p&g final

P&G Financial Analysis Beta 5

FINANCIAL ANALYSIS – TOBACCO vs. RETAIL

Beta 5Pallavi Daliparthi

Nathan DeLanoJesus Flores del Bosque

Scott MonkEric Ryza

1


Executive Summary

Proctor & Gamble (P&G) is trying to broaden its horizons and expand into a new

market. P&G is considering two industries: Tobacco or Discount Store.

P&G has historically manufactured consumer goods, but they have been researching

and considering an entry into the Tobacco industry. At first glance, it seems intuitive that

expanding into this sector would hinder P&G’s brand and growth. Our careful financial

analysis into other Tobacco companies, such as Lorillard (LO), Reynolds American (RAI),

and British American Tobacco (BTI) – three potential competitors, if P&G chooses this

division – has confirmed that P&G would lose value by creating this division.

The other option considered is a discount store division, similar to giants like Costco

and Sam’s Club. P&G currently sells to these warehouses, so there is a high probability that

P&G will lose their business if it develops in this area. To conduct a thorough evaluation of

this division, we compared our likelihood of growth in this area to Costco (COST), Wal-Mart

(WMT), and Target (TGT). This evaluation shows that the discount store project leads to

an even greater loss in value for P&G than the tobacco division.

At this time, we propose that P&G scrap both of these projects and consider other

options.

~ Beta 5 Finance Team

2


Detailed Analysis

Selecting an appropriate cost of capital for a project is essential for accurately

determining the net present value and, ultimately, determining whether to accept a project.

The cost of capital not only represents the borrowing cost of the firm but also the minimum

return investors expect; hence, any project a firm pursues should have a return at least

equal to the cost of capital. The nature of the industry, volatility of the market, and

exposure to government regulation are some of the factors investors in a firm may consider

in determining whether a firm’s risk is aligned with the expected return. In general, the

greater the cost of capital, the greater the risk and returns investors will expect, and vice

versa.

P&G operates in the consumer goods sector and produces mainly personal care

products. The nature of the personal care business is relatively stable and exposed to little

risk when compared to a tobacco firm or discount retail store. Many of P&G’s products

fulfill the basic needs of proper hygiene, resulting in stable demand since consumers will

most likely continue to purchase the products despite even deteriorating economic

conditions. Furthermore, P&G’s products have negligible exposure to government

regulation and taxes, which in other markets can increase the price of goods, causing a

decrease in demand.

A tobacco-producing firm is subject to higher risk due to a variety of reasons. Taxes

on tobacco products imposed by the federal government result in price increases for the

end consumer and can negatively impact demand over time. Government regulations

determine the age of consumers who can purchase tobacco products, which limits the size

of the market. The government can also determine how and where tobacco companies may

3


advertise their products, further hindering the ability of tobacco firms to effectively reach

their target markets. Tobacco companies have also been held liable in the past for health

care costs associated with the use of their products. For these and other reasons, the risks

involved in the tobacco industry are greater than P&G’s typical market; hence, the greater

risk necessitates using a greater cost of capital.

A discount retail store may also experience a higher degree of risk than P&G’s

typical market. Although similar in some regard with the products offered to consumers,

there are also many other non-essential consumer goods sold by discount retail stores.

Consumers may not have quite as large a propensity to consume personal computers and

home entertainment electronics during periods of slow economic growth. The non-

essential need of these product offerings results in market volatility, which may otherwise

not be experienced by P&G. Once again, a greater degree of risk requires a greater cost of

capital, differing from that of P&G.

We calculated P&G’s overall WACC at 2.89% and WACC for the tobacco division

project at 3.31%. As explained above, using the P&G WACC in the evaluation of the tobacco

project is wrong due to the differences in risk and natures of the business. Using P&G’s

WACC of 2.89% for the tobacco project yields a net present value of ($1,713,188). The

correct WACC of 3.31% for the tobacco project results in a net present value of

($5,043,346). The error of using the incorrect WACC is a difference of $3,330,158. Despite

using the incorrect WACC for the tobacco project analysis, the net present value still ends

up a negative value, so in either case the project will not move forward. However, there is a

significant difference between the two net present values.

4


Using P&G’s WACC of 2.89% for the discount store project yields a net present value

of ($88,061,059). The correct WACC of 3.47% for the discount store project results in a net

present value of ($91,166,666). The error of using the incorrect WACC is a difference of

$3,105,607. Once again, despite using the incorrect WACC for the discount store project

analysis, the net present value still ends up a negative value, so in either case the project

will not move forward. There is however a significant difference between the two net

present values.

Our analysis proved it is not wise to move forward with either project given a five-

year horizon. However, if we assume P&G will take on either of the new divisions, the

effect to the equity beta is negligible. P&G’s equity beta is hardly affected because the

present value of future cash flows for either project is minimal in comparison to the market

capitalization of P&G. P&G’s market capitalization is approximately $182B, and the

discounted future cash flows for the tobacco and discount store division projects are only

in the millions.

5


Recommendation

Our recommendation is that Procter & Gamble, Inc. should not approve either the

tobacco or the discount store project they were considering. During our evaluation of

these projects, our calculations confirmed that we should use a WACC of 3.31% and 3.47%

for the tobacco and discount store projects respectively. These WACCs showed that the

tobacco project would have a net present value (NPV) of ($5,043,346) while the discount

store project would have a NPV of ($91,166,666). The negative present values reveal that if

P&G were to invest in either one of the projects, they will not make the minimum return

that they require. However, if P&G were to analyze the tobacco industry project on a six-

year horizon, they could see a positive return on their investment, as seen in Exhibit (6-

Year Time Frame Tobacco Tab). We also performed a sensitivity analysis, in which we

proposed different scenarios for the following variables:

Investment

Unit Sales

Price/Unit

Salvage Value

Political Risk

WACC

However, even with the sensitivity analysis, we recommend that P&G reject both

divisions, at this time.

6


Exhibits

7


8

AssumptionsDiscount Rate 3.31%

GDP growth rate2 3.0% 3.0% 3.0% 3.0%Marginal Tax Rate 35%

Political Risk 14%Depreciation 20.0% 32.0% 19.2% 11.5% 11.5% 5.8%

Depreciable Basis 250,000,000 Salvage Value 35,000,000 Book Value 14,400,000

P&G's overall WACC 2.89%

Concept Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6Units Sold 4,000,000 4,120,000 4,243,600 4,370,908 4,502,035

Price $ 75.00 $ 75.00 $ 75.00 $ 75.00 $ 75.00 Revenue 300,000,000 309,000,000 318,270,000 327,818,100 337,652,643

COGS 240,000,000 247,200,000 254,616,000 262,254,480 270,122,114 Gross Profit 60,000,000 61,800,000 63,654,000 65,563,620 67,530,529

S,G, & AR&D

Depreciation 50,000,000 80,000,000 48,000,000 28,800,000 28,800,000 EBIT 10,000,000 (18,200,000) 15,654,000 36,763,620 38,730,529 Tax 3,500,000 (6,370,000) 5,478,900 12,867,267 13,555,685 EAT 6,500,000 (11,830,000) 10,175,100 23,896,353 25,174,844

Plus Dep. 50,000,000 80,000,000 48,000,000 28,800,000 28,800,000 Less Capex 250,000,000

Less increase in NWC 18,000,000 540,000 556,200 572,886 590,073 Plus equip. salvage 27,790,000

Plus Term. decrease in NWC 20,259,159 FCF (250,000,000) 38,500,000 67,630,000 57,618,900 52,123,467 53,384,771 48,049,159

FCF Weighted for Pol. Risk 33,110,000 58,161,800 49,552,254 44,826,182 45,910,903 41,322,276 Yr. 5 + Term FCF = 87,233,179

NPV (5,043,346)NPV using P&G WACC (1,713,188)

effect of using wrong WACC (3,330,158)

NWCCash

Inventory 30,000,000 30,900,000 31,827,000 32,781,810 33,765,264 Receivables 0 0 0 0 0

Payables 12,000,000 12,360,000 12,730,800 13,112,724 13,506,106 NWC 18,000,000 18,540,000 19,096,200 19,669,086 20,259,159

Total Proportion of Revenues 6% 6% 6% 6% 6%

Case 1 - Tobacco


Concept LO3 RAI7 BTI9 (in billions of $) (in billions of $) (in billions of GBP) 90.34 (in billions of $)

Market Cap 14.810 23.440 58.134 in GBP ($1=.6435 GBP on 1/20/12)10 Plus Debt 1.769 4.101 10.250

Plus Min. Int. 0.342 Plus Pref. Eq.

Less Cash 2.063 2.195 0.943 Enterprise Val. 14.516 25.346 67.783

Company Ticker Equity Beta D/V Debt Rating Debt Beta5 Asset Beta Lorillard LO 0.390 0.122 BBB4 0.100 0.355

Reynolds American, Inc. RAI 0.620 0.162 BBB8 0.100 0.536 British American Tobacco BTI 0.630 0.151 BBB11 0.100 0.550

5.00%0.91%48.01%

WACC Ra 3.31%

Hist. Mkt. Risk Prem.6 Risk-free T-Bill Rate1 Average Asset Beta

Tobacco Calculations

WACC

9


Deviation NPV Deviation NPV Deviation NPVfrom Base -$5,043,346 from Base -$5,043,346 from Base -$5,043,346

-30% $175,000,000 $49,289,307 -30% 2,800,000 -$52,875,573 -10% $67.50 -$85,528,5320% 250,000,000 -5,043,346 0% 4,000,000 -5,043,346 0% 75.00 -5,043,34630% 325,000,000 -59,375,999 30% 5,200,000 42,788,881 10% 82.50 75,441,840

Deviation NPV Deviation NPV Deviation NPV

from Base -$5,043,346 from Base -$5,043,346 from Base -$5,043,346

-100% - -$21,668,085 -50% 7.0% $14,894,986 -50% 1.66% $8,360,0940% 35,000,000 -5,043,346 0% 14.0% -5,043,346 0% 3.31% -5,043,346

100% 70,000,000 11,581,393 50% 21.0% -24,981,678 50% 4.97% -17,434,017

SENSITIVITY ANALYSIS

Salvage Value Political Risk WACC

Investment Unit Sales Price/Unit

10

Deviationfrom Base Investment Price/Unit Unit Sales Salvage Value Political Risk WACC

-100% $49,289,307 -$85,528,532 -$52,875,573 -$21,668,085 $14,894,986 $8,360,0940% -$5,043,346 -$5,043,346 -$5,043,346 -$5,043,346 -$5,043,346 -$5,043,346

100% -$59,375,999 $75,441,840 $42,788,881 $11,581,393 -$24,981,678 -$17,434,017Range $108,665,306 $160,970,373 $95,664,455 $33,249,478 $39,876,665 $25,794,110

Sensitivity Graph for Tabacco Investment Evaluation

NPV with Variables at Different Deviations from Base

Data for Sensitivity Graph

Price/Unit

Unit Sales

Salvage Value

Political Risk

Investment

WACC

-$100,000,000

-$80,000,000

-$60,000,000

-$40,000,000

-$20,000,000

$0

$20,000,000

$40,000,000

$60,000,000

$80,000,000

$100,000,000

-100% -80% -60% -40% -20% 0% 20% 40% 60% 80% 100%

NPV($)

% Deviation from Base


Tornado Diagram for Tobacco Investment

Price/Unit

Unit Sales

Salvage Value

Political Risk

Investment

WACC

Base NPV = -$5,043,346

-$100,000,000 -$80,000,000 -$60,000,000 -$40,000,000 -$20,000,000 $0 $20,000,000 $40,000,000 $60,000,000 $80,000,000 $100,000,000

NPV

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12

Discount Rate 3.5%GDP growth rate2 3.0% 3.0% 3.0% 3.0%

Tax Rate 35%Depreciation 10.0% 18.0% 14.4% 11.5% 9.2% 7.4%

Depreciable Basis 220,000,000 Salvage Value 15,000,000

Book Value 81,092,000 P&G's overall WACC 2.9%

1,620 Concept Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6

Price 1,800 1,800 1,800 1,800 1,800 Units Sold 100,000 103,000 106,090 109,273 112,551 Revenue 180,000,000 185,400,000 190,962,000 196,690,860 202,591,586

COGS 162,000,000 166,860,000 171,865,800 177,021,774 182,332,427 Gross Profit 18,000,000 18,540,000 19,096,200 19,669,086 20,259,159

S,G, & AR&D

Depreciation 22,000,000 39,600,000 31,680,000 25,344,000 20,284,000 EBIT (4,000,000) (21,060,000) (12,583,800) (5,674,914) (24,841)Tax (1,400,000) (7,371,000) (4,404,330) (1,986,220) (8,694)EAT (2,600,000) (13,689,000) (8,179,470) (3,688,694) (16,147)

Plus Dep. 22,000,000 39,600,000 31,680,000 25,344,000 20,284,000 Less Capex 220,000,000

Less increase in NWC 27,000,000 810,000 834,300 859,329 885,109 Plus equip. salvage 38,132,200

Plus Term. decrease in NWC

30,388,738

FCF (220,000,000) (7,600,000) 25,101,000 22,666,230 20,795,977 19,382,744 68,520,938 Yr. 5 + Term FCF 87,903,682

NPV (91,166,666)NPV using P&G WACC (88,061,059)Effect of using wrong

WACC(3,105,607)

NWCCash 0 0 0 0 0

Inventory 18,000,000 18,540,000 19,096,200 19,669,086 20,259,159 Receivables 18,000,000 18,540,000 19,096,200 19,669,086 20,259,159

Payables 9,000,000 9,270,000 9,548,100 9,834,543 10,129,579 NWC 27,000,000 27,810,000 28,644,300 29,503,629 30,388,738

15% 15% 15% 15% 15%

Case 2 - Discount Store

Total Proportion of Revenues


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Concept COST12 WMT14 TGT16

(in billions of $) (in billions of $) (in billions of $)

Market Cap 35.410 208.940 33.690 Plus Debt 2.153 49.864 15.726

Plus Min. Int. 0.571 3.113 Plus Pref. Eq.

Less Cash 4.009 7.395 0.583 Enterprise Val. 34.125 254.522 48.833

Company Ticker Equity Beta D/V Debt Rating Debt Beta5 Asset Beta

Costco COST 0.660 0.063 AA13 0.030 0.620 Wal-Mart WMT 0.360 0.196 AA15 0.030 0.295

Target TGT 0.890 0.322 A17 0.050 0.619

5.00%0.91%

51.17% WACC Ra 3.47%

Hist. Mkt. Risk Prem.6 Risk-free T-Bill Rate1 Average Asset Beta

Retail Store Calculations

WACC


Deviation NPV Deviation NPV Deviation NPVfrom Base -$91,166,666 from Base -$91,166,666 from Base -$91,166,666

-30% $154,000,000 -$45,583,960 -30% 70,000 -$106,932,848 -10% $1,620.00 -$146,848,4060% 220,000,000 -91,166,666 0% 100,000 -91,166,666 0% 1,800.00 -91,166,66630% 286,000,000 -136,749,372 30% 130,000 -75,400,484 10% 1,980.00 -35,484,925

Deviation NPV Deviation NPV Deviation NPV

from Base -$91,166,666 from Base -$91,166,666 from Base -$91,166,666

-100% - -$99,388,414 -50% 0.5% -$91,810,833 -50% 1.73% -$81,614,9790% 15,000,000 -91,166,666 0% 1.0% -92,454,999 0% 3.47% -91,166,666

300% 60,000,000 -66,501,421 50% 1.5% -93,099,166 100% 6.94% -107,860,195

SENSITIVITY ANALYSIS

Salvage Value Political Risk WACC

Investment Unit Sales Price/Unit

14

Deviationfrom Base Investment Price/Unit Unit Sales Salvage Value Political Risk WACC

-100% -$45,583,960 -$146,848,406 -$106,932,848 -$99,388,414 -$91,810,833 -$81,614,9790% -$91,166,666 -$91,166,666 -$91,166,666 -$91,166,666 -$92,454,999 -$91,166,666

100% -$136,749,372 -$35,484,925 -$75,400,484 -$66,501,421 -$93,099,166 -$107,860,195Range $91,165,412 $111,363,481 $31,532,364 $32,886,993 $1,288,333 $26,245,216

Sensitivity Graph for Retail Investment Evaluation

NPV with Variables at Different Deviations from Base

Data for Sensitivity Graph

Price/Unit

Unit Sales

Salvage Value

Political Risk

Investment

WACC

-$160,000,000

-$140,000,000

-$120,000,000

-$100,000,000

-$80,000,000

-$60,000,000

-$40,000,000

-$20,000,000

$0

-100% -80% -60% -40% -20% 0% 20% 40% 60% 80% 100%

NPV($)

% Deviation from Base


15

Concept PG18

(in billions of $)Market Cap 182.22Plus Debt 32.014

Plus Min. Int. 0.361Plus Pref. Eq. 1.234

Less Cash 2.768Enterprise Val. 213.061

Company Ticker D/V Debt Rating Equity Beta Debt Beta5 Asset Beta

Procter & Gamble PG 0.15025744 AA19 0.46 0.03 0.3953893

5.0%0.91%

Asset Beta 0.3954 WACC Ra 2.89%

Hist. Mkt. Risk Prem.6

Risk-free T-Bill Rate1

P&G Calculations

WACC


16

P&G B(asset) 0.39539 P&G B(asset) 0.39539 Tobacco B(asset) 0.48013 Discount Store B(asset) 0.51170

Assets of P&G 218,597,000,000 Assets of P&G 218,597,000,000 Assets of Tobacco Project 244,956,654 Assets of Discount Store Project 128,833,334 Total Assets 218,841,956,654 Total Assets 218,725,833,334

New B(asset) of P&G 0.39548 New B(asset) of P&G 0.39546

P&G D/V 0.15026 P&G D/V 0.15026 P&G E/V 0.84974 P&G E/V 0.84974 P&G B(debt) 0.03000 P&G B(debt) 0.03000 New P&G B(equity) 0.46011 New P&G B(equity) 0.46008

Beta Equity Calculations

AssumptionsDiscount Rate 3.31%

GDP growth rate2 3.0% 3.0% 3.0% 3.0%Marginal Tax Rate 35%

Political Risk 14%Depreciation 20.0% 32.0% 19.2% 11.5% 11.5% 5.8%

Depreciable Basis 250,000,000Salvage Value 35,000,000Book Value 0

P&G's overall WACC 2.89%

Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6Units Sold 4,000,000 4,120,000 4,243,600 4,370,908 4,502,035 4,502,035 TerminalRevenue 300,000,000 309,000,000 318,270,000 327,818,100 337,652,643 337,652,643

COGS 240,000,000 247,200,000 254,616,000 262,254,480 270,122,114 270,122,114Gross Profit 60,000,000 61,800,000 63,654,000 65,563,620 67,530,529 67,530,529

S,G, & AR&D

Depreciation 50,000,000 80,000,000 48,000,000 28,800,000 28,800,000 14,400,000EBIT 10,000,000 (18,200,000) 15,654,000 36,763,620 38,730,529 53,130,529Tax 3,500,000 (6,370,000) 5,478,900 12,867,267 13,555,685 18,595,685EAT 6,500,000 (11,830,000) 10,175,100 23,896,353 25,174,844 34,534,844

Plus Dep. 50,000,000 80,000,000 48,000,000 28,800,000 28,800,000 14,400,000Less Capex 250,000,000

Less increase in NWC 18,000,000 540,000 556,200 572,886 590,073 0Plus equip. salvage 22,750,000

Plus Term. decrease in NWC 20,259,159 FCF (250,000,000) 38,500,000 67,630,000 57,618,900 52,123,467 53,384,771 48,934,844 43,009,159

FCF Weighted for Pol. Risk 33,110,000 58,161,800 49,552,254 44,826,182 45,910,903 42,083,965 36,987,876 Yr. 5 + Term FCF 79,071,842

NPV 24,880,061

NWCCash

Inventory 30,000,000 30,900,000 31,827,000 32,781,810 33,765,264 33,765,264Receivables

Payables 12,000,000 12,360,000 12,730,800 13,112,724 13,506,106 13,506,106NWC 18,000,000 18,540,000 19,096,200 19,669,086 20,259,159 20,259,159

Alternative Case 1 - Tobacco (6 Year Model)


17


Works Cited

1http://www.treasury.gov/resource-center/data-chart-center/interest-

rates/Pages/TextView.aspx?data=yield2 http://www.e-forecasting.com/US_Economic_Forecasts.htm3 http://www.google.com/finance?q=NYSE:LO4 http://quicktake.morningstar.com/stocknet/bonds.aspx?symbol=lo

5Source: S. Schaefer and I. Strebulaev, "Risk in Capital Structure Arbitrage," Stanford

GSB working paper, 2009.

6http://seekingalpha.com/article/263536-surveying-u-s-equity-risk-premium-in-

20117 http://www.google.com/finance?q=NYSE:RAI8 http://quicktake.morningstar.com/stocknet/bonds.aspx?symbol=RAI9 http://www.google.com/finance?q=NYSEAMEX:BTI

10

http://www.google.com/finance?hl=en&safe=active&biw=1920&bih=955&q=CURRENCY:USDGBP&ei=iFAaT9-

zAerq2AXox5nmAQ&sa=X&oi=currency_onebox&ct=currency_onebox_chart&resnum=1&sqi=2&ved=0CB8Q5QYwAA

11 http://quicktake.morningstar.com/stocknet/bonds.aspx?symbol=BTI12 http://www.google.com/finance?q=NASDAQ:COST#13 http://quicktake.morningstar.com/stocknet/bonds.aspx?symbol=cost14 http://www.google.com/finance?q=NYSE:WMT#15 http://quicktake.morningstar.com/stocknet/bonds.aspx?symbol=WMT16 http://www.google.com/finance?q=NYSE:TGT#

17http://quicktake.morningstar.com/StockNet/bonds.aspx?Symbol=TGT&Country=U

SA18 http://www.google.com/finance?q=NYSE%3APG#

19http://quicktake.morningstar.com/StockNet/bonds.aspx?Symbol=PG&Country=US

A

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p&g final

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