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FINANCIAL ANALYSIS TOBACCO vs. RETAIL

 
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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&Gs 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 Sams 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

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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 firms 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&Gs 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&Gs 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
s

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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&Gs 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&Gs
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 nonessential 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&Gs overall WACC at h.89% and WACC for the tobacco division
project at s.s1%. 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&Gs
WACC of h.89% for the tobacco project yields a net present value of ($1,71s,188). The
correct WACC of s.s1% for the tobacco project results in a net present value of
($5,0:s,s: ). The error of using the incorrect WACC is a difference of $s,ss0,158. 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.

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Using P&Gs WACC of h.89% for the discount store project yields a net present value
of ($88,0 1,059). The correct WACC of s.:7% for the discount store project results in a net
present value of ($91,1

). The error of using the incorrect WACC is a difference of

$s,105, 07. 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 fiveyear horizon. However, if we assume P&G will take on either of the new divisions, the
effect to the equity beta is negligible. P&Gs 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&Gs market capitalization is approximately $18hB, and the
discounted future cash flows for the tobacco and discount store division projects are only
in the millions.

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## 

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 s.s1% and s.:7% for
the tobacco and discount store projects respectively. These WACCs showed that the
tobacco project would have a net present value (NPV) of ($5,0:s,s: ) while the discount
store project would have a NPV of ($91,1

). 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 sixyear horizon, they could see a positive return on their investment, as seen in Exhibit ( 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.

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