Finance 450 Assignment 1 Case Study Group 2

Submitted By: Diksha Mulani @00040358 Kanishka Ajwani @00043033 Shyam Panchal @00040312 Muhammed Rafiudeen @00036494 Husam Khaled Al-Kendi @00029395

Coca-cola vs. Pepsi Case Study

3. What is the weighted average cost of capital (WACC) and why is it important to estimate it? Is the cost of capital something that managers set? Who sets it? Answer 3 The Weighted Average Cost of Capital (WACC) is basically an average representing the expected return on all of a company's securities. The various sources of capital, like stocks, bonds, and other debt, is assigned a required rate of return, and then these required rates of return are weighted in proportion to the share each source of capital contributes to the company's capital structure. Thus, this is the permanent long-term financing of a company, including long-term debt, common stock and preferred stock, and retained earnings, differing from financial structure, which includes short-term debt and accounts payable. The rate derived is what the firm would use as a minimum for evaluating a capital project or investment. Note: WACC can be calculated by using the following formula: WACC = [Kd(1-Tc)*D/(D+E)] + Ke*E/(D+E) It is also important to keep in mind that, the weighted average cost of capital is an important component of any EVA calculation, as also of capital budgeting and project evaluation decisions, in which it is used as the discount rate in determining the value of projects being evaluated by the firm. Therefore, we can realise that the weighted average cost of capital is dependent upon the firms capital structure as well as the valuation of the market on the firms riskiness, which reflects the cost of capital sources only if the corporate tax rate are constant and fair to every firm.

The task of the financial manager is to define a combination of debt and equity that minimizes the firms WACC. 4. Calculate the WACCs for Coca-Cola and PepsiCo. Assume a tax rate of 35 percent. Be prepared to explain your assumptions for the following components: Answer 4 Coca-Cola: Kd is before-tax cost of debt = 7.09% KE is cost of equity (using CAPM) = o CAPM= 5.73% + 0.88 (5.90%) = 10.92% Wd = 1.14% We = 98.86% T is tax rate = 35%

WACC= Wd * Kd (1-t) + We * Ke WACC= (0.014) ( 7.09) (1- 0.35) + (0.9886) (10.92) = 10.86% Pepsi: Kd is before-tax cost of debt = 6.98% KE is cost of equity (using CAPM) = o CAPM= 5.73% + 0.88 (5.90%) = 10.92% Wd = 10.32% We = 89.68% T is tax rate = 35%

WACC= Wd * Kd (1-t) + We * Ke WACC= (0.1032) ( 6.98) (1- 0.35) + (0.8968) (10.92) = 10.26%

Assumptions for the following components: a. Kd calculated the return on publicly traded debt because we want the return on the market value of debt. b. Ke used the CAPM model because we have historical data and information c. d. e. Rf used the 10 year treasury bonds as proxy Beta used average beta Market risk premium used the geometric mean as we are estimating current returns f. Weights of debt and equity capital weights were calculated after finding the market values of debt and equity

5. Interpret the results of your WACC calculations. What observations can you make? Answer 5 Both companies have similar WACCs and you can see that they have the same cost of equity as both have the same average betas. But Coca-Cola has a higher WACC because it carries more equity in its capital structure. Also, Pepsi uses a lot more debt in its capital structure (10.32%), as compared to Coca-Cola which only uses (1.14%) according to market value calculations. But Pepsis lower cost of debt compared to Coca-Cola balances its WACC and for that reason its WACC is similar to Coca-Cola.