There are two major types of investments that a company provides to investors. These include the common stock, where payouts are not compulsory for a certain subsequent number of years. The higher common stock prices are beneficial for the company in case of additional shares issue, which can be made at a higher than par value, raising more funds from a fewer number of shares. The preferred stock is where the payouts are fixed and compulsory and are usually accumulated in case of non-payment. These payouts are also priority payouts which have to be paid before current year's payout and common stock declared payout. The third type, i.e. debt has a special characteristic which declared it defaulted if the interest due is not paid. Thus debt is given priority over other forms of investment capital. A company with a good debt rating is more likely to pay out dividend to shareholder. In this case we have analyze the debt management of PepsiCo, through comparison with other comparable companies. It has been found that PepsiCo has been maintaining the single-A senior debt rating however its performance compared with four other comparable firms is not at par. This means that PepsiCo is barely managing the credit rating. To make sure that the credit rating remains, it should improve its performance, by revising the target net debt ratio from ranging between 20% - 25% to 15% - 20%. The revision of target and the early response to these can trigger an appreciation of the stock, which can further make the target more achievable, and also maintain or even improve the debt ratings. The options regarding the capital structure and its changes have been considered, such as PepsiCo can divest its least profitable product line in favor of growing product lines. It has also been discussed that it be found whether credit rating agencies ratings are trusted by the investors of PepsiCo business category. This can thus validate the reliability and significance of the target ratings in PepsiCo's point of view. Comparisons are made with Coca-Cola to signify the target benchmarks. Cost of capital is an issue that has been accorded a special focus, as it is a benefit derived from retiring debt and issuing more equity.
Methodology
The methodology of this research involves the interjection of the assumptions provided in Question 1 into the formulae provided in the question itself to find the net debt ratio.
Later in the next question, there have been several ratios used to considered for an analysis done later in the project. These ratios include the coverage ratios which use Earnings before income and taxes (EBIT) to calculate the interest coverage and fixed charge coverage ratios. For the fixed charge calculation, the rental payments have been considered as a fixed charge just like an operating lease commitment is done. Capitalization ratios such as long term debt ratio and total debt to adjusted capitalization ratio take into account the current market prices and the number of shares issued, and the market capitalization. Lastly the analysis required the calculation the cash flow based ratios, which are the annual cash flow to long term debt and annual cash flow to total debt ratios.
In the analysis, various related issues are discussed based on the ratios provided above.
Question 1
Based on the assumptions that the present value of operating leases of PepsiCo is five time its annual rent expense and also that a quarter of the value of cash and marketable securities is deducted, the net debt ratio can be calculated using the formulae used by Pepsico, and using the figures provided in Exhibit 5, is:
L* = (D + PVOL - (1-0.25)CMS)/(NP + D + PVOL - (1-0.25)CMS)
L* = (9,453 + 5(ARE) - (0.75)1,498)/(788(55.875) + 5(ARE) - (0.75)1,498)
L* = 10,724.5/54.754 = 19.59
Where D is the total market value of debt, PVOL is the present value of operating lease commitments, ARE is the annual rent expense, CMS is the gross value of cash and marketable securities, N is the number of shares and P is the price of one common stock.
The net debt ratio of 19.59% is higher than the 18% calculated without the assumptions in the question, which shows that the assumption overstates the debt and thus results in a higher net debt ration.
Question 2
Interest coverage ratio is calculated by dividing the Earnings Before Interest and Taxes (EBIT) by the interest expense. It determines how easily a company is able to meet its interest expenses. The lower the interest coverage ratio, the more doubtful it is for the company to pay its interest expenses (Bernstein et al, 2000). Using the formulae below:
Interest coverage ratio = EBIT/Interest Expense
The interest coverage ratio of Coca-Cola at 16.91 is the highest followed by McDonald's at 7.38, PepsiCo at 4.57, Cadbury Schweppes at 4.53 and Coca-Cola Enterprises at 1.44. PepsiCo significantly lags behind Coca-Cola, its direct competitor in its core product i.e. the soft drinks.
Fixed charge coverage ratio is calculated by the following formulae:
Fixed charge coverage ratio
= (EBIT + Pre-tax fixed charge)/(Pre-tax fixed charge + Interest Expense)
We take the annual rental expense to be the pre-tax fixed charge because most of the operating lease commitments are in the form of rental expense. This using this formula, again Coca Cola takes the lead at 16.91 due to have no operating lease commitments, followed by a large margin, Cadbury Scheppes at 3.975, McDonalds at 3.58 due to the substantial operating lease commitments, PepsiCo at 3.09 and Coca-Cola Enterprises at 1.40. We can infer that PepsiCo and McDonald's both have relatively larger operating lease commitments as their fixed charge coverage ratio is quite lower than the interest coverage ratio.
Long term debt ratio, in contrast to net debt ratio, takes only the long term debt for the numerator. Thus, long term debt ratio can be calculated by:
Long term debt ratio = Long term debt/(Long term debt + Market value of equity)
Also known as the capitalization ratio, Coca-Cola leads at an impressive figure of 1.12%, which is evident by its equity-focused capital structure. Cadbury Schweppes at 9.03% and McDonald's at 11.25% are plausible, while PepsiCo at 16.58% appears to be a little away from its competitors, however much better than Coca-Cola Enterprises which is heavily debt burdened at 51.76%.
Total debt to adjusted total capitalization is another capitalization ratio which includes the short term debt. Therefore the formula is:
Total debt to adjusted total capitalization=Total debt/(Total debt + market value equity)
Coca-Cola impresses once again at 1.65% while most other range from 12 to 18 percent; McDonald's at 12.59%, Cadbury Schweppes at 14.62% and PepsiCo at 17.68%. Coca-Cola Enterprises is at 52.14% which again shows the heavy debt burden.
In the above capitalization ratios, the market capitalization of the companies has a strong relationship with the ratios.(Bragg, 2007) We have seen here that Coca-Cola has been performing the best in these ratios as it has the highest capitalization while Coca-Cola Enterprises is a poor performer due to its low capitalization.
The ratio of cash flow to long-term debt determines the ease with which a company can utilize its cash flow to manage its long term debt. A company with a high ratio can manage its long-term debt with greater ease. (Fabozzi et al, 2003) The ratio is calculated as:
Cash flow to long term debt = Annual cash flow/Long term debt
Coca-Cola is the best performer in this ratio too, at 273% while Cadbury Schweppes, McDonald's and PepsiCo performed closely at 56.94%, 53.92% and 42.78% respectively. The range at which the latter three are operating is justified as long term debt does not need urgent repayment as these are usually spread over a longer periods of time. Coca-Cola Enterprises performance is poor, at a mere 15.56%.
Similar to the previous ratio, the ratio of cash flow to total debt determines the ease with which a company can utilize its cash flow to manage its total debt (Bragg, 2007). This ratio can be calculated as:
Cash flow to total debt = Annual cash flow/Total debt
Coca-Cola at 184% is the best performer in this ratio while similar to the previous ratio, the three companies posted close results; McDonald's, PepsiCo and Cadbury Schweppes produces the results of 47.48%, 39.59% and 33.02% respectively. Coca-Cola performed relatively better compared to previous ratio 15.33% which means that it has very little short term debt compared to long term debt.
Question 3
PepsiCo currently has a net debt ratio of 19.59%, calculated using the assumption made in Question 1. Under the Moody's/S&P debt ratings of A1/A respectively, the current net debt ratio is possible. However at 20% to 25% target net debt ratio, the debt rating would go worse than better. This is so because a higher debt ratio makes it relatively more debt burdened and this makes it difficult to meets its debt interest payments. (Missale, 1994) If PepsiCo wishes to maintain a single-A senior debt rating, it should bring down it target net debt ratio to 15% to 20% or more reasonably close to 16% under the original calculation method that brought the 18% mentioned. In terms of attainability, the target net debt ratio of 20% to 25% can be maintained itself however this cannot maintain the debt ratings. The targets proposed may be easy to attain but not to retain. This is because
PepsiCo's performance in other debt benchmarks is not at par with its market capitalization position. PepsiCo's market capitalization at USD 44Bn is the second highest amongst the five comparable companies given in Exhibit 5, less than half of the highest i.e. Coca-Cola at USD 100Bn. Despite being large, (the other companies are McDonalds at USD 33.5Bn, Cadbury Schweppes at USD 8.7Bn and Coca-Cola Enterprises at USD 3.8Bn) it usually comes down in at third and fourth position. Pepsi-Co's performance should be closer to its direct competitor i.e. Coca-Cola. [1] This performance gap has to be filled. What is more is that PepsiCo may be at an optimal size according to the market. It can take advantage of the size it has over Coca-Cola. For instance, if Coca-Cola needs to restructure its capital structure, it would need more time to negotiate with the institutional investors and would also have to undergo strategic activities such as mergers, acquisitions and divestitures at the same time, which can be not only a strain on its time but also on its resources. However the advantage Coca-Cola has today its equity focused capital structure and has a lot of capability to issue new debt at conditions that can be favorable to both investors, i.e more likelihood of over-subscription and the company itself i.e. over-subscription premium through above par bids. Moreover Coca-Cola has recently issued corporate bond at low rated in order to retire its existing debt [2] , [3] . PepsiCo on the other hands can more easily restructure its capital structure through issuing more common stock and retiring its debt pre-mature from the excess proceeds. There is a challenging choice of chosing debt or equity or which one is more beneficial to any company. (Marsh 1982)
Better performance in debt management will also help the market value of PepsiCo common stock to go up, as this will build confidence of investors in the ability of the company to pay its debt holders and thus to shareholders in the form of dividends. Therefore this can lead to capital gains for stock investors, which in turn can lead to a lower and better net debt ratio and the cycle goes on until an optimal net debt ratio is reached.
One must not ignore the impact of the external environment on the net debt ratio. At times of recession, when the spending in the world economy slows down and cost-push inflation dominates the business climate, we find that companies are less likely to achieve the targets that were set in the better days. [4] The future environment shows a slow recovery from the current financial recession, [5] which means that over the long term, the capital markets will begin to show its performance. Therefore PepsiCo is more likely to perform better in the long term, however, it has the capacity to enhance the responsiveness to the economy i.e. its beta against the stock market can be improved. It should also be taken into consideration that there will be many smaller companies which may be more agile in the face to recovery, responding quicker to changes in demand, and this grow faster than established companies. To counter excessive competition, the company has to be as agile as the smaller companies. One advantage enjoyed by PepsiCo over its prime competitor, Coca-Cola is the level of its product diversification. [6] While Coca-Cola mainly sells beverages, PepsiCo is now also recognized as a world leader in snack food business. This product diversification allows global companies like PepsiCo to reduce the risk and the sales volatility inherent in mainly fewer products business.(Xu, 2010) This can ensure more agility in competitions. [7] One business strategy PepsiCo can implement to attain its target net debt ratio is to focus on its earnings potential. We see that the profit margins of PepsiCo are thinning over successive years. This means that PepsiCo can enhance cost cutting, divest products which may lack future earnings potential and may not provide any significant benefit or loss to other products and focus on growing products.
One issue that may have been missed altogether is related to the credit rating agencies such as Standard and Poor's and Moody's may not always be trusted by investors. There have been cases of risky companies being rated as high investment grade while these were on a verge to collapse as it happened during 2007. [8] There have even been cases when these agencies ratings caused companies to lose investor's interest, and thus suffered losses mainly due to the ratings.(Tomlinson et al, 2007) Moreover ratings are not done using commonly-known standard but based on the opinions of financial research analysts. As the dynamics of each company's business, cash flows and performance standards are different, giving similar credit ratings to many such businesses may not satisfy investors. In other words, when setting targets for a credit ratings, large companies like PepsiCo should consider the reliability and significance to a certain ratings to most of its investors. (Partnoy, 2001) Most highly rated companies that collapsed in 2007 were large businesses.
I propose that net debt ratio should not be the only indicator that should be focused upon but rather a group of other indicators, such as the capitalization ratios, interest and fixed charge coverage ratios and cash flow to debt ratios. For each of these ratios, there should be a different set of targets, based on the benchmarks set by the main competitor, Coca-Cola.
Compared to Coca-Cola's approximately 16% interest coverage ratio, after a debt restructuring by retiring debt from the proceeds of a stock issue, the target ratio of PepsiCo should range from 10% to 12% considering the approximately 7% of McDonald's which is the third largest in terms of market capitalization.
Accordingly the fixed charge coverage ratio should range from 6% to 9% if the above targets are to be accepted. Logically both the ratios usually move with each other except for during when the operational lease commitments are high.
The long term debt ratio of PepsiCo should range from 5% to 9%, against approximately 16% which is now. This will be the second best ratio if implemented and would support the above ratios.
Now comes an area which should be considered i.e. earnings. Earnings are a prelude to cash flows that run a business. Without a proper cash flow management, a profitable business may need to forego important decisions as well as look for short term financing. Therefore the targets for cash flow to long term debt of PepsiCo should range from 100% to 175% close to that of the leader.
Similarly for the cash flow to total debt, PepsiCo should range from 75% to 125%.
If these targets are met, Pepsi can become a prime example of an optimal debt structured company that can have the potential to grow from equity financing and its own retained earnings. The growth from within model is particularly good and is preferred over leveraged growth because of the non-compulsory repayment of capital.(Chittenden et al, 1996)) The cost of capital is also low when debt is retired.
It is of common knowledge that debt is a main reason behind high cost of capital. (Brealey et al, 2008) Debt is relatively easier way to raise capital as investors are promised a certain rate of return on the investment, while equity may be difficult to raise owing to regulatory barriers as well as the risk factors accounted by investors. At times of recession, investors generally look for investing in debt as it promises returns while at times of growth, equity capital may appreciate as there is bullish activity in the bourses. (Bernake, 1981)
I therefore propose that for more reasonable targets, the target net debt ratio should be brought down by a change in the capital structure. This can be made by issuing some share and retiring some debt. This more of a cosmetic change as the total value of the company remains the same. To make this change useful, the company should then focus on its debt management through retiring debt using the excess quarterly earnings. This move can help the company foster growth from within. The growth can then lead to appreciation of the PepsiCo stock, thereby bringing down the net debt ratio and improving debt ratios across the board.
Conclusion
Zero debt companies is a relatively rare phenomena which is being considered by many new companies. For example Basu (2010) has reported about an Indian mobile phone company which is zero debt company. Moreover there is a growing number of zero debt companies in India, many of these are Multinationals. [9] 10CNBC's Moreano (2010) has pointed out zero debt companies such as Novell, Cognizant Tech Solutions, Electronic Arts, Broadcom Corps, GAP Inc, Texas Instruments, Ebay, Apple and Google, most of which have been technology startups in the beginning, yet grew with little or no debt, which is a testimony that startups can become giants with little debt and can achieve such a position as Coca-Cola is fast achieving with little debt today.
To achieve the ideal above it is important that reliance on debt should be reduced and more efforts be made into creating companies from within. A company with little debt is more likely to have a strong ratings from agencies. (Barclay et all, 1995)
From this assignment, the research has made me aware that debt management is important for any company's survival and also that ratings should be considered when making company's policies on strategies. I have also gained the knowledge that the ideals of a zero debt company can be achieved just as many company have been able to achieve. I recall an example from a tutor of a plant which is supported by a structure, and is too weak to stand on its own. Once the structure collapses, the plant also collapses as the plant is used to require someone else's help to stand. So is debt. A highly leveraged company constantly needs debt to pay off debt, which turns into a vicious cycle thereby the company goes into bankruptcy.
