Lima-Nada Capital Budgeting Decision Introduction Luiz Santos, the owner of Grupo Verano is contemplating an investment opportunity in a new product line, called Lima-Nada. The idea of Lima-Nada originated about three months earlier, in September 2012, when Luiz 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, Luiz was still very disturbed by the statistics. Mexico now had the highest overweight rate in the world, surpassing the United States.1 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. After the seminar, Luiz discussed the idea of Lima-Nada, a low-price, zero-calorie carbonated soft drink, with his general manager Carlos Reyes. Carlos was excited about the idea, and liked the opportunity to launch something new, especially given that the company had not introduced a new product in the last five years. However, Carlos thought a market study should be done to gauge the potential demand before the firm undertook the investment. Company Background Grupo Verano is a small, family owned soda company based in Monterrey, Mexico. The company was founded in 1998 by Ricardo Santos. During his career as a restaurant executive, Ricardo 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.2 The average per capita consumption was 40% higher than the United States, at 163 liters (4.3 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 Consumers Power. Due to the high obesity problem, health and consumer groups in Mexico had demanded that the government impose a 2 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.3 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 $39.2bn in 2011, representing a compound annual growth rate (CAGR) of 6.3% between 2007 and 2011. Market consumption volumes increased with CAGR of 4.5% between 2007 and 2011, reaching a total of 49.3 billion liters in 2011.4 Ricardo 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 carbonates and non-cola carbonates, such as lemon/lime or orange carbonates. The products of Grupo Verano were sold only in small, independent grocery stores and convenience store in Mexico.5 The firm avoided the supermarkets and hypermarkets because it could not sustain the desired margin in these large stores. Moreover, most of the consumers, especially the middle-to-low income ones, shopped at 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, Luiz Santos, Ricardos only son, took over the business when Ricardo unexpectedly passed away. Luiz started working on the sales side of the business two years before his fathers death. He had gathered a few valuable tips on how to run the business from his father, which had made him a rather conservative businessman. A year after Luiz took over the business, the global financial crisis hit. The economic downturn in Mexico actually benefitted the low-price soda business. Demand increased dramatically as many consumers became price conscious and switched from international brands to private labels. Sales of Grupo Verano increased by 60% from 2008 to 2009, and continued to increase without the firm changing any of its business strategy or practices. The companys return on sales (net profit margin) also had been increasing in the last few years. 3 The Proposal Reading once again the executive summary of the report, Luiz recalled what his father told him several times during the two years he was working with him: Dont 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, Luiz felt the timing could not be better. Due to strong sales and profitability in the last few years, Grupo Verano 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 Lima-Nada. In the proposal, Carlos Reyes 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 Luizs mind was whether there would be sufficient demand for this new, zero-calorie product line. Even though the demand for low-calorie sodas had increased in Mexico, they seemed to be consumed mainly 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 was not clear whether this was because the low-income group lacked the awareness of the obesity problem, or because there were not too many lowpriced, low-calorie soda options available.6 If it were the former, the outlook for low-price, lowcalorie carbonated soft drinks might not be too promising at this time. If it were the latter, it might be the perfect timing for Grupo Verano to introduce Lima-Nada. Carlos hired a consultant to do a market study right after Luiz discussed the idea of Lima-Nada 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 Carlos 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-line basis over a period of five years. Carlos believed that the purchase of these machines would enable Grupo 4 Verano 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. Carlos 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 Lima-Nada, 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 Grupo Verano. The annex was also large enough to store the finished products before they were shipped out to grocery stores. Luizs 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 Luiz recently received an offer to lease out the space for 60,000 pesos a year. Carlos 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 production. 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 companys 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 the current sales force of Grupo Verano 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, Luiz 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 productsthe regular sodas. The market study suggested that potential erosion 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 the project?

1)

i. What are the relevant and incremental cash flows?

ii. Explain your decisions with respect to the expected consultancy costs, the potential rental value of the unoccupied annex, the interest charges on debt, and effects on net working capital.

iii. Explain your treatment of any expected erosion of existing products

iv. Calculate the NPV and IRR based on your DCF

v. Calculate the payback and discounted payback period and explain how to interpret these

vi. Describe the various benefits and risks associated with this project