[Editor's note: This post continues yesterday's article, found here.]
3.2. Methodology and Assumptions
This “legal discount” test provides how much Coca Cola may lose in the acquisition of Huiyuan Juice if the application were rejected because of improper enforcement of law.
The potential loss Coca Cola suffered was the potential net income of the Huiyuan Juice for fiscal year 2009, the first year of operation if the transaction were approved.
It was difficult to predict whether the profit of the new company would increase because it was a component of the Coca Cola (by economies of scale, for example) or decrease (as actually occurred with Huiyuan in year 2010). We assumed that the annual profit of the new company was stable.
It was not sufficient that we merely estimated the profit if Coca Cola successfully purchased Huiyuan, because Coca Cola’s funding does not exist in a vacuum, i.e., Coca Cola would not be required to pay for the costs of funding, whether dividends to shareholders or interest expense to creditors, if it did not spend the USD24 billion for the deal.
Thus, potential income should be divided by the weighted average cost of capital (WACC) of Coca Cola.
Because legal risk is variable case by case, the analysis only examines the highest level of loss caused by uncertainty in the rule of law in the Chinese legal environment. This assumption also matches the conservatism in accounting principle, which suggests that expenses should be over-estimated at their highest possibility when the amount is not certain.
To reflect the possibility of judicial intervention, the discount should be multiplied by 1/67, which reflects the highest legal risk.
The potential return on the project resulting from the assumptions made above is that made for USD24 billion in investment funds.
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