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Peter Franklin is the CEO of Nature Cola company located in Bridgeport




Peter Franklin is the CEO of Nature Cola company located in Bridgeport (an imaginary;country). He is pondering about whether his company should introduce a new cola;drink which has no calories and can be considered as a healthy drink. He has a number;of options and is pondering over which of these options are the best.;Cola Market in Bridgeport;Bridgeport is a small country with a population of about 25 million. It has a mix of both;rich and middle class people. Nature Cola was started by James Franklin, father of;Peter in 1999. Because of the size of the country, multinationals such as Coco Cola and;Pepsi Cola did not consider Bridgeport as a viable market and there was no cola market;in Bridgeport until Nature Cola was formed. In the initial stages, it was difficult to;market the product, but by 2001, the market had picked up. The target market for;Nature Cola was the large middle class and Nature Cola was priced at $1 per bottle. A;bottling plant was commissioned which could produce 50000 litres of Cola every;month. With bottle size of 250 ml, it amounted to 200,000 bottles per month. The;demand for Nature Cola is currently at 200,000 bottles per month which is being met;by the existing bottling plant.;In 2005, Pepsi saw an opportunity to enter the market. However, it could not compete;directly in the market against Nature Cola as the price of Nature Cola was very low.;Pepsi positioned its cola drink as a gourmet drink and started selling the same through;restaurants and hotels as opposed to Nature cola being sold in shops and supermarkets.;In 2011, 3 years back, another company Low C Cola, was started by a local;entrepreneur, Benjamin. Benjamin lacked the financial clout of Pepsi or Nature Cola;and was not experienced in marketing aspects of cola. Though people liked the taste of;Low C Cola, its price was $2 per 250 ml and this company was struggling to market the;cola. It also had a bottling plant that has a capacity of 200,000 bottles per month but;sales have been stagnating at about 50,000 bottles per month.;Introducing a new drink called Zero Cola was mooted by Peter after he visited other;Western countries where he saw companies like Coco Cola and Pepsi Cola had;introduced zero calorie Cola with health benefits. This gave him the idea of introducing;this Zero Cola in Bridgeport. In order to induce the people to form healthy habits, he;studied the obesity rate in Bridgeport and found that it ranked very high in both;overweight category and obesity category. Thus, Peter felt that with proper education;of the population towards healthy habits, he can find a market for Zero Cola.;His research team developed a cola that had zero calorie and used that in test;marketing. A market research team was engaged at a cost of $200,000 to estimate the;possible demand for this Zero Cola. The market research team found that there is likely;to be good demand for the same which encouraged Peter to think carefully about the;introduction.;He formed a team consisting of CFO Joshua, Finance Manager Christian and;Production Manager Rasool to look into the feasibility of introducing this product.;FIN351e Copyright 2014 SIM University;CASE: NATURE COLA July Semester 2014;Page 2 of 17;Joshua, Christian and Rasool worked on the project and formulated the following cost;and sales estimates;Cost;Since the current bottling plant is running at full capacity, introduction of a new drink;would require a new bottling plant. This plant would require a large area as well as a;set of machinery. Currently the company already owns a large warehouse which cannot;be rented out to others. The team felt that this area can be used for locating the new;plant.;The search for machinery showed there are machineries available with different;capacities and different prices. The details of the machinery is shown in Table 1.;The cost includes the cost of machinery as well as installation costs. This machine can;be depreciated using straight line depreciation over a period of 5 years towards zero;salvage value. The resale value of these machines if sold at the end of the year over the;next 5 years is also shown in Table 1.;Table 1 Details of Machinery Available;Capacity (bottles per month);Cost;Resale value at end of year 1;Resale value at end of year 2;Resale value at end of year 3;Resale value at end of year 4;Resale value at end of year 5;Machine 1;200,000;6,000,000;5,000,000;4,000,000;3,000,000;2,000,000;1,000,000;Machine 2;500,000;12,000,000;10,000,000;8,000,000;6,000,000;4,000,000;2,000,000;Machine 3;800,000;20,000,000;16,000,000;12,000,000;9,000,000;6,000,000;4,000,000;Next, the team analysed the possible demand for the new cola. Since this is a new cola;with no calories, they were not sure whether the demand will be high or low. They;contacted the market research team that conducted the original research and formulated;the following demand for the new cola. The cola can be priced at $2.00 per bottle. The;demand estimates for the next 5 years are shown in Table 2.;Table 2 Demand Estimates;Demand (bottles per month);100,000;200,000;500,000;800,000;Probability;0.15;0.2;0.5;0.15;Based on this estimate, the expected demand is calculated as 425,000 bottles per;month.;FIN351e Copyright 2014 SIM University;CASE: NATURE COLA July Semester 2014;Page 3 of 17;Costs;Various costs associated with Zero Cola are;Raw material cost;Labour costs;Overhead costs;Fixed;Variable;$0.20 per bottle;$0.10 per bottle;$0.30 per bottle with Machine 1;$0.25 per bottle with Machine 2;$0.20 per bottle with Machine 3;$0.15 per bottle irrespective of machine used;Marketing costs;General and administrative expenses;$200,000 per year;$200,000 per year;The retailer would charge a sales commission of $0.1 per bottle irrespective of the;machine used.;It is also expected that introduction of zero calorie cola will result in a reduction in after;tax cash flow from Nature Cola to the tune of $500,000 a year.;Working capital needed;Raw material inventory will be maintained at one month production needs;Collection period for receivables will be 30 days;Accounts payable will be paid in 36 days;For calculation purposes, 360 days in a year will be used;The tax rate for the company is 30%;Cost of capital;Nature Cola has a capital structure of 30% debt and 70% equity. The beta of nature;Cola is estimated as 0.75. The risk-free rate is based on short-term government bond;rate which stands at 4% currently. The market risk premium has varied between 4%;and 8% in the past and the team believes that an estimate of 6% can be used. The debt;is from a bank which charges interest at 8% per annum. The tax rate for Nature Cola is;30%.;Purchase of machinery through bank loan;Nature Cola has sufficient cash in hand that can be used to purchase the machinery.;However, Joshua feels that Bank of Bridgeport with whom Nature Cola has a very;good relationship will be able to provide a loan towards the purchase of machinery. The;bank will provide a loan to the value of 80% of the purchase price at an interest rate of;8% per annum. This loan will have no prepayment penalty.;FIN351e Copyright 2014 SIM University;CASE: NATURE COLA July Semester 2014;Page 4 of 17;Leasing the machinery;Another option that Joshua has identified is that Nature Coal can enter into a sale and;leaseback arrangement with Bridgeport Leasing company. The leasing company is;willing to enter into such sale and leaseback arrangement with the following terms;Lease period: 5 years irrespective of the capacity of machinery;Lease payments will be calculated based on the following financing rates;Machine with capacity of 200,000 bottles: 7%;Machine with capacity of 500,000 bottles: 8%;Machine with capacity of 800,000 bottles: 9%;The lease also will come with a cancellation option. If lease is cancelled by nature Cola;at any time, Nature Cola will need to pay a penalty of 1% of the remaining value of;lease.;Based on the assumptions of demand and cost and assuming that the company will use;existing cash to purchase the machinery, the team worked out the net present value for;various demands. They decided to use the machinery with capacity of 200,000 bottles;to calculate the NPV for demand of 100,000 bottles and 200,000 bottles. For a demand;of 500,000 (800,000) bottles, they assumed that machinery with a capacity of 500,000;(800,000) bottles will be bought. The calculations are shown in Exhibits 1 to 4.;Exhibit 5 shows the calculation of NPV if the actual demand is the expected demand of;425,000 bottles per month.;Exhibit 6 shows the expected NPV using the probabilities of demand estimated.;New offer to purchase Low C Cola;As Peter is pondering about whether to introduce the Zero Cola, he received a phone;call from Benjamin. Benjamin, the owner of Low C Cola would like to get out of this;business and invest in something else. The valuation of Low C Cola is provided in;Exhibit 7. The valuation is based on the current cash flow being in perpetuity and;discounted at the cost of equity of Nature Cola. If Peter is interested, Benjamin is;willing to sell Low C Cola to Peter for a consideration of $7,000,000.;Peter and his team believe that if Nature Cola purchases Low C Cola, it can use the;existing marketing personnel to promote Low C Cola to increase its sale from the;current 50,000 bottles to 100,000 bottles per month. It can also reduce administrative;and general costs from $200,000 to $50,000. The marketing costs will be reduced from;$100,000 to $50,000. Further, because of the economies of scale, the raw material cost;can be brought down from 0.25 to 0.2 per bottle. In order to promote the sale of Low C;cola, the price would be reduced from $2 to $1.50. Since Low C Cola has lower;calories than Nature Cola, promoting Low C Cola will also help in promoting the zero;cola in the future. Since Low C Cola has a capacity of 200,000 bottles per month and;the production of Low C Cola will be only 100,000 bottles per month, remaining;capacity can be used to produce 100,000 bottles of Zero Cola. If the demand for Zero;FIN351e Copyright 2014 SIM University;CASE: NATURE COLA July Semester 2014;Page 5 of 17;Cola turns out to be high after 1 year, the company can plan to divest Low C Cola and;continue only with Zero Cola. If demand for Zero Cola remains at 100,000 bottles only;even after a year, company can continue to produce 100,000 bottles of Low C Cola and;100,000 bottles of Zero Cola.;Even though acquisition provides additional options, Peter is not sure whether the;consideration demanded by Benjamin is appropriate.;Thus, Peter and Team have a number of options;Should zero coal be introduced at all?;If it is introduced, what capacity machinery should be introduced at the current;time?;Should the machinery be bought with cash or with borrowed funds?;Should the company buy the machinery with cash or enter into a sale and;leaseback arrangement?;Should the company buy Low C Cola?;FIN351e Copyright 2014 SIM University;CASE: NATURE COLA July Semester 2014;Page 6 of 17;Exhibit 1 NPV for demand 100,000 bottles per month;0;monthly sales;(units);Price per unit;Annual sales;Costs;Raw material costs;per bottle;labour costs;overhead costs;Commission on;sales;Total variable costs;per unit;Fixed overhead;costs;Total costs per unit;Total costs per;year;Marketing costs;General and;Administrative;costs;Total costs;Cost of machine;life;resale value at end;of 5 years;Amount of;depreciation;Depreciation per;year;Additional;working capital;Raw material;inventory;Receivables;Payables;Total working;capital investment;Sales;Costs;Depreciation;Pretax income;Tax rate;1;2;3;4;5;100,000;2;2,400,000;100,000;2;2,400,000;100,000;2;2,400,000;100,000;2;2,400,000;100,000;2;2,400,000;0.2;0.1;0.15;0.2;0.1;0.15;0.2;0.1;0.15;0.2;0.1;0.15;0.2;0.1;0.15;0.1;0.1;0.1;0.1;0.1;0.55;0.55;0.55;0.55;0.55;0.3;0.85;0.3;0.85;0.3;0.85;0.3;0.85;0.3;0.85;1,020,000;200,000;1,020,000;200,000;1,020,000;200,000;1,020,000;200,000;1,020,000;200,000;200,000;1,420,000;200,000;1,420,000;200,000;1,420,000;200,000;1,420,000;200,000;1,420,000;1,000,000;1,000,000;1,000,000;1,000,000;1,000,000;2,400,000;1,420,000;1,000,000;-20,000;30%;2,400,000;1,420,000;1,000,000;-20,000;30%;2,400,000;1,420,000;1,000,000;-20,000;30%;2,400,000;1,420,000;1,000,000;-20,000;30%;2,400,000;1,420,000;1,000,000;-20,000;30%;6,000,000;5;1,000,000


Paper#25902 | Written in 18-Jul-2015

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