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COKE VERSUS PEPSI CASE STUDY

Economic Value Added (EVA); Advantages and Disadvantages



The Economic Value Added (EVA) is a measure of surplus value created on an
investment. It is closest in both theory and construct to the net present value of a
project in capital budgeting. It is the difference between the firms after-tax
return on capital and its cost of capital.
The basic concept of EVA is that performance should be measured in terms of the
value added during the period. It is a measure of performance that is directly
linked to shareholder wealth.
Advantages of EVA
1. EVA is closely related to NPV. It is closest in spirit to corporate finance
theory that argues that the value of the firm will increase if you take
positive NPV projects.
2. It avoids the problems associated with approaches that focus on
percentage spreads - between ROE and Cost of Equity and ROC and Cost
of Capital. These approaches may lead firms with high ROE and ROC to
turn away good projects to avoid lowering their percentage spreads.
3. It makes top managers responsible for a measure that they have more
control over - the return on capital and the cost of capital are affected by
their decisions - rather than one that they feel they cannot control as well
- the market price per share.
4. It is influenced by all of the decisions that managers have to make within
a firm - the investment decisions and dividend decisions affect the return
on capital (the dividend decisions affect it indirectly through the cash
balance) and the financing decision affects the cost of capital.
Disadvantages of EVA
1. The calculation process requires numerous adjustments to profit and
capital employed figures.
2. EVA does not facilitate comparisons between divisions since EVA is an
absolute measure.
3. WACC calculation includes a huge number of assumptions.
4. EVA is based on historical data, which might not continue in the future.
Coca-Cola and Pepsi Co. EVA [1994-2000]

As shown in Exhibit 1, between the period 1994-2000, Coca-Cola has had a much
more stable EVA figure as compared to Pepsi Co. It should be noted though that
Coca-Colas EVA has been depreciating from 1997-2000. Pepsi Co., on the other
hand, has shown negative EVA figures in the past but has been increasing rapidly
and passed Coca-Colas EVA in 2000.

Such trends in EVAs can be explained somewhat by Roger Enricos (Pepsi CEO)
decision to sell off KFC, Taco Bell and Pizza Hut in 1997. Coca-Colas EVA figures
have been mainly driven by the recent difficulties faced due to the economic
environment but even more due to the business mistakes made by Doug Ivester,
CEO from 1997-1999.

To understand the key drivers of EVA, it is important to look at the formula for
EVA:

( )

Where, ROIC = Return on Invested Capital = NOPAT/ Invested Capital

Exhibit 1 shows that both Coca-Cola and Pepsi have a similar value of WACC and
between 1994-1998; Coca-Cola had lesser invested capital than Pepsi but had
higher ROICs and hence higher EVAs. For the year 2000, the situation reversed
and hence Pepsi Co. had a higher EVA. Thus, it can be concluded that for this case
the deciding factor for EVA analysis is the Return on Invested Capital (ROIC).
Weighted Average Cost of Capital (WACC)

WACC refers to the Weighted Average Cost of Capital, which is the average of the
costs of all sources of financing used by a firm. By calculating a weighted average,
we can see how much interest the company has to pay for every dollar it
finances. A firm's WACC is the overall required return on the firm as a whole. It is
considered the appropriate discount rate to use for cash flows with risk that is
similar to that of the overall firm. A firms WACC can be calculated using the
following formula:



WACC is a very significant number and is often used to assess the soundness of a
companys financial position. When considering a new project or a
merger/acquisition, WACC is used to discount the cash flows to understand the
NPV of the project and understanding the WACC of a target company gives an
idea of what level of returns are required to remain profitable in the future.
Hence, WACC is a vital input to decision making at a corporate level.

From the definition of WACC, it can be seen that WACC is dependent upon the
firms capital structure and the markets valuation of the firms riskiness,
reflected in the cost of capital sources provided the corporate tax rate is
constant. As we know, it is the managements decision to change the percentage
of debt to equity in the firm so; theoretically, the manager can reduce WACC by
changing the capital structure. In general, debt is cheaper than equity but at the
same time, increasing debt means higher riskiness and hence leads to higher

and

.
WACC Calculation

As mentioned above, following are the steps involved in the calculation of WACC
for a firm:
Cost of Debt (

):
As both Coca-Cola and Pepsi Co. have debt that is publicly traded, the most
appropriate method would be to calculate the yield to maturity on this debt,
which can be used as a measure for cost of debt. As shown in Appendix 1, Coca-
Cola has a before tax cost of debt of 7.09% whereas Pepsi Co. has a value of
6.92%. Assuming a tax rate of 35%, the after-tax cost of debt of Coca-Cola and
Pepsi Co. is 4.61% and 4.50% respectively.
Cost of Equity (

):
There are three main techniques that analysts use to calculate the Cost of Equity,
the Capital Asset Pricing Model (CAPM), the Dividend Discount Model (DDM) and
Equity Capital Model. CAPM is considered the most appropriate model as it
incorporates the firms beta, the risk-free rate and the market risk premium.
Hence using CAPM,

)

Using data from Exhibit 8, the current yield of 5.73% on 10-year U.S. Treasuries
is taken as the risk-free rate,

. The average beta () for both Coca-Cola and


Pepsi Co. is given as 0.88. The geometric mean of the Equity risk premium of
5.90% is taken as the market risk premium because geometric mean includes
compounding. As shown in Appendix 1, using the above values, the cost of equity
of Coca-Cola and Pepsi Co. is 10.92%.

Market Value of Debt (D):
The market value of debt can be calculated by using data given in Exhibit 6 (for
Coca Cola) and Exhibit 7 (for Pepsi) that are the total long-term debt, the par
value of the coupon and the current price of the debt traded. As shown in
Appendix 1, the Market Value of Debt for Coca-Cola and Pepsi Co. is
$623,387,400 and $1,964,055,600 respectively.
Market Value of Equity (E):
The market value of equity can be calculated by multiplying the current share
price as on December 4, 2000 with the total number of outstanding shares as
given in Exhibit 8. We use the number of diluted shares to account for
convertible securities, preferred stocks, warranties, etc. As shown in Appendix 1,
the market value of equity for Coca-Cola and Pepsi Co. was found to be
$156,059,250,000 and $64,619,750,000 respectively.
WACC:
Substituting all of the above mentioned value in the WACC formula,



It is found that Coca-Cola has a WACC of 10.90% whereas Pepsi Co. has a WACC
of 10.73%, provided the data is accurate. Interestingly, even though Pepsi Co. has
a much higher amount of long-term debt, their cost of debt offsets the WACC and
Coca-Colas higher market value of equity leads to higher WACC for Coca-Cola
than Pepsi.
EVA Calculation [2001-2003]

As mentioned above, the first step in calculating the Economic Value Added
(EVA) is to calculate the firm WACC that has already been done previously. The
next step is calculating the Invested Capital.

Using the data provided in the balance sheet in Exhibit 6(for Coca-Cola) and
Exhibit 7(for Pepsi), the Invested Capital can be calculated by subtracting A/P
and accrued liabilities from the Total Assets. The accumulated Goodwill
Amortization has been excluded from this calculation due to the lack of
information for the years 2001-2003. As shown in Appendix 2, Pepsi Co has a
consistently higher Invested Capital as compared to Coca-Cola.

The next step in estimating EVA is to calculate the firms Net Operating Profit
after Taxes (NOPAT). Using the data from Exhibit 6 & 7, NOPAT can be calculated
by subtracting the income taxes paid from the Operating Income. Appendix 2
shows that in terms of NOPAT, Coca-Cola consistently outperforms Pepsi Co.

The next step is to calculate the Return on Invested Capital (ROIC) by dividing
the NOPAT by the Invested Capital. Appendix 2 shows that as expected, Coca-
Cola consistently outperforms Pepsi Co. in terms of ROIC.

Now, using ( ) , the Economic Value
Added (EVA) for both companies can be calculated for the coming three years,
2001-2003.
EVA Interpretation & Conclusion

Appendix 2 shows that assuming the forecast data is accurate, the Economic
Value Added (EVA) by Coca-Cola is consistently higher than Pepsi Co. Once again,
it can be seen that Coca-Colas ROIC is higher than Pepsi Co.s which further
strengthens the argument that ROIC is the key driver of EVA.



The above graph clearly shows that based on EVA, Coca-Cola will significantly
outperform Pepsi Co. between the years 2001-2003 and hence, Coca-Cola should
be chosen as the firm which would create most value.

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Coke vs Pepsi EVA Forecast[2001-2003]
Pepsi Co.
Coca-Cola


To have a more robust view of the situation, it is important to look at the EVA
figures for both companies from 1994-2003 together. It is also important to note
that in the long run, Coca-Cola can survive more efficiently since it has faced near
bankruptcy cases and recovered from them whereas Pepsi Co. has not.

In conclusion, based on the EVA analysis, Coca-Cola would be considered the
clear favourite for the future. It should also be noted that Coca-Cola and Pepsi
Co.s recent attempts to enter other market segments is likely to be highly
profitable given the changes in customer orientations from carbonated drinks to
non-carbonated drinks.









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Coke vs Pepsi EVA [1994-2003]
Pepsi Co.
Coca-Cola
APPENDIX 1

WACC Calculations

Cost of Debt
Coca-Cola Pepsi Co.
Face Value $1,000.00 $1,000.00
Annual Coupon Rate 5.75% 5.75%
Number of Payments 17 15
Coupon Payments per year 2 2
Current Bond Price $915.40 $932.60

Yield to Maturity/ Kd before tax 7.09% 6.92%

Corporate Tax Rate 35% 35%

After Tax Cost of Debt 4.61% 4.50%

Cost of Equity
Coca-Cola Pepsi Co.
Risk-free Rate 5.73% 5.73%
Beta 0.88 0.88
Market Risk Premium 5.90% 5.90%

Cost of Equity/ Ke 10.92% 10.92%

Market Value of Debt
Coca-Cola Pepsi Co.
Long-term Debt $681,000,000.00 $2,106,000,000.00
Par value of Coupon $1,000.00 $1,000.00
Current price of traded debt $915.40 $932.60

Market Value of Debt $623,387,400.00 $1,964,055,600.00

Market Value of Equity
Coca-Cola Pepsi Co.
Current Share Price $62.75 $43.81
No. of outstanding shares 2,487,000,000.00 1,475,000,000.00

Market Value of Equity

$156,059,250,000.00

$64,619,750,000.00

Wd or [D/(D+E)] 0.40% 2.95%
We or [E/(D+E)] 99.60% 97.05%

WACC 10.90% 10.73%








APPENDIX 2

EVA Calculations

2001
Coca-Cola Pepsi Co.
Total Assets

$21,434,000,000.00

$22,757,000,000.00
A/P and accrued liabilities $3,796,000,000.00 $5,017,000,000.00

Invested Capital

$17,638,000,000.00

$17,740,000,000.00

Operating Income $5,399,000,000.00 $4,385,000,000.00
Income Tax $1,682,000,000.00 $1,406,000,000.00
Accumulated Goodwill Amortization $- $-

NOPAT $3,717,000,000.00 $2,979,000,000.00

ROIC 21.07% 16.79%
WACC 10.90% 10.73%

EVA $1,795,008,180.08 $1,075,053,066.64

2002
Coca-Cola Pepsi Co.
Total Assets

$21,901,000,000.00 $25,716,000,000.00
A/P and accrued liabilities $3,868,000,000.00 $5,284,000,000.00

Invested Capital

$18,033,000,000.00 $20,432,000,000.00

Operating Income $6,132,000,000.00 $4,885,000,000.00
Income Tax $1,894,000,000.00 $1,593,000,000.00
Accumulated Goodwill Amortization $- $-

NOPAT $4,238,000,000.00 $3,292,000,000.00

ROIC 23.50% 16.11%
WACC 10.90% 10.73%

EVA $2,272,965,501.27 $1,099,133,949.13

2003
Coca-Cola Pepsi Co.
Total Assets

$22,311,000,000.00

$25,511,000,000.00
A/P and accrued liabilities $4,066,000,000.00 $5,573,000,000.00

Invested Capital

$18,245,000,000.00

$19,938,000,000.00

Operating Income $6,633,000,000.00 $5,369,000,000.00
Income Tax $2,062,000,000.00 $1,783,000,000.00
Accumulated Goodwill Amortization $- $-

NOPAT $4,571,000,000.00 $3,586,000,000.00

ROIC 25.05% 17.99%
WACC 10.90% 10.73%

EVA $2,582,864,114.16 $1,446,152,539.04