Grading Criteria,Please see separate Assignment Grading Criteria Autumn 2010 sheet for this Assignment.,Your Task,PepsiCo, Inc. (PepsiCo) is the world leader in the snack food business, and it is a strong number two in soft drinks (or maybe number 1). It has more than two dozen well-established consumer brands, including Doritos, Fritos, Ruffles, and Lay’s (snack foods); and Pepsi-Cola, Diet Pepsi, and Mountain Dew (soft drinks).,In recent years, PepsiCo has pursued several initiatives designed to expand international sales. To take advantage of overseas opportunities, PepsiCo has begun a major overhaul of its foreign beverage operations. This effort included redesigning the firm’s soft drink cans and bottles and changing Pepsi-Cola’s distinctive red, white, and blue packaging to an all-blue design.,Overview of PepsiCo,PepsiCo was formed in 1965 when the Pepsi-Cola Company merged with Frito-Lay Inc. Over the next 30 years, net sales grew at an average compound rate of 15% per year, with sales doubling about every five years. Exhibit 1 furnishes income statements for PepsiCo, and Exhibit 2 furnishes balance sheets.,PepsiCo has book liabilities of $18.1 billion and book value of stockholders’ equity of $7.3 billion. The market value of PepsiCo’s stockholders’ equity is much greater. With 788 million common shares outstanding and a share price of $55.875, the market value of its stockholders’ equity is $44.0 billion, roughly six times its book value.,Capital Spending,PepsiCo’s capital investing has reflected strategic investments in both industry segments as well as acquisitions and investments in unconsolidated affiliates. PepsiCo expects its investments to generate cash returns in excess of its long-term cost of capital, which it estimates to be approximately 10%. About 75% of PepsiCo’s total acquisition and investment activity represents international transactions. PepsiCo continues to seek opportunities to strengthen its position in its industry segments, beverages and snack foods, through strategic acquisitions.,Financial Leverage,PepsiCo measures financial leverage on both a market-value and an historical-cost basis. PepsiCo believes that the most meaningful measure of debt is on a net basis, which takes into account its investment in marketable securities held outside the United States. These portfolios are managed as part of PepsiCo’s overall financing strategy; they are not required to support day-to-day operations. Net debt reflects the pro forma remittance of the cash value of these portfolios (net of related taxes) to the United States with the net proceeds used to reduce total debt. Total debt includes the present value of operating lease commitments (which are not capitalized on PepsiCo’s balance sheet).,PepsiCo believes that market leverage (defined as (1) net debt divided by (2) net debt plus the market value of equity, based on PepsiCo’s year-end stock price) is the most appropriate measure of PepsiCo’s long-term financial leverage. Exhibit 3 shows the net debt ratio for the last three years and contrasts it to PepsiCo’s historical cost net debt ratio. Unlike historical cost measures, the market value of equity is more meaningful because it reflects the estimated net present value of expected future cash flows, which will both support debt and provide returns to PepsiCo’s shareholders. PepsiCo has established a long-term target range of 20%-25% for its net debt ratio, which PepsiCo believes will optimize its cost of capital.,Measured on a market-value basis, net debt equals total debt, including the present value of its operating lease commitments, minus the cash and marketable securities it holds outside the United States (it does so mainly for tax reasons). The net debt ratio, L*, is defined as,L* = (D + PVOL – CMS)/(NP + D + PVOL – CMS),Where D is the total market value of debt, PVOL is the present value of operating lease commitments, CMS is cash and marketable securities (net of the cost of remitting these funds to the United States), N is the number of common shares, And P is the common stock price.,PepsiCo’s market net debt ratio declined 8 points to 18% at the most recent year-end due primarily to a 54% increase in PepsiCo’s stock price. The 4-point increase to 26% at the previous year-end was due to a 13% decline in PepsiCo’s stock price coupled with an 8% increase in net debt. As measured on an historical cost basis, the ratio of net debt to net capital employed (defined as net debt, other liabilities, deferred income taxes, and shareholders’ equity) declined 3 points in the latest year to 46%. This decline reflected a 2% decrease in net debt and a 4% increase in net capital employed. The 1-point decline to 49% at the prior year-end was due to a 9% increase in net capital employed, partially offset by the 8% increase in net debt.,Capital Structure Objective,PepsiCo would like to maintain a single-A senior debt rating. Is this objective compatible with PepsiCo’s long-term target net debt ratio of 20% to 25%?,PepsiCo’s common stock price is $55.875. Exhibit 4 furnishes information regarding PepsiCo’s operating lease commitments. Exhibit 5 provides information regarding comparable firms.,Guidelines,1. Calculate PepsiCo’s net debt ratio, assuming that the present value of operating leases is five times the annual rental expense and that remitting the cash and marketable securities to the United States reduces them by 25% due to taxes and transaction costs.,20 marks,2. For each firm in Exhibit 5, calculate the interest coverage ratio, the fixed charge coverage ratio, the long-term debt ratio, the total debt to adjusted total capitalization (recall that adjusted capitalization includes short-term debt), the ratio of cash flow to long-term debt, and the ratio of cash flow to total debt.,20 marks,3. Suppose PepsiCo’s real objective is to maintain a single-A senior debt rating. Does its net debt ratio target seem reasonable, or would you recommend a different target?,10 marks,EXHIBIT 1,PepsiCo Income Statements,(Dollars in millions),EXHIBIT 2,PepsiCo Balance Sheets,(Dollars in millions),a Approximates market value.,b Approximate market value is $8,747 million.,Source: PepsiCo, Inc., Annual Reports to Shareholders.,EXHIBIT 3,PepsiCo’s Net Debt Ratio,Market Net Debt Ratio,22%,26%,18%,Two Years Ago One Year Ago Latest Year,Market Net Debt Ratio,22%,26%,18%,Two Years Ago One Year Ago Latest Year,50% 49%,46%,Two Years Ago One Year Ago Latest Year,Historical Cost Net Debt Ratio,Source: PepsiCo, Inc., Annual Reports to Shareholders.,EXHIBIT 4,Information Concerning PepsiCo’s Operating Leases,Note 10 – Leases,PepsiCo has non cancelable commitments under both capital and long-term operating leases. PepsiCo is lessee under non cancelable leases covering vehicles, equipment, and real estate. Capital and operating lease commitments expire at various dates through 2088 and, in many cases, provide for rent escalations and renewal options. Most leases require payment of related executory costs, which include property taxes, maintenance, and insurance. Sublease income and sublease receivables are insignificant.,Future minimum commitments under non cancelable leases are set forth below:,Capital,Operating,Year 1,$ 57,$ 350,Year 2,49,297,Year 3,68,269,Year 4,37,240,Year 5,38,218,Later years,299,1,170,$548,$2,544,At year-end, the present value of minimum payments under capital leases is $294 million, after deducting $1 million for estimated executory costs and $253 million representing imputed interest.,The details of rental expense are set forth below:,Latest Year,One Year Ago,Two Years Ago,Minimum,$439,$433,$392,Contingent,40,32,28,$479,$465,$420,.,Source: PepsiCo, Inc., Annual Reports to Shareholders.,EXHIBIT 5,Selected Information Concerning PepsiCo and Comparable Firms,(Dollars in millions),Sources: Value Line Investment Survey and company annual reports to shareholders.
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