Question

Loreto Fernández, the regional director of Inka-Kola, the international empire of soft drinks, was
reviewing investment plans in the Caribbean. There were plans to launch Inka-Soda in Cuba in
2014. This would result in a payment of $ 20 million in 2014 to rebuild a bottling plant and
distribution system established there. Fix costs (production, distribution and marketing) would
be $ 3 million a year from 2015 onwards. This would be enough to produce and sell 200 million
liters per year - enough for every man, woman and child in Cuba to drink four bottles a week!
– but there will be have very few savings in case of building a smaller plant, and tariff and
transportation costs in the region maintain all production within national boundaries.
The variable costs of production and distribution would be 12 cents per liter. The company
policy requires a rate of return of 25 percent in nominal dollars after local taxes, but before
deducting any costs of funding. Sales revenues are expected at 35 cents per liter.
Bottling plants last almost forever, and all unit costs and revenues were expected to remain
constant in nominal terms. Tax would be payable at a rate of 30 percent under the Cuba
corporate tax code capital expenditures can be written off on a straight lane basis over four
years.
All these inputs were reasonably clear but Miss Fernandez racked brain trying to estimate sales.
Inka-Soda had found that the rule "1-2-4" worked in most new markets. Sales typically doubled
in the second year, it doubled again in the third, and after that, remain roughly constant. Loreto
best guess was that if she went ahead immediately, initial sales in Cuba would be 12.5 million
liters in 2015, jumping to 50 million from 2017 onwards.
Miss Fernandez was also worried whether it would be better to wait a year. The soft drink
market was developing rapidly in neighboring countries, and within a year, she should have a
much better idea whether Inka-Soda was likely to catch on in Cuba. If it didn’t catch on, and
sales stayed below the 20 million liters, a large investment would probably not be justified.
Ms. Fernandez had assumed that Inka-Soda keen rival Teh Botol, would not also enter the
market but last week she received a shock when in the lobby of the National Hotel she bumped
into her opposite number at Teh Botol. Teh Botol should face costs similar to Inka-Soda. How
would Teh Botol respond if Inka-Soda enter the market? Would it decide to enter also? If so,
how would that affect the profitability of Inka-Soda project?
Miss Fernandez thought again about postponing investment for one year. Suppose Teh Botol
were interested in the Cuban market. Would that favor delay or immediate action? Maybe Inka-
Soda should announce its plans before Teh Botol had the chance to develop its own proposals.
It seemed that the Cuban project was becoming more complicated by the day.
Calculate the NPV of the investment proposal, using the inputs suggested in this case.
How sensitive is the NPV to future sales volume? Do a sensitivity and simulation analysis.
2. What are the pros and cons of waiting for a year before deciding whether or not to invest?
Hint: What happens if demands turn out high and Teh Botol also invest.? What if Inka-Soda
invests right away and gains a year head start on Teh Botol? Explain the possible outcomes.

Answer 1

The following table summarises the information given in the question:

Capex ($ mn)	20
Fixed costs ($ mn) annually	3
Annual production capacity (mn)	200
Variable cost ($ per bottle)	0.12
Selling cost ($ per bottle)	0.35
Required rate of return	0.25
Depreciation (over 4 years)	0.25
Tax	0.3
Final Demand	50

Based on the above given data, the following table give the P&L statement of the business for the initial 10 years, which will continue as is for the extended period:

Year	41640	42005	42370	42736	43101	43466	43831	44197	44562	44927	45292
	0	1	2	3	4	5	6	7	8	9	10
% of final demand	25%	50%	100%	100%	100%	100%	100%	100%	100%	100%
Number of units sold (mn)	12.50	25.00	50.00	50.00	50.00	50.00	50.00	50.00	50.00	50.00
Revenue		4.38	8.75	17.50	17.50	17.50	17.50	17.50	17.50	17.50	17.50
Variable cost	1.50	3.00	6.00	6.00	6.00	6.00	6.00	6.00	6.00	6.00
Fixed Cost		3.00	3.00	3.00	3.00	3.00	3.00	3.00	3.00	3.00	3.00
EBITDA		-0.13	2.75	8.50	8.50	8.50	8.50	8.50	8.50	8.50	8.50
Depreciation	5.00	5.00	5.00	5.00
EBIT		-5.13	-2.25	3.50	3.50	8.50	8.50	8.50	8.50	8.50	8.50
Tax		-	-	1.05	1.05	2.55	2.55	2.55	2.55	2.55	2.55
PAT		-5.13	-2.25	2.45	2.45	5.95	5.95	5.95	5.95	5.95	5.95

The Free Cash Flow statment of the business is as under:  

Year	01-01-2014	01-01-2015	01-01-2016	01-01-2017	01-01-2018	01-01-2019	01-01-2020	01-01-2021	01-01-2022	01-01-2023	01-01-2024
0	1	2	3	4	5	6	7	8	9	10
Free Cash Flow	-20	-0.13	2.75	7.45	7.45	5.95	5.95	5.95	5.95	5.95	5.95
PV	-20	-0.10	1.76	3.81	3.05	7.80
NPV	-3.675296

The NPV of the project is $ (3.675 mn) as above.

Annual Sales in year 3	NPV
	-3.68
25	-16.27
50	-3.68
75	8.18
100	19.60
125	31.03
150	42.30
175	53.38
200	64.46
57.67	0

With annual sales of 57.67 mn liters from year 3 onwards, the project will breakeven.

The pros of investing now are:

a) get a headstart into the business

b) start recouping the investments sooner

The cons of investing now are:

a) Develop an undeveloped market

b) Risk of sales taking off