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Minicase 15
PepsiCo’s Capital Structure Choice
PepsiCo, Inc. (PepsiCo) is the world leader in the snack food business, and it is a strong number
two in soft drinks. 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 15-1 furnishes income statements for PepsiCo, and
Exhibit 15-2 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
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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 dayto-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 15-3 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)
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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 15-4 furnishes information regarding
PepsiCo’s operating lease commitments. Exhibit 15-5 provides information regarding
comparable firms.
Questions
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.
2. For each firm in Exhibit 15-5, 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.
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3. (Supplemental question based on Chapter 16) 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?
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EXHIBIT 15-1
PepsiCo Income Statements
(Dollars in millions)
Two Year Ago
Amount
%
One Year Ago
Amount
%
Latest Year
Amount
$25,021
100
$28,472
100
$30,421
100
22,114
88
25,271
89
27,434
90
Operating profit
2,907
12
3,201
11
2,987
10
Interest expense
(573)
(2)
(645)
(2)
(682)
(2)
89
-
108
-
127
-
Pretax income
2,423
10
2,664
9
2,432
8
Income taxes
(835)
(4)
(880)
(3)
(826)
(3)
-
-
(32)
-
-
-
$1,588
6
$1,752
6
$1,606
5
Net sales
Costs and expenses
Other income (expense)
Effect of accounting
changes
Net income
Earnings per share
$1.96
$2.22a
$2.00
Dividends per share
$0.62
$0.70
$0.78
a
Before cumulative effect of accounting changes.
Source: PepsiCo, Inc., Annual Reports to Shareholders.
%
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EXHIBIT 15-2
PepsiCo Balance Sheets
(Dollars in millions)
One Year Ago
Latest Year
Amount
%
Amount
%
Cash and cash equivalents
$331
1
$382 a
2
Short-term marketable securities (at cost)
1,157
5
1,116 a
4
Other current assets
3,584
14
4,048
16
5,072
20
5,546
22
Investments in unconsolidated affiliates
1,295
5
1,635
6
Property, plant, and equipment (net)
9,883
40
9,870
39
Intangible assets (net)
7,842
32
7,584
30
700
3
797
3
$24,792
100
$25,432
100
$1,452
6
$1,556
6
Short-term borrowings
678
2
706 a
3
Other current liabilities
3,140
13
2,968
12
5,270
21
5,230
21
Long-term debt
8,841
36
8,509 b
33
Other liabilities
3,825
15
4,380
17
17,936
72
18,119
71
6,856
28
7,313
29
$24,792
100
$25,432
100
Assets
Total current assets
Other assets
Total assets
Liabilities and Stockholders’ Equity
Accounts payable
Total current liabilities
Total liabilities
Stockholders’ equity (790 million shares
outstanding in 1994; 788 million in 1995)
Total liabilities and stockholders’ equity
a Approximates
market value.
market value is $8,747 million.
Source: PepsiCo, Inc., Annual Reports to Shareholders.
b Approximate
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EXHIBIT 15-3
PepsiCo’s Net Debt Ratio
Market Net Debt Ratio
26%
22%
18%
Two Years Ago
One Year Ago
Latest Year
Historical Cost Net Debt Ratio
50%
49%
46%
Two Years Ago
One Year Ago
Source: PepsiCo, Inc., Annual Reports to Shareholders.
Latest Year
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EXHIBIT 15-4
Information Concerning PepsiCo’s Operating Leases
Note 10 - Leases
PepsiCo has noncancelable commitments under both capital and long-term operating leases.
PepsiCo is lessee under noncancelable 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 noncancelable leases are set forth below:
Capital Operating
Year 1
Year 2
Year 3
Year 4
Year 5
Later years
$ 57
49
68
37
38
299
$548
$ 350
297
269
240
218
1,170
$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:
Minimum
Contingent
Latest
Year
$439
40
$479
One Year Two Years
Ago
Ago
$433
$392
32
28
$465
$420
.
Source: PepsiCo, Inc., Annual Reports to Shareholders.
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EXHIBIT 15-5
Selected Information Concerning PepsiCo and Comparable Firms
(Dollars in millions)
FIRM
PepsiCo
Cadbury Schweppes
Coca-Cola
Coca-Cola Enterprises
McDonald’s
DEBT
RATINGS
(MOODY’S/
S&P)
A1/A
ANNUAL
INTEREST
$682
CASH AND
MARKETABLE
SECURITIES
$1,498
MARKET
VALUE OF
LONG-TERM
DEBT
$8,747
MARKET
VALUE OF
TOTAL
DEBT
$9,453
ANNUAL
CASH
FLOW
$3,742
NUMBER
OF SHARES
(MILLIONS)
788.00
YEAR-END
SHARE
PRICE
$55.875
25
135
129
864
1,490
492
247.75
35.125
4,600

272
1,315
1,141
1,693
3,115
2,504.60
40.250
A3/AA
471
31
326
8
4,138
4,201
644
385.65
10.000
Aa2/AA
2,509
498
340
335
4,258
4,836
2,296
699.70
48.000
ANNUAL
EBIT
$3,114
ANNUAL
RENTAL
EXPENSE
$479
A2/A
661
Aa3/AA
Sources: Value Line Investment Survey and company annual reports to shareholders.