Hola Kola Case

1) What are the relevant cash flows? How should you treat the following?
a) the consultants market study cost?
b) the potential rental value of the unoccupied annex?
c) the interest charges?
d) working capital?
Working capital requirements
Inventory = (600,000 liters @ 1.8 pesos per liter) = 1,080,000 pesos
Accounts Receivable = Sales/365 * Average Collection Period = 4,438,356 pesos
Accounts Payable = (raw materials cos/365) * Average Payment Period = 1,278,247
pesos
Total working capital needed = Inventory + Accounts Receivable – Accounts Payable
= 1,080,000 + 4,438,356 – 1,278,247 = 4,240,110
Cash Flow is a financial statement that shows how changes in balance sheet accounts
and income affect cash and cash equivalents, and breaks the analysis down to operating,
investing and financing activities. Meanwhile, a general cash flow can be in the form of
expenses and revenues generated by the business. However, the relevant cash flows are
the cash flows that are related to this specific proposal. Further, in order to be relevant,
the cash inflow and cash outflow must arise in the future, additionally, the cash flows
must be incremental in order to be relevant to specific investment decision.
Working capital is an amount required by the business operations in order to finance the
additional operations and business growths. However, since the working capital is
injected at the beginning of operations and subsequent cash flows required by the
business operations are not fully reinvested in the business, instead the increment
amount will be required during the subsequent years. However, because the cash
outflow of working capital will only occur if the decision to proceed with the Hola-Kola
project has been made, therefore, they are relevant cash flows and they should be
included in the cash flows in order to calculate the net present value of the project.
There are many relevant cash flows for this investment project such as the initial
investment of machines, materials, labor, overhead expenses, capital expenditures, and
working capital and SG&A expenses.

How shall we treat?

Market study cost

The market study cost is a past cost which has been incurred before the appraisal of the
project has been performed; therefore, it is a sunk cost and should not be considered in
the investment appraisal.

Potential rental value of the unoccupied annex

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 This is the opportunity lost therefore, this should be treated as a negative cash flow as
opportunity cost.

The interest charges

The cost of financing of debt and equity is included in the weighted average cost of
capital therefore; there is no need to include them again.

Working capital

This should be included in the appraisal. Only the incremental working capital would be
deducted.

2) Should we consider the erosion of the existing product in the analysis?

Why or why not?
 The company also realized that with the introduction of this new product line their
existing products might suffer as many of the existing customers will switch between
products of the same company. It was estimated that it will cause a potential erosion of
800,000 pesos (i.e. 0.8 million pesos) of after tax cash flow each year.
 Yes, the erosion of the existing product as a result of the introduction of new zero
calorie carbonates should be considered as the cannibalization cost in the analysis as the
sales of this product are going to erode the sales of the existing products of the
company, which is regular soda. Furthermore, these costs are going to have a significant
impact on the earnings of the company therefore, they should be included in the NPV
analysis.

After taking into account the above facts and figures we will be doing a financial analysis to find
whether venturing into the new project would be ideal for the company.

3) Calculate the projects' NPV,IRR and payback period

The NPV of the project has been calculated to be $ -1.72 million, its IRR is 17%,
payback period is 3 years and 5 months approximately, discounted payback period is
more than 5 years approximately which means never and profitability index is almost 1.
The calculations are shown in the excel spreadsheet.

Product per year (ltr) 7200000

cost of equipment (pesos) 50000000
Sales price per liter (pesos) 5
Opportunity cost (yearly) 60000
Raw material per liter (pesos) 1.8
Labour cost yearly (pesos) 2160000
energy cost yearly (pesos) 600000
Admin. & selling expense Yearly (pesos) 300000

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 Overhead Cost 1% of sales yearly 360000
Tax 30%
WACC 18.20%

Year 1 2 3 4 5
revenue 36000000.00 36000000.00 36000000.00 36000000.00 36000000.00
- - - - -
Depreciation 10000000.00 10000000.00 10000000.00 10000000.00 10000000.00
salvage 0.00 0.00 0.00 0.00 4000000.00
- - - - -
Raw Material Cost 12960000.00 12960000.00 12960000.00 12960000.00 12960000.00
Labour Cost -2160000.00 -2160000.00 -2160000.00 -2160000.00 -2160000.00
Energy Cost -600000.00 -600000.00 -600000.00 -600000.00 -600000.00
Admin & Selling
Exp -300000.00 -300000.00 -300000.00 -300000.00 -300000.00
Overhead Cost -360000.00 -360000.00 -360000.00 -360000.00 -360000.00
EBT 9620000.00 9620000.00 9620000.00 9620000.00 13620000.00
Tax -2886000.00 -2886000.00 -2886000.00 -2886000.00 -4086000.00
Net Income 6734000.00 6734000.00 6734000.00 6734000.00 9534000.00
CF 16734000.00 16734000.00 16734000.00 16734000.00 19534000.00

Disc. CF 14157360.41 11977462.27 10133216.81 8572941.47 8466497.82

Capital Budget
NPV: 3,307,478.77
IRR: 21.04 %
Payback Period: 3.01 years (=Cost of project/ Annual Cash Inflows)
Discounted Payback period: 3.49 years
Profitability Index: 0.93

4) Perform sensitivity analyses on sales volume, price, direct labor, materials

and energy cost. What do you observe?
The sensitivity analysis has been performed in the excel spreadsheet and it has been
observed from the analysis that the raw material costs, labor costs, sales revenues and
other operating expenses such as the energy costs impact significantly on the NPV of the
new product. Furthermore, it is recommended for the company to increase the selling
price of the new product by 0.5 pesos.

Sensitivity Analysis
There are variables that can have an effect on the projected NPV. The selling prices of
raw materials can be subject to change. Labor/energy costs also have the possibility of
fluctuating as well as the sales volume itself. Unforeseen expenses are also plausible.

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 Effect on NPV as raw materials are selling price increases
Effect on NPV as sales volume and selling price fluctuate
Effect on NPV as labour costs and selling price fluctuate

5) What are the benefits and risks of undertaking this project?

Benefits

The benefits of investing in the Hola-Kola product would be increased market share for the
company. The sales of the company would also increase and as a result, the earnings of the
company would also grow. Furthermore, more production space would be created, and
efficiency would be introduced in the production processes of the company.

 An increase in market share, net income, and production space.

 An improvement in company efficiency.

Risks

The risks associated with this product are that it might cause the erosion of the existing
products of the company. The second risk is that there might not be significant demand for
this product in the market despite the findings of the market study. Furthermore, the
government might introduce new regulations regarding soda and the competitors might also
lower the prices of their products.

 The possibility of erosion or cannibalization of current products when Hola-Kola is

introduced to the market.

 Little or no demand for diet soda.

 Soda competitors may lower their prices to better compete in the market.

 The Government may introduce or increase current regulations on the sale or

manufacturing of sodas.

Risks of undertaking the projects:

Concerning the possible erosion of sales, the firm could potentially have a cost of
800,000 pesos of after-tax cash flows (net income). However, the net income for Bebida
Sol that was reported in 2011 was 50.145 million pesos. Therefore, the potential net
income decrease of 800,000 pesos is not very significant.
Erosion of current products: the erosion cost will have negative effect on the company’s
overall earnings.
No demand for no-calorie soda
Government increases regulation on soda
Competitors lower their prices

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 Benefits:
Increase market share
Increase in net income
Improvement of efficiency
More production space

6) Should Bebida Sol undertake this project?

The consultants cost of market study before the start of project was necessary cost that
was needed to be done in order to establish whether the project is feasible to be
pursued or not. Since the study has already been completed and the outflow of the cash
has taken place for the purpose of decision making regarding the investment in Hola-
Kola project, this market study cost is irrelevant and would not be considered while
making this investment decision.
Considering the analysis for the base case a recommendation to take up the project is
advisable. Mr Ortega should market the new product towards low-income individuals
who do not have any low-cost substitute products.

The net present value of this project is lower and its internal rate of return is lower than
the company’s cost of capital, therefore, if the company undertakes this project, then it is
going to destroy the wealth of the shareholders. Furthermore, the project is also sensitive
to many key inputs therefore; Bebida Sol should not undertake this project. On the other
hand, Ortega needs to consider the opportunity that had also been considered by his
father, which was to venture into the mineral water business......................

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Based upon the project’s calculated NPV of 3,264,830.60 pesos, an IRR of 21%, an
MIRR of 20%, a payback period of 3.1 years, and a profitability index of 1.06, the project
should be accepted. However, based upon the sensitivity analysis, Bebida Sol should
increase the selling price of Hola-Kola by at least 0.25-0.50 pesos to outweigh any
fluctuations or unexpected expenses. Ortega should also concentrate on marketing Hola-
Kola towards low income individuals as there are not many low-calorie soda options or
substitutes available. He should also consider his father’s plan of venturing in the mineral
water business as an additional product to introduce to lower income individuals as a
substitute to sodas entirely. Mineral water would also be unsusceptible to government
regulations affecting soda production.
7) convert Pesos to U.S. dollars at the prevailing exchange rate (before or
after your analysis

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