STUDENTS’ RESPONSES TO PEPSI – COKE EXERCISEis.hun.afp.040

CLAIM

Part I: Your claim

appears to have the better future prospects at the most recent balance sheet dates, taking into consideration expected future ROEs, growth rates, and risks.

QUESTION

Part II: Your arguments

Provide no more than three arguments in support of your claim in the space provided below, numbered and arranged according to your assessment of their strength (from strongest to weakest).

ARGUMENTS SUPPORTING PEPSI HAVING SUPERIOR FUTURE ROEs

Evaluate the following groups’ arguments. What feedback would you provide: (i) on the margin of written reports or (ii) during class, if the arguments were presented?

Group 1

“At the close of the 2013 fiscal year, Pepsi had a higher return on equity (ROE) than Coca-Cola. Pepsi’s ROE was 29.01% versus Coca-Cola’s 25.9%. Both Coca-Cola and Pepsi’s ROEs have decreased since 2010. Coca-Cola has seen a decrease in ROE from 41.86% to 25.9% while Pepsi’s decrease has been less drastic, falling only 3 points from 32.57% to 29.01%. Pepsi has shown its investors they are still consistent and reliable than their competitor. A higher return on equity means that investors will earn more on their investments. Because Pepsi’s ROE is over three percentage points higher than that of Coca-Cola, Pepsi’s investors will earn more per dollar of investment than their Coca-Cola counterparts. A greater return on invested capital indicates a high probability that Pepsi’s financial future is stronger than that of Coca-Cola.”

Group 2

“Argument: Pepsi’s expected future return on equity is higher since it has a more diversified product portfolio than Coke.

  • Evidence & warrant: Pepsi’s ROE has been consistently higher than Coke’s, in particular due to a higher efficiency in terms of asset turnover. Among the four factors in the DuPont model, Coke’s strongest advantage during the past four years has been its profitability factor, i.e. its profit margin. Arguably, this ratio will decrease since Coke’s core business - carbonated soft drinks - is expected to decline in its strongest markets even though they continue to expand their marketing efforts (pg. 3 “ibisWorld research). Since Pepsi is more diversified in terms of its product portfolio, the negative trend in soda consumption will not affect it as much.”

Part III: Your counterarguments

Provide no more than three counterarguments to your claim, numbered and arranged according to your assessment of their challenge to the claim (from strongest to weakest). If possible provide rebuttals immediately below each counterargument.

COUNTERARGUMENTS SUPPORTING PEPSI HAVING LOWER FUTURE RISKS

Evaluate the following groups’ counterarguments. What feedback would you provide: (i) on the margin of written reports or (ii) during class, if the counterarguments were presented?

Group 1

“After evaluating financial leverage, the common-size balance sheet, working capital, and current ratio, Pepsi seems slightly riskier than Coca-Cola. Pepsi has a higher financial leverage of 69% compared to Coca-Cola’s 63%. Even when adjusted for market value (assuming total liabilities remain the same), Pepsi’s estimated financial leverage is 30%, implying about $102b worth of assets are not considered on the balance sheet, while Coca-Cola’s estimated financial leverage is only 24%, implying about $149b worth of assets are not considered on the balance sheet, according to the market.

Pepsi’s financial leverage has been relatively consistent in recent years, while Coca-Cola’s financial leverage has steadily increased by about 2% per year on their common-size balance sheet.”

Group 2

“Risk: Pepsi’s financial leverage is higher than Coke’s (69% vs 63% in 2013), meaning a higher percentage of their assets are financed by liabilities. This makes Pepsi more sensitive to changes in the economy. Additionally, PPE, a relatively high risk asset in the industry, makes up a higher percentage of Pepsi’s total assets (24% vs 17% in 2013). PPE is a higher risk asset because it is subject to depreciation and breakdowns, especially in the developing areas into which these companies are expanding. This problem is potentially enhanced by Pepsi’s expectation that ⅔ of their global growth will come from expanding markets, a risky proposition.

(IndraNooyi PepsiCo, Inc. Chairman and CEO, February 2014 Conference Call)

Rebuttal: Pepsi’s higher risk may not be an issue because Pepsi wants to grow organically, through existing businesses rather than acquisitions. Acquisitions are inherently risky, and by avoiding these, Pepsi is reducing the risk of its operations. Pepsi is also increasing their cash returns to shareholders by 35% in 2014 through dividends and share repurchases. Pepsi is confident enough to give away large sums of cash to shareholders, which indicates that the company is satisfied with its financial position.

(Indra Nooyi PepsiCo, Inc. Chairman and CEO, February 2014 Conference Call)”

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