September 26, 2002 Coke vs. Pepsi To: Maurry Tamarkin From: Alexzander Downs Micheal Jordan Cynthia Tang Yi-Shun Chan Subject: Corporate Finance

We researched Coke and Pepsi as was requested to see which one would be a better investment over the other. One of the ways to see how a company is doing is to look at how much (EVA) Economic Value Added that company is producing. EVA is a way of measuring an operations real profitability. EVA is better than conventional ways because it takes into account the total cost of the operating capital. EVA is simply the after-tax operating profit minus the total annual cost of capital. Using EVA has advantages as well as disadvantages.

Advantages EVA sends the message than managers should invest only if the increase in

earnings is enough to cover cost of capital EVA allows a good way for companies to set a reward system that is not

overly expensive to implement because is not too difficult for top management to monitor.

EVA makes the cost of capital visible to operating managers Stock prices track EVA more closely than they track other popular measures. Ways to improve EVA

o Increase earnings o Reduce capital employed o Invest capital in high-return projects

Disadvantages EVA does not involve forecasts of future cash flows and does not measure

present value. EVA therefore rewards managers who take on projects with quick paybacks

and penalize those who invest in projects with long gestation period. Need to make changes in income statements and the balance sheet to measure

economic value. Looking at the historical trends of Coke and Pepsi in terms of EVA we find Coca-Cola's EVA has been slowly decreasing while PepsiCo's EVA has been increasing (see Exhibit 1.1). Coca-Cola's NOPAT has decreased in recent years as a result of slowing sales growth and worsening profit margins. If it were not for Coca-Cola's decreasing WACC, its EVA would decrease more rapidly. If Coca-Cola used a WACC of 12%, about the average of the past seven years, its EVA would have been $445,000,000 in 2000. PepsiCo was able to more than double their EVA in 2000 due to higher NOPAT and lower WACC. The higher NOPAT, was mainly a result of improved margins which lead to a higher ROI. The key to EVA is the spread between ROI and WACC. It is important to invest capital at a higher rate than the capital is obtained at. In theory, as long as there

are enough projects that produce ROI > WACC and enough capital supplied, EVA can grow indefinitely.

EVA ($MM)

($2,000)

($1,000)

$0

$1,000

$2,000

1994 1995 1996 1997 1998 1999 2000

Year

EVA Coca-Cola

PepsiCo

WE mentioned above that the (WACC) Weighted Average Cost of Capital is important. So now lets take a look at what WACC is and why it is important. Firms must use capital for operations. We want to know what the cost of that capital is to that firm. Therefore we look at the cost of the companies debt, the companies equity, and other costs when applicable such as preferred. Once we determine these costs we weight them so they reflect the true structure of the company. Calculating the WACC is important because it is the opportunity cost of capital or what the owners would expect to earn on their money in an equally risky project elsewhere. It is the financial managers who usually set the WACC. They do so with the aid of published sources, financial advisors, and other sources to estimate values for Beta, risk free rate, and market premium. The type of company sometimes influences the weighting of debt to equity. A new company that faces potential bankruptcy will often take that cost into account and will be much more equity financed. A company that is relatively certain of profits will lean toward more debt to take advantage of the tax shields available.

WACC

0.00%0.05%0.10%0.15%0.20%0.25%

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

Coke Pepsi

To get a good idea of how Coke and Pepsi compare in WACC we calculated their WACC projecting out to 2003 and assuming a 35 percent tax rate (see appendix 1.2). When we look the WACC for Coke and Pepsi we can see that Cokes WACC is consistently close yet slightly higher than Pepsis. However in 1997 when Pepsis CEO Roger Enrico spun off the fast food chains KFC, Taco Bell, and Pizza Hut, Pepsis WACC jumped significantly higher and then returned to normal in 1997. We can conclude that both Coke and Pepsi have similar costs of capital.

EVA

($2,000)($1,000)

$0$1,000$2,000$3,000$4,000

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

Coca-ColaPepsiCo

Continuing with EVA we used Coke and Pepsis forecasts to see how their EVA war would play out (see Exhibit 1.3). We can see that Pepsi takes the lead in 2000 with an EVA of $1,201 million compared with Coke Cola $1,016 million. By 2001 Coke Cola takes the lead with $2,470 million in EVA and Pepsi at $2,102 million. In 2002 Coca Cola will have risen to $2,871 as compared to Pepsis $2,419. Then in 2003 Coke Colas EVA is now projected at $3,124 million compared to Pepsis $3,555 million.

If you have to choose between Coke and Pepsi which would you choose and why. According to the Sept 20, 1993 Fortune article titled The Real Key to Creating Wealth, by Shawn Tully: One of EVAs most powerful properties is its strong link to stock prices. In the article the CFO for AT&T James Meenan found that there was almost a perfect correlation between EVA and their stock price. EVA does a better job telling investors what they really care about which is their net cash return on their capital. Therefore we could conclude that it will be a better investment to invest in Coke Colas stock over Pepsis stock because they will create more Economic Value Added and hence create more value for the shareholders over this period.

Appendix

Exhibit 1.3

2001 2002 2003 2001 2002 2003Pretax Income 5605 6313 6874 4394 4979 5571Equity Income (197) (227) (261) (157) (186) (239)Goodwill 295 295 295 236 295 295Cash Taxes (1738) (1957) (2131) (1142) (1245) (1504)Interest Income (295) (244) (254) 0 0 0Interest Expense 310 280 264 148 92 37NOPAT 3980 4460 4787 3479 3935 4160Debt 5426 5172 4919 6833 6810 6304Equity 11267 11898 12368 9282 11648 11382Acc. Goodwill 487 782 1077 987 1282 1577Cash and Equivalents (2238) (2406) (2432) (2241) (4143) (2923)Invested Capital 14942 15446 15932 14861 15597 16340ROI 26.64% 28.87% 30.05% 23.41% 25.23% 25.46%WACC 10.11% 10.29% 10.44% 9.26% 9.72% 9.82%Spread 16.53% 18.59% 19.61% 14.15% 15.51% 15.64%EVA 2470 2871 3124 2102 2419 2555

Coca-Cola PepsiCo1994 $1,602 ($464)1995 $1,814 ($760)1996 $1,292 ($916)1997 $1,601 $241998 $1,422 $4281999 $1,063 $5222000 $1,016 $1,2012001 $2,470 $2,1022002 $2,871 $2,4192003 $3,124 $2,555

Coke Pepsi

EVA

EVA

($2,000)($1,000)

$0$1,000$2,000$3,000$4,000

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Coca-ColaPepsiCo

Appendix1.2

Coke 2001 2002 2003 Pepsi 2001 2002 2003% Debt 32.50% 30.30% 28.45% 42.40% 36.89% 35.64%% Equity 67.50% 69.70% 71.55% 57.60% 63.11% 64.36%Beta 0.88 0.88 0.88 0.88 0.88 0.88Risk free rate 6.15% 6.15% 6.15% 6.15% 6.15% 6.15%Market risk premium 7.50% 7.50% 7.50% 7.50% 7.50% 7.50%Cost of Debt 7.10% 7.10% 7.10% 6.97% 6.97% 6.97%Cost of Equity 12.75% 12.75% 12.75% 12.75% 12.75% 12.75%Tax Rate 35.00% 35.00% 35.00% 35.00% 35.00% 35.00%WACC 10.11% 10.29% 10.44% 9.26% 9.72% 9.82%

Coca-Cola: 2001Coca-Cola: 2001

WACC = Rd (1-Tc) (D / V) + Re (E / V)0.071 (1 -.35) (5426 /16693 ) + 0.1275 (11,267 / 16693)=10.11%

Cost of debt = 7.1%Cost of Equity = Ke =Rf +(Rm-Rf) =6.15%+0.88(7.5%)=12.75%

The average Beta is 0.88, Market premium: 7.5%. Arithmetic mean

Pepsi: 2001

WACC = Rd (1-Tc) (D / V) + Re (E / V)0.071(1 -.35) (6833 / 16115) + 0.1275(6833 / 16115)=9.26%

Cost of debt = 6.97Costt of Equity = Ke =Rf +(Rm-Rf) =6.15%+0.88(7.5%)=12.75%

The average Beta is 0.88, Rm=6.15%..T-bill three months , Rf=7.5.. Arithmetic mean

WACCCoke Pepsi

1994 0.12% 0.12%1995 0.11% 0.11%1996 0.13% 0.21%

WACC

00.0005

0.0010.0015

0.0020.0025

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Coke Pepsi