Question

As an example of a company that did not ignore its cost of capital, consider Coca-Cola in the 1980s. It had very little debt because it preferred to raise equity capital from its stockholders. It also had a diversified product line, including products like aquaculture and wine. But none of these activities earned as much as its soft drink division. The opportunity cost of investing in these unrelated businesses was the forgone opportunity to expand the soft drink division, which at the time was earning a 16 percent return on capital. Although these other businesses were earning a positive 10 percent rate of return on capital, the opportunity cost of that capital was 16 percent. CEO Robert Goizueta correctly decided to sell off these under-performing divisions and invest the capital in its soft drink division. By making decisions whose benefits were greater than their costs, the topic of this chapter, Coca-Cola increased its profitability. Discuss why this was a good decision.

Answer 1

Opportunity cost principle is one of the most important principle of economics, that guides the management to take decisions. In the case of Coca-Cola, the company is earning 16% ROC in soft drink business, but in other vertical it is earning only 10%. So, for the other verticals, the opportunity cost is 16% that is higher than 10% and it is wrong according to the opportunity cost principle. As per this principle, investment should take place in those businesses that have a lower opportunity cost. In this regard, soft drink business has a lower opportunity cost. So, Coca Cola CEO took the right decision sell the under performing businesses and invested the funds in the soft drink business. It will also help raise more equity capitals for the expansion plan in this business. So, it is a right decision.