London School MBA/MSC Finance

of Business &
Finance (LSBF)
Module
Corporate Finance

Assignment PepsiCo’s Capital Structure Choice

Title
Assignment Type Essay
Word Limit 3500 +- 10%
Weighting 50%
Student Cohort Intake 5
Issue Date 5th November 2010
Submission Date 16th December 2010
Feedback Date
Issued by Augustin Entonu
(Assessor)
Internal Verifier
Plagiarism When submitting work for assessment, students should be aware of the LSBF
guidance and regulations in concerning plagiarism. All submissions should be your
own, original work.

You must submit an electronic copy of your work. Your submission will be
electronically checked.

Harvard The Harvard Referencing System must be used. The Wikipedia website must not
Referencing be referenced in your work.

Learning On successful completion of this assignment you will be able to:

Outcomes
Identify principles and trends in the corporate finance.

Determine and evaluate the nature of different source of finance.

Demonstrate deep and systemic knowledge in the sphere of corporate

finance development.

Demonstrate effective approaches to analyzing corporate finance structure

Possess the ability to plan and implement tasks at professional level; make
decisions in complex and unpredictable context of using rational decision-
making approach

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
Market Net
Net Debt
Debt Ratio
Ratio

26%
26%

22%
22%

18%
18%

Two
TwoYears
Years Ago
Ago One
OneYear
YearAgo
Ago Latest
LatestYear
Year

Historical Cost Net Debt Ratio

50% 49%
46%

Two Years Ago One Year Ago Latest Year

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 One Year Two Years

Year Ago 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.

Note This Assignment Briefing Sheet Autumn 2010 is available on

http://docs.google.com/ for you to view and print off at a type size more
convenient to you.
LSBF Student Name Course Unit Title / Code Type of Assessment

Postgraduate Assessment Name of Student Text

Feedback Sheet □ Staff Assessment
Date of Assessment Student ID Course Unit Level □ Self Assessment
Date AA 000000 7 □ Peer Assessment
Type of Assessment Course and College Assignment / Project Title
□ Formative
Text Course Text
□ Summative
College

The feedback you are given will General comments and advice on how to improve your work in the future
be informed by each of the
marking criteria overleaf. Text
Marks are arrived at through
markers’ holistic judgement,
informed by the criteria

The feedback you receive

should help you to understand
your overall level of
performance for the
assessment. Feedback should
help you plan and execute work
as well as understand how your
mark was arrived at.
 London School of Business & Finance
Postgraduate Marking Criteria

Criteria Level of Achievement Indicators

Fail Pass
0–29% 30–39% 40-49% 50-59% 60-69% 70+%
1 Research Little or no evidence of Information presented Adequate research has Information is accurate Well informed Extensive independent
Systematic appropriate research does not relate been carried out and and from a range of judgements made of research, accuracy, familiarity
identification and sufficiently to the task; appropriate information sources, with evidence the relative value of with the material, and sound
investigation of there may be evidence has been gathered and of some analysis and connected information judgments
appropriate sources of rudimentary research documented from evaluation from a wide range of
readily available academic sources
sources applying
standard techniques

0–29% 30–39% 40-49% 50-59% 60-69% 70+%

2 Analysis Little or no evidence of Judgments (with or Key elements within Uses examination and Judgements are astute Evidence of analysis which
Examination and analytical engagement without complete data) relevant information are interpretation of and well supported; potentially contributes new
interpretation of are not sound; critiques identified, but may lack sources to make sound able to deal with ideas, processes or knowledge
resources are not well argued; accurate interpretation judgments ; shows complex issues both to the field or is ground
response to complex and analysis critical awareness of systematically and breaking in a way that would
issues is not systematic current problems creatively; critiques are be recognized as valid by
or creative insightful and well experts in the field
substantiated; offers
new insights

0–29% 30–39% 40-49% 50-59% 60-69% 70+%

3 Subject Knowledge Inaccurate and/or Fragmentary and/or Evidence of Knowledge is accurate Systematic and Brings a valid individual
Understanding and incomplete knowledge partial knowledge of the understanding key and current within the extensive knowledge, at understanding to concepts and
application of subject of the subject field and subject and its aspects of the subject field, and applied the forefront of their knowledge in the field Where
knowledge and its development development context, in current appropriately field of study, perhaps appropriate, able to propose
underlying principles debates and/or informed by related or original ideas or hypotheses
historical background. external fields, used
creatively

0–29% 30–39% 40-49% 50-59% 60-69% 70+%

4 Experimentation Unable to identify Exploration of methods Operates within familiar Decision making is Effective decision Risk taking shows a profound
Problem solving, risk problems; does not or concepts is not and well established based on sound making in complex and and precise understanding of
taking, experimentation understand the purpose sufficient to resolve ideas, processes, judgement of available unpredictable the nature of the field, and
and testing of ideas and of risk taking or barriers and/or move media and/or materials; options; risk is situations; progresses the field, perhaps
materials in the exploration of practice forward some evidence of managed appropriately; demonstrates originality in an individually distinctive
realisation of concepts alternatives exploration of ideas and applies established in tackling and solving way
concepts techniques creatively in problems; approach
the discipline consistently moves
practice forwards

0–29% 30–39% 40-49% 50-59% 60-69% 70+%

5 Technical Execution shows very Techniques are limited Skills are adequate to Skilled command of Discernment and Idea and technique are unified.
Competence limited command of or rudimentary in communicate ideas; conventions and judgement are evident. Discernment and judgement
Skills to enable the techniques and poor selection or skill accepted conventions procedures. Technical Idea and technique are are evident. Technical Skills
execution of ideas judgement and procedures are skills facilitate practice, unified. Breadth of may have contributed to
appropriate to the usually applied conceptual techniques adopted conceptual advances
medium development and the may be a feature
communication of ideas

0–29% 30–39% 40-49% 50-59% 60-69% 70+%

6 Communication and Ineffective use of visual/ Partial lack of Conventions and Able to communicate Communication is Communication shows an
Presentation oral/ written awareness and standards are applied; own conclusions and persuasive and exceptional and integrated
Clarity of purpose; skills communication observance of structure is clear; explain and summarise compelling; diverse understanding of the topic and
in the selected media; conventions in the conventions and information selection existing work clearly, in audience needs are audience needs
awareness and production and standards; lack of and organisation shows appropriate media to accounted for; message
adoption of appropriate presentation of ideas clarity in structure awareness of audience specialist and non and medium are unified
conventions; sensitivity selection and requirements and specialist audiences with personal style
to the needs of the organisation of preferences
audience information; lack of
awareness of audience

0–29% 30–39% 40-49% 50-59% 60-69% 70+%

7 Personal Consistent lack of Evidence of reflection Evidence that reflection Demonstrable capacity Takes full responsibility Evidence of strong sense of
and Professional evidence of reflection or and planning for and planning have led to continue to advance for own learning and motivation and commitment to
Development planning for learning. learning not to increased subject their knowledge and development through personal and professional
Management of Little or no awareness consistently engagement and understanding, and to iterative cycles of well development, explicitly and
learning through of personal strengths progressed. Incomplete commitment. develop new skills to a articulated purposeful clearly communicated and
reflection, planning, self and weaknesses in awareness of personal Developing an high level analysis and planning, evidenced
direction, subject relation to task strengths and awareness of strengths supported by extensive
engagement and weaknesses and weaknesses evidence
commitment

0–29% 30–39% 40-49% 50-59% 60%60-69% 70+%

8 Collaborative and / or Shows little accurate Insufficient Awareness of main Shows self-direction Regularly shows self- Makes sound decisions readily
Independent knowledge of related understanding of standards required of and/or originality in direction and originality in complex and unpredictable
Professional Working profession; is professional life; relevant profession. tackling and solving in tackling and solving situations; operates both
Demonstration of unproductive working struggles to plan and Able work both problems; can plan and problems; shows autonomously and
suitable behaviour for alone; does not complete work alone; collaboratively and implement tasks at a initiative and personal collaboratively as a
working in a collaborate effectively collaborates reluctantly; independently professional or responsibility; professional; a consistently
professional context with others behaviour may be equivalent level; able to consistently plans and strong contributor to any team,
alone, or with others unsupportive of others work effectively in implements tasks at a in any role
diverse teams professional or
equivalent level,
autonomously or
collaboratively; able to
work effectively in
diverse teams, in
multiple roles