techniques returned the same result – Coca Cola should expand their ownership in GMCR by another 4%.

The Model also offers a worst case scenario analysis and even if the project should not return cash inflows as high as estimated most-likely and even go in the negative the capital budgeting techniques lead to the decision to invest in this project. The worst case scenario provides these results: NPV - $888.87, IRR – 290%, MIRR – 33% and PI – 5.28. Since both scenarios indicate added value to the firm by pursuing this investment project it is recommended for Coca Cola to obtain an additional 4% in shares of the Keurig Green Mountain, Inc..

References

Coca Cola. (2015). SEC 10K. Retrieved from http://www.coca-colacompany.com/content/dam/journey/us/en/private/fileassets/pdf/2015/02/2014-annual-report-on-form-10-k.pdf

Peterson, P. & Fabozzi, F. (2002). Capital Budgeting Theory and Practice. John Wiley & Sons 2002.

Trefis Team. (2014, May 16). Coca-Cola-Keurig Green Mountain Deal: A Win-Win Situation For Both. Retrieved from http://www.forbes.com/sites/greatspeculations/2014/05/16/coca-cola-keurig-green-mountain-deal-a-win-win-situation-for-both-2/#7f132b1a57ee

Yahoo! Finance. (2016). KO Key Statistics. Retrieved from http://finance.yahoo.com/q/ks?s=KO