Reference no: EM13902369

RESIDUAL INCOME VALUATION. The Coca-Cola Company is a global soft-drink beverage company (ticker: KO) that is a primary and direct competitor with PepsiCo. The data in Chapter 12's Exhibits 12.13, 12.14, and 12.15 include the actual amounts for 2006, 2007, and 2008 and projected amounts for Year +1 to Year +6 for the income statements, balance sheets, and statements of cash flows, respectively, for Coca-Cola (in millions).

The market equity beta for Coca-Cola at the end of 2008 is 0.61. Assume that the risk- free interest rate is 4.0 percent and the market risk premium is 6.0 percent. Coca-Cola has 2,312 million shares outstanding at the end of 2008, when Coca-Cola's share price was $44.42.

Required

Part I-Computing Coca-Cola's Share Value Using the Residual Income Valuation Approach

a. Use the CAPM to compute the required rate of return on common equity capital for Coca-Cola.

b. Derive the projected residual income for Coca-Cola for Years +1 through +6 based on the projected financial statements. The financial statement forecasts for Year +6 assume that Coca-Cola will experience a steady-state long-run growth rate of 3 per- cent in Year +6 and beyond.

c. Using the required rate of return on common equity from Part a as a discount rate, compute the sum of the present value of residual income for Coca-Cola for Years +1 through +5.

d. Using the required rate of return on common equity from Part a as a discount rate and the long-run growth rate from Part b, compute the continuing value of Coca- Cola as of the start of Year +6 based on Coca-Cola's continuing residual income in Year +6 and beyond. After computing continuing value as of the start of Year +6, discount it to present value at the start of Year +1.

e. Compute the value of a share of Coca-Cola common stock. (1) Compute the total sum of the present value of all residual income (from Parts c and d). (2) Add the book value of equity as of the beginning of the valuation (that is, as of the end of 2008, or the start of Year+1). (3) Adjust the total sum of the present value of resid- ual income plus book value of common equity using the midyear discounting adjustment factor. (4) Compute the per-share value estimate.

Part II-Sensitivity Analysis and Recommendation

f. Using the residual income valuation approach, recompute the value of Coca-Cola shares under two alternative scenarios. Scenario 1: Assume that Coca-Cola's long-run growth will be 2 percent, not 3 percent as above, and that Coca-Cola's required rate of return on equity is 1 percent higher than that calculated in Part a. Scenario 2: Assume that Coca-Cola's long-run growth will be 4 percent, not 3 percent as above, and that Coca-Cola's required rate of return on equity is 1 percent lower than that cal- culated in Part a. To quantify the sensitivity of your share value estimate for Coca- Cola to these variations in growth and discount rates, compare (in percentage terms) your value estimates under these two scenarios with your value estimate from Part e.

g. Using these data at the end of 2008, what reasonable range of share values would you have expected for Coca-Cola common stock? At that time, what was the market price for Coca-Cola shares relative to this range? What would you have recommended?

h. If you completed Problem 12.16 in Chapter 12, compare the value estimate you obtained in Part e of that problem (using the free cash flows to common equity shareholders valuation approach) with the value estimate you obtain here using the residual income valuation approach. The value estimates should be the same. If you have not completed Problem 12.16, you would benefit from doing so now.

Text Book: Financial Reporting, Financial Statement Analysis and Valuation: A Strategic Perspective By James Wahlen, Stephen Baginski, Mark Bradshaw.