LENA CHUA BOOTH HOLA-KOLATHE CAPITAL BUDGETING DECISION The consumption of sugar-sweetened beverages has been linked to risks for obesity, diabetes, and heart disease; therefore, a compelling case can be made for the need for reduced consumption of these beverages. Health Policy Report, The New England Journal of Medicine, October 15, 2009. Mexico leads world in soda consumption, World Health Organization planning to fight it. Carolyn Crist, Obesity Initiative, October 25, 2012. In December 2012, Antonio Ortega, the owner of Bebida Sol, had just finished reading a report done by his general manager, Pedro Cortez, about the possible investment in a new product line, Hola-Kola. The idea of Hola-Kola came about three months earlier when Antonio attended a seminar on youth obesity organized by a local high school that his two children attended. Even though he had often heard of the rising obesity problem in Mexico, Antonio was still very disturbed by the statistics indicating how the obesity rate in Mexico had tripled since 1980, and that 69.5% of the people 15 years and older were either obese or overweight. Even more shocking to Antonio, based on this statistic, Mexico now had the highest overweight rate in the world, surpassing the United States.' After the seminar, Antonio discussed the idea of Hola-Kola, a low-price, zero-calorie carbonated soft drink, with Pedro Cortez, Pedro was excited about the idea, and liked the opportunity to launch something new, espe- cially given that the company had not introduced a new product in the last five years. However, Pedro thought a market study should be done to gauge the potential demand before the firm undertook the investment. Company Background Bebida Sol is a small, privately owned carbonated soft drink company based in Puebla, Mexico. A retired ex- ecutive from a popular fast-food restaurant chain, Roberto Ortega, founded it in 1998. During his career as a restaurant executive, Roberto learned that Mexicans, regardless of social status, loved their soda pop. Many would drink soda to quench their thirst on a regular basis, due to the lack of hygienic, drinkable water. With the influx of international brands of soda pop, Mexico now had the highest consumption of carbonated soft drinks per capita in the world. The average per capita consumption was 40% higher than the United States, at 163 liters (43 gallons) per year, while the United States consumed 118 liters (31 gallons), according to statistics presented by the international organization Oxfam and the Mexican NGO Consumer's Power. Due to the high obesity problem, health and consumer groups in Mexico had demanded that the government impose a 20% tax on soft drinks, claiming that it would not only reduce consumption, but the tax revenue could also be used to fight health problems that soft drinks generated. Exhibit 1. Rates of Overweight and Obesity Persons by Country (2010) Obey 40200 Nof adult population Nof population Source World Obesity Stats-2010 and Beyond." Douglas Robb, Sept. 27, 2010. Herlib News The market leaders for carbonated soft drinks in Mexico were Coca-Cola, Pepsi-Cola, Dr. Pepper Snapple, and Grupo Penafiel. Together, they accounted for a combined market share of more than 90%, with Coca Cola being the major player. The Mexican soft drink market (products include bottled water, carbonates, RTD tea coffee, functional drinks, fruit/vegetable juices, and other soft drinks) had total revenues of $99.2bn in 2011, representing a compound annual growth rate (CAGR) of 6.3% between 2007 and 2011. Market consumption volumes increased with a CAGR of 4.5% between 2007 and 2011, reaching a total of 49.3 billion liters in 2011. Roberto thought these popular international brands commanded prices that might be out of reach for the poorer segment of the population. To capture this market, he started the company to offer private-labeled carbonated soft drinks with similar tastes, but at about half the price. His products consisted of regular cola carbonates and non-cola carbonates, such as lemon/lime or orange carbonates. Bebida Sol's products were sold only in small, independent grocery stores and convenience stores in Mexico. The firm avoided the supermarkets and hypermarkets because it could not sustain the desired margin in these largestones. Moreover, most of the consumers, especially the middle-to-low income one shopped a small independent grocery stores. To create awareness, the owners of these independent stores were given incentives to personally promote the products Sales increased dramatically, from 80 million pesos in 1998 to about 900 million pesos in 2011. In 2007, Antonio Ortega, Roberto's only son, took over the business when Roberto unexpectedly passed away. Antonio started working on the sales side of the business two years before his father's death. He had gath cred a few valuable tips on how to run the business from his father, which had made him a rather conservative businessman. A year after Antonio took over the business, the global financial crisis hit. The economic downturn in Mexico actually bencfitted the low-price soda business. Demand increased dramatically as many consumers became price conscious and switched from international brands to private labels. Bebida Sol's sales increased by 60% from 2008 to 2009. and continued to increase without the form changing any of its business strategy or practices. The company's return on sales (net profit margin) also had been increasing in the last few years 900 101 opos Exhibit 2. Bebida Sol's Sales and Return on Sales $1,000,000 $900,000 $800,000 $700,000 S600,000 $500.000 $400,000 $300,000 $200,000 $100,000 Return ofsas) Sales C 2010 2011 Sales Return on Sales The Proposal Reading once again the executive summary of the report, Antonio recalled what his father told him several times during the two years he was working with him: "Dant grow the company for the sake of growing Invest only when you are confident there is sufficient demand for a new product, and also when you have the financial resources. As far as financial resources, Antonio felt the timing could not be better. Due to strong sales and profitability in the last few years, Bebida Sol had accumulated a sizable amount of cash. With solid financial performance and steady cash flows, his banker had agreed to extend him a five-year, 16% annual interest term loan to launch Hola Kola. In the proposal, Pedro Cortez estimated that with 20% of the needed capital borrowed, the 20/80 debt equity structure would result in an 18.2% weighted average cost of capital for this project. The bigger question lingering in Antonio's mind was whether there would be sufficient demand for this new, ro-calorie product line. Even though the demand for low-caloric sodas had increased in Mexico, they seemed to be consumed mainly by the middle-to-upper income segment of the population. The majority of the lower income people still consumed only the regular, high-sugared carbonated soft drinks. It wasn't dear whether this was because the low-income group lacked the awareness of the obesity problem, or because there were not too many low priced, low-calorie soda options available. If it were the former, the outlook for low price, low calorie carbonated soft drinks might not be too promising at this time. If it were the latter, it might be the perfect timing for Bebida Sol to introduce Hola-Kola Pedro hired a consultant to do a market study right after Antonio discussed the idea of Hola Kola with him. The consultant estimated that the company could sell a total of 600,000 liters of these zero-calorie carbonates a month, at a projected price of five pesos a liter. This volume of sales was expected for a period of five years at the same price. The market study took about two months to complete and cost the company five million pesos, which Pedro had paid shortly after its completion Since the existing bottling plant was running at 100% capacity producing regular sodas, the proposal called for a fleet of new, semi-automated bottling and kegging machines designed for long, high-quality runs. The total cost of these machines, including installation, was estimated to be 50 million pesos. This amount could be fully depreciated on a straight-linc basis over a period of five years. Pedro believed that the purchase of these machines would enable Bebida Sol to reduce its cost of labor and therefore the price to the customers, putting the firm in a more competitive position. With proper maintenance, these machines could produce at least 600,000 liters of carbonated drinks per month. Pedro also estimated that these machines would have a resale value of four million pesos in five years time, if the company were to either shut down the production of Hola-Kola, or replace these machines with fully automated ones at that time. The new machines would be housed in an unoccupied annex by the main production facility of Bebida Sol. The annex was also large enough to store the finished products before they were shipped out to grocery stores, Antonio's father built the annex years ago when he planned to venture into the mineral water business. He died before he could execute his plan. The annex had been vacant ever since, even though Antonio recently received an offer to lease out the space for 60,000 pesos a year. Pedro determined that additional working capital was needed to ensure smooth production and sales of this new product line. He proposed keeping raw materials inventory at a level equal to one month of produc tion. To encourage the independent grocery stores to carry the new product line, he proposed offering a longer collection period, letting the grocers pay in 45 days, instead of the normal 30 days. As far as accounts payable, he would follow the company's normal policy, and settle the accounts in 36 days. The proposal also outlined the various estimates of production and overhead costs, and selling expenses. Raw materials needed to produce the sodas were estimated to be 1.8 pesos per liter, while labor costs and energy costs per month were estimated to be 180,000 pesos and 50,000 pesos, respectively. The incremental general administrative and selling expenses were quite modest, estimated to be 300.000 a year, as the new product could be sold by Bebida Sol's current sales force and via existing distribution channels. The accounting department typically charged 1% of sales as overhead costs for any new projects. Glancing back at his notes, Antonio started pondering. The market study seemed to indicate sufficient demand for the new product line. What he really feared was that the new zero-calorie carbonates might erode the sales of his existing products the regular sodas. The markert study u sted that potential crocion could cost the firm as much as 800,000 pesos of after-tax cash flows per year. At the new tax rate of 30% for both income and capital gains, could he add value to the firm by taking on this project? Appendix 1. Bebida Sol-Income Statements for the Year Ending December 31 (thousands of pesos) Income lice Sales COGS Gros margin 2002 642.400 100.0% 3984 54.59 292.516 45.5% 2010 832.41 100 09 $56.002 54.9 375.932 45.2% 2011 900,101 100 09 48702051 413.081 45.9% Marketing & Selling Expenses General Administrative Expenses EBITDA 120.359 65.340 106,817 18.7% 10.29% 16.6% 150.322 88.622 136.988 18.19 1076 16.5% 168.330 18.79 SA2911099 166,960 16.3% Depreciation 45.046 61.771 709 9.6% 59.444 77.544 219 9.39 65.985239 80.975 23.120 38,651 3.6% 6.0% 110SA 63,456 .29 7.6% 9340209 71.635 Taxes 30% Net Income 11.595 27.056 1896 .296 44.419 2.39 5.3.4 21.491 50.145 Dividends Retained Earnings 20.000 7.056 20,000 24,419 20.000 30,145 Appendix 2. Bebida Sol Balance Sheet as of December 31 (thousands of pesos) Cash Accounts Receivable Inventory Braids Current Assets 2009 12,023 3.1% 61,600 15.7% 32,592 8.3% U1.7923.096 118,007 30.1% 2010 36,090 8.9% 25.253 18.6% 45.016 11.1% 20.60 16 177.01943.8% 2011 53,020 78,913 60.044 14.0% 20.8% 15.84 207,095 54.59 Grossed assets Locum depreciation Net fixed 439,230 112.0% 452,020 111.7 165.M6 12.106 22.1.490 55.56 2786992274510 56.296 463.122 12209 280. 76.59 172.6-Z 15.55 Total Aucts 392.191 100.0% $0.519 100.0% 379.70 100.0% 2010 Libilities Accounts Payable Acredexp Short-term debe Current Liabilities 2009 34.509 15.083 20.520 120.112 8.996 3.8% 18.095 30.6% 43.765 19.087 $3.29 126.281 10. 479 15.2 31.29 18.0351264 20.493 545 220000 91.428 2019 26.793 6.6% 251 75 6226 6.693 189 2015122125 Long-term debe Equity Liabilities Neural 45.023 11.5 227.056 57.9% 392.191 100.0% 40.519 100.0% 37.70 100.0% LENA CHUA BOOTH HOLA-KOLATHE CAPITAL BUDGETING DECISION The consumption of sugar-sweetened beverages has been linked to risks for obesity, diabetes, and heart disease; therefore, a compelling case can be made for the need for reduced consumption of these beverages. Health Policy Report, The New England Journal of Medicine, October 15, 2009. Mexico leads world in soda consumption, World Health Organization planning to fight it. Carolyn Crist, Obesity Initiative, October 25, 2012. In December 2012, Antonio Ortega, the owner of Bebida Sol, had just finished reading a report done by his general manager, Pedro Cortez, about the possible investment in a new product line, Hola-Kola. The idea of Hola-Kola came about three months earlier when Antonio attended a seminar on youth obesity organized by a local high school that his two children attended. Even though he had often heard of the rising obesity problem in Mexico, Antonio was still very disturbed by the statistics indicating how the obesity rate in Mexico had tripled since 1980, and that 69.5% of the people 15 years and older were either obese or overweight. Even more shocking to Antonio, based on this statistic, Mexico now had the highest overweight rate in the world, surpassing the United States.' After the seminar, Antonio discussed the idea of Hola-Kola, a low-price, zero-calorie carbonated soft drink, with Pedro Cortez, Pedro was excited about the idea, and liked the opportunity to launch something new, espe- cially given that the company had not introduced a new product in the last five years. However, Pedro thought a market study should be done to gauge the potential demand before the firm undertook the investment. Company Background Bebida Sol is a small, privately owned carbonated soft drink company based in Puebla, Mexico. A retired ex- ecutive from a popular fast-food restaurant chain, Roberto Ortega, founded it in 1998. During his career as a restaurant executive, Roberto learned that Mexicans, regardless of social status, loved their soda pop. Many would drink soda to quench their thirst on a regular basis, due to the lack of hygienic, drinkable water. With the influx of international brands of soda pop, Mexico now had the highest consumption of carbonated soft drinks per capita in the world. The average per capita consumption was 40% higher than the United States, at 163 liters (43 gallons) per year, while the United States consumed 118 liters (31 gallons), according to statistics presented by the international organization Oxfam and the Mexican NGO Consumer's Power. Due to the high obesity problem, health and consumer groups in Mexico had demanded that the government impose a 20% tax on soft drinks, claiming that it would not only reduce consumption, but the tax revenue could also be used to fight health problems that soft drinks generated. Exhibit 1. Rates of Overweight and Obesity Persons by Country (2010) Obey 40200 Nof adult population Nof population Source World Obesity Stats-2010 and Beyond." Douglas Robb, Sept. 27, 2010. Herlib News The market leaders for carbonated soft drinks in Mexico were Coca-Cola, Pepsi-Cola, Dr. Pepper Snapple, and Grupo Penafiel. Together, they accounted for a combined market share of more than 90%, with Coca Cola being the major player. The Mexican soft drink market (products include bottled water, carbonates, RTD tea coffee, functional drinks, fruit/vegetable juices, and other soft drinks) had total revenues of $99.2bn in 2011, representing a compound annual growth rate (CAGR) of 6.3% between 2007 and 2011. Market consumption volumes increased with a CAGR of 4.5% between 2007 and 2011, reaching a total of 49.3 billion liters in 2011. Roberto thought these popular international brands commanded prices that might be out of reach for the poorer segment of the population. To capture this market, he started the company to offer private-labeled carbonated soft drinks with similar tastes, but at about half the price. His products consisted of regular cola carbonates and non-cola carbonates, such as lemon/lime or orange carbonates. Bebida Sol's products were sold only in small, independent grocery stores and convenience stores in Mexico. The firm avoided the supermarkets and hypermarkets because it could not sustain the desired margin in these largestones. Moreover, most of the consumers, especially the middle-to-low income one shopped a small independent grocery stores. To create awareness, the owners of these independent stores were given incentives to personally promote the products Sales increased dramatically, from 80 million pesos in 1998 to about 900 million pesos in 2011. In 2007, Antonio Ortega, Roberto's only son, took over the business when Roberto unexpectedly passed away. Antonio started working on the sales side of the business two years before his father's death. He had gath cred a few valuable tips on how to run the business from his father, which had made him a rather conservative businessman. A year after Antonio took over the business, the global financial crisis hit. The economic downturn in Mexico actually bencfitted the low-price soda business. Demand increased dramatically as many consumers became price conscious and switched from international brands to private labels. Bebida Sol's sales increased by 60% from 2008 to 2009. and continued to increase without the form changing any of its business strategy or practices. The company's return on sales (net profit margin) also had been increasing in the last few years 900 101 opos Exhibit 2. Bebida Sol's Sales and Return on Sales $1,000,000 $900,000 $800,000 $700,000 S600,000 $500.000 $400,000 $300,000 $200,000 $100,000 Return ofsas) Sales C 2010 2011 Sales Return on Sales The Proposal Reading once again the executive summary of the report, Antonio recalled what his father told him several times during the two years he was working with him: "Dant grow the company for the sake of growing Invest only when you are confident there is sufficient demand for a new product, and also when you have the financial resources. As far as financial resources, Antonio felt the timing could not be better. Due to strong sales and profitability in the last few years, Bebida Sol had accumulated a sizable amount of cash. With solid financial performance and steady cash flows, his banker had agreed to extend him a five-year, 16% annual interest term loan to launch Hola Kola. In the proposal, Pedro Cortez estimated that with 20% of the needed capital borrowed, the 20/80 debt equity structure would result in an 18.2% weighted average cost of capital for this project. The bigger question lingering in Antonio's mind was whether there would be sufficient demand for this new, ro-calorie product line. Even though the demand for low-caloric sodas had increased in Mexico, they seemed to be consumed mainly by the middle-to-upper income segment of the population. The majority of the lower income people still consumed only the regular, high-sugared carbonated soft drinks. It wasn't dear whether this was because the low-income group lacked the awareness of the obesity problem, or because there were not too many low priced, low-calorie soda options available. If it were the former, the outlook for low price, low calorie carbonated soft drinks might not be too promising at this time. If it were the latter, it might be the perfect timing for Bebida Sol to introduce Hola-Kola Pedro hired a consultant to do a market study right after Antonio discussed the idea of Hola Kola with him. The consultant estimated that the company could sell a total of 600,000 liters of these zero-calorie carbonates a month, at a projected price of five pesos a liter. This volume of sales was expected for a period of five years at the same price. The market study took about two months to complete and cost the company five million pesos, which Pedro had paid shortly after its completion Since the existing bottling plant was running at 100% capacity producing regular sodas, the proposal called for a fleet of new, semi-automated bottling and kegging machines designed for long, high-quality runs. The total cost of these machines, including installation, was estimated to be 50 million pesos. This amount could be fully depreciated on a straight-linc basis over a period of five years. Pedro believed that the purchase of these machines would enable Bebida Sol to reduce its cost of labor and therefore the price to the customers, putting the firm in a more competitive position. With proper maintenance, these machines could produce at least 600,000 liters of carbonated drinks per month. Pedro also estimated that these machines would have a resale value of four million pesos in five years time, if the company were to either shut down the production of Hola-Kola, or replace these machines with fully automated ones at that time. The new machines would be housed in an unoccupied annex by the main production facility of Bebida Sol. The annex was also large enough to store the finished products before they were shipped out to grocery stores, Antonio's father built the annex years ago when he planned to venture into the mineral water business. He died before he could execute his plan. The annex had been vacant ever since, even though Antonio recently received an offer to lease out the space for 60,000 pesos a year. Pedro determined that additional working capital was needed to ensure smooth production and sales of this new product line. He proposed keeping raw materials inventory at a level equal to one month of produc tion. To encourage the independent grocery stores to carry the new product line, he proposed offering a longer collection period, letting the grocers pay in 45 days, instead of the normal 30 days. As far as accounts payable, he would follow the company's normal policy, and settle the accounts in 36 days. The proposal also outlined the various estimates of production and overhead costs, and selling expenses. Raw materials needed to produce the sodas were estimated to be 1.8 pesos per liter, while labor costs and energy costs per month were estimated to be 180,000 pesos and 50,000 pesos, respectively. The incremental general administrative and selling expenses were quite modest, estimated to be 300.000 a year, as the new product could be sold by Bebida Sol's current sales force and via existing distribution channels. The accounting department typically charged 1% of sales as overhead costs for any new projects. Glancing back at his notes, Antonio started pondering. The market study seemed to indicate sufficient demand for the new product line. What he really feared was that the new zero-calorie carbonates might erode the sales of his existing products the regular sodas. The markert study u sted that potential crocion could cost the firm as much as 800,000 pesos of after-tax cash flows per year. At the new tax rate of 30% for both income and capital gains, could he add value to the firm by taking on this project? Appendix 1. Bebida Sol-Income Statements for the Year Ending December 31 (thousands of pesos) Income lice Sales COGS Gros margin 2002 642.400 100.0% 3984 54.59 292.516 45.5% 2010 832.41 100 09 $56.002 54.9 375.932 45.2% 2011 900,101 100 09 48702051 413.081 45.9% Marketing & Selling Expenses General Administrative Expenses EBITDA 120.359 65.340 106,817 18.7% 10.29% 16.6% 150.322 88.622 136.988 18.19 1076 16.5% 168.330 18.79 SA2911099 166,960 16.3% Depreciation 45.046 61.771 709 9.6% 59.444 77.544 219 9.39 65.985239 80.975 23.120 38,651 3.6% 6.0% 110SA 63,456 .29 7.6% 9340209 71.635 Taxes 30% Net Income 11.595 27.056 1896 .296 44.419 2.39 5.3.4 21.491 50.145 Dividends Retained Earnings 20.000 7.056 20,000 24,419 20.000 30,145 Appendix 2. Bebida Sol Balance Sheet as of December 31 (thousands of pesos) Cash Accounts Receivable Inventory Braids Current Assets 2009 12,023 3.1% 61,600 15.7% 32,592 8.3% U1.7923.096 118,007 30.1% 2010 36,090 8.9% 25.253 18.6% 45.016 11.1% 20.60 16 177.01943.8% 2011 53,020 78,913 60.044 14.0% 20.8% 15.84 207,095 54.59 Grossed assets Locum depreciation Net fixed 439,230 112.0% 452,020 111.7 165.M6 12.106 22.1.490 55.56 2786992274510 56.296 463.122 12209 280. 76.59 172.6-Z 15.55 Total Aucts 392.191 100.0% $0.519 100.0% 379.70 100.0% 2010 Libilities Accounts Payable Acredexp Short-term debe Current Liabilities 2009 34.509 15.083 20.520 120.112 8.996 3.8% 18.095 30.6% 43.765 19.087 $3.29 126.281 10. 479 15.2 31.29 18.0351264 20.493 545 220000 91.428 2019 26.793 6.6% 251 75 6226 6.693 189 2015122125 Long-term debe Equity Liabilities Neural 45.023 11.5 227.056 57.9% 392.191 100.0% 40.519 100.0% 37.70 100.0%