Sangria Topochico - The Capital Budgeting Decision In December 2012, Mara Guadalupe, the owner of Sidral Mundet Sol, had just finished reading a report done by his general manager, Francisco Javier, about the possible investment in a new product line, Sangria Topochico. The idea of Sangria Topochico came about three months earlier when Maria 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, Maria 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 Maria, based on this statistic, Mexico now had the highest overweight rate in the world, surpassing the United States. After the seminar, Mara discussed the idea of Sangria Topochico, a low-price, zero-calorie carbonated soft drink, with Francisco Javier, Francisco 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, Francisco thought a market study should be done to gauge the potential demand before the firm undertook the investment. Company Background Sidral Mundet Sol is a small, privately owned carbonated soft drink company based in Puebla, Mexico. A retired executive from a popular fast-food restaurant chain, Juan Manuel, founded it in 1998. During his career as a restaurant executive, Juano leamed 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 f 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 Perosns by Country (2010) Overweight Obesity 50 Jupe 08 Karne Suicerad 2007) Innby(2008) Norw(2008 Swada(2007) Frac(2006) Demar(2005) Nederland (2009) Austria (2006) Poland 2004 Bur2008) Belgium) Turkey(2008) Purg000 Tild2008 OECD Ger(2000) Slove007 Slovak Republic 2005) Carch Republic(2008) Spel(2009) Grec(2005) Hungary(2003) Lamber007 2007) Chile(2005) Ir2001) Cad(2005) United Kingdom) New Zealand 2007 Mic(2006) United Sta2008 India 2005) lade 2005) China (2005) Bruil 2015 Rumi Peder2005) 2008) South Africa (2004) 35 50 50 61 22 80 20 60 40 adult population 0 10 20 30 40 % adult population 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 a CAGR of 4.5% between 2007 and 2011, reaching a total of 49.3 billion liters in 2011. Juano 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. Sidral Mundet 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 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, Maria Guadalupe, Juano's only son, took over the business when Juano unexpectedly passed away. Maria started working on the sales side of the business two years before his father's 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 Maria 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. Sidral Mundet Sol's sales increased by 60% from 2008 to 2009, and continued to increase without the firm 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. Exhibit 2. Sidral Mundet Sol's Sales and Return on Sales 6.00% 5.57% $1,000,000 $900,000 $800,000 $600,000 $700,000 5.00% 4.21% (thousands ofpesos) 4.00% $500,000 3.00% Retums of sales (6) $900,101 $832,341 $400,000 $300,000 2.00% $642,400 $200,000 1.00% $100,000 0.00% 2009 2011 2010 Return of Sales Sales The proposal Reading once again the executive summary of the report, Mara recalled what his father told him several times during the two years he was working with him: Don't 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, Maria felt the timing could not be better. Due to strong sales and profitability in the last few years, Sidral Mundet 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 Sangria Topochico. In the proposal, Francisco Javier 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 Maria's 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 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 clear 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 Sidral Mundet Sol to introduce Sangria Topochico. Francisco hired a consultant to do a market study right after Mara discussed the idea of Sangria Topochico 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 Francisco 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. Francisco believed that the purchase of these machines would enable Sidral Mundet 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. Francisco 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 Sangria Topochico, 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 Sidral Mundet Sol. The annex was also large enough to store the finished products before they were shipped out to grocery stores. Mara'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 Maria recently received an offer to lease out the space for 60,000 pesos a year. Francisco 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 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 Sidral Mundet 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, Maria 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 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 this project? Appendix 1. Sidral Mundet SolIncome Statements for the Year Ending December 31 (thousands of pesos) Income Item 2010 2009 2011 Sales COGS Gross margin 642,400 349.884 292,516 100.0% 832,341 54,5% 456,409 45.5% 375,932 100.0% 54.8% 45.2% 900,101 100.0% 487,020 54.1% 413,081 45.9% Marketing & Selling Expenses 120,359 General Administrative Expenses 65,340 EBITDA 106,817 18.7% 150,322 10.2% 88,622 16.6% 136,988 18.1% 10.6% 16.5% 168,330 97,791 146,960 18.7% 10.9% 16.3% Depreciation EBIT 45,046 61,771 7.0% 9.6% 59,444 77,544 7.1% 9.3% 65,985 80,975 7.3% 9.0% Interest EBT 23,120 38,651 3.6% 14,088 6.0% 63,456 1.7% 7.6% 9,340 71,635 1.0% 8.0% Taxes @ 30% Net Income 11,595 27,056 1.8% 4.2% 19,037 44.419 2.3% 5.3% 21,491 50.145 2.4% 5.6% Dividends Retained Earnings 20,000 7,056 20,000 24,419 20,000 30,145 Appendix 2. Sidral Mundet Sol-Balance Sheet as of December 31 (thousands of pesos) Assets 2009 2010 2011 Cash 12,023 3.1% 36,090 8.9% 53,020 14.0% Account Receivable 61,600 15.7% 75,253 18.6% 78,913 20.8% Inventory 32,592 8.3% 45,016 11.1% 60,044 15.8% Prepaid Expenses 11,792 3.0% 20,660 5.1% 15.117 4.0% Current Assets 118,007 30.1% 177,019 43.8% 207,093 54.5% Gross fixed assets 439,230 112.0% 452,020 111.7% 463,122 122.0% Accum depreciation 165,046 42.1% 224.490 55.5% 290,475 76.5% Net fixed assets 274.184 69.9% 227.530 56.2% 172.647 45.5% Total Assets 392,191 100.0% 404,549 100.0% 379.740 100.0% Liabilities & Net Worth 2009 2010 2011 Accounts Payable 34,509 8.8% 43,765 10.8% 48,035 12.6% Accrued expenses 15,083 3.8% 19,087 4.7% 20,493 5.4% Short-term debt 70,520 18.0% 63.429 15.7% 22.900 6.0% Current Liabilities 120,112 30.6% 126,281 31.2% 91,428 24.1% Long-term debt 45,023 11.5% 26,793 6.6% 6,693 1.8% Equity 227,056 57.9% 251,475 62.2% 281,619 74.2% Liabilities & Net Worth 392,191 100.0% 404,549 100.0% 379,740 100.0% 5. Perform sensitivity analyses and calculate the project's NPV, IRR, and payback period if a. sales volume increases 4.5% b. unit price increases 20% c. direct labor cost increases 5% d. raw materials increase 5% e. energy cost increases 5% 6. What are the benefits and risks of understanding this project? 7. Should Sangria Topochico undertake this project? Sangria Topochico - The Capital Budgeting Decision In December 2012, Mara Guadalupe, the owner of Sidral Mundet Sol, had just finished reading a report done by his general manager, Francisco Javier, about the possible investment in a new product line, Sangria Topochico. The idea of Sangria Topochico came about three months earlier when Maria 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, Maria 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 Maria, based on this statistic, Mexico now had the highest overweight rate in the world, surpassing the United States. After the seminar, Mara discussed the idea of Sangria Topochico, a low-price, zero-calorie carbonated soft drink, with Francisco Javier, Francisco 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, Francisco thought a market study should be done to gauge the potential demand before the firm undertook the investment. Company Background Sidral Mundet Sol is a small, privately owned carbonated soft drink company based in Puebla, Mexico. A retired executive from a popular fast-food restaurant chain, Juan Manuel, founded it in 1998. During his career as a restaurant executive, Juano leamed 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 f 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 Perosns by Country (2010) Overweight Obesity 50 Jupe 08 Karne Suicerad 2007) Innby(2008) Norw(2008 Swada(2007) Frac(2006) Demar(2005) Nederland (2009) Austria (2006) Poland 2004 Bur2008) Belgium) Turkey(2008) Purg000 Tild2008 OECD Ger(2000) Slove007 Slovak Republic 2005) Carch Republic(2008) Spel(2009) Grec(2005) Hungary(2003) Lamber007 2007) Chile(2005) Ir2001) Cad(2005) United Kingdom) New Zealand 2007 Mic(2006) United Sta2008 India 2005) lade 2005) China (2005) Bruil 2015 Rumi Peder2005) 2008) South Africa (2004) 35 50 50 61 22 80 20 60 40 adult population 0 10 20 30 40 % adult population 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 a CAGR of 4.5% between 2007 and 2011, reaching a total of 49.3 billion liters in 2011. Juano 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. Sidral Mundet 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 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, Maria Guadalupe, Juano's only son, took over the business when Juano unexpectedly passed away. Maria started working on the sales side of the business two years before his father's 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 Maria 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. Sidral Mundet Sol's sales increased by 60% from 2008 to 2009, and continued to increase without the firm 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. Exhibit 2. Sidral Mundet Sol's Sales and Return on Sales 6.00% 5.57% $1,000,000 $900,000 $800,000 $600,000 $700,000 5.00% 4.21% (thousands ofpesos) 4.00% $500,000 3.00% Retums of sales (6) $900,101 $832,341 $400,000 $300,000 2.00% $642,400 $200,000 1.00% $100,000 0.00% 2009 2011 2010 Return of Sales Sales The proposal Reading once again the executive summary of the report, Mara recalled what his father told him several times during the two years he was working with him: Don't 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, Maria felt the timing could not be better. Due to strong sales and profitability in the last few years, Sidral Mundet 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 Sangria Topochico. In the proposal, Francisco Javier 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 Maria's 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 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 clear 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 Sidral Mundet Sol to introduce Sangria Topochico. Francisco hired a consultant to do a market study right after Mara discussed the idea of Sangria Topochico 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 Francisco 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. Francisco believed that the purchase of these machines would enable Sidral Mundet 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. Francisco 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 Sangria Topochico, 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 Sidral Mundet Sol. The annex was also large enough to store the finished products before they were shipped out to grocery stores. Mara'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 Maria recently received an offer to lease out the space for 60,000 pesos a year. Francisco 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 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 Sidral Mundet 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, Maria 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 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 this project? Appendix 1. Sidral Mundet SolIncome Statements for the Year Ending December 31 (thousands of pesos) Income Item 2010 2009 2011 Sales COGS Gross margin 642,400 349.884 292,516 100.0% 832,341 54,5% 456,409 45.5% 375,932 100.0% 54.8% 45.2% 900,101 100.0% 487,020 54.1% 413,081 45.9% Marketing & Selling Expenses 120,359 General Administrative Expenses 65,340 EBITDA 106,817 18.7% 150,322 10.2% 88,622 16.6% 136,988 18.1% 10.6% 16.5% 168,330 97,791 146,960 18.7% 10.9% 16.3% Depreciation EBIT 45,046 61,771 7.0% 9.6% 59,444 77,544 7.1% 9.3% 65,985 80,975 7.3% 9.0% Interest EBT 23,120 38,651 3.6% 14,088 6.0% 63,456 1.7% 7.6% 9,340 71,635 1.0% 8.0% Taxes @ 30% Net Income 11,595 27,056 1.8% 4.2% 19,037 44.419 2.3% 5.3% 21,491 50.145 2.4% 5.6% Dividends Retained Earnings 20,000 7,056 20,000 24,419 20,000 30,145 Appendix 2. Sidral Mundet Sol-Balance Sheet as of December 31 (thousands of pesos) Assets 2009 2010 2011 Cash 12,023 3.1% 36,090 8.9% 53,020 14.0% Account Receivable 61,600 15.7% 75,253 18.6% 78,913 20.8% Inventory 32,592 8.3% 45,016 11.1% 60,044 15.8% Prepaid Expenses 11,792 3.0% 20,660 5.1% 15.117 4.0% Current Assets 118,007 30.1% 177,019 43.8% 207,093 54.5% Gross fixed assets 439,230 112.0% 452,020 111.7% 463,122 122.0% Accum depreciation 165,046 42.1% 224.490 55.5% 290,475 76.5% Net fixed assets 274.184 69.9% 227.530 56.2% 172.647 45.5% Total Assets 392,191 100.0% 404,549 100.0% 379.740 100.0% Liabilities & Net Worth 2009 2010 2011 Accounts Payable 34,509 8.8% 43,765 10.8% 48,035 12.6% Accrued expenses 15,083 3.8% 19,087 4.7% 20,493 5.4% Short-term debt 70,520 18.0% 63.429 15.7% 22.900 6.0% Current Liabilities 120,112 30.6% 126,281 31.2% 91,428 24.1% Long-term debt 45,023 11.5% 26,793 6.6% 6,693 1.8% Equity 227,056 57.9% 251,475 62.2% 281,619 74.2% Liabilities & Net Worth 392,191 100.0% 404,549 100.0% 379,740 100.0% 5. Perform sensitivity analyses and calculate the project's NPV, IRR, and payback period if a. sales volume increases 4.5% b. unit price increases 20% c. direct labor cost increases 5% d. raw materials increase 5% e. energy cost increases 5% 6. What are the benefits and risks of understanding this project? 7. Should Sangria Topochico undertake this project