Harvard Case Study Coca Cola Residual Income Valuation

Solved Coca-Cola: Residual Income Valuation Case Study Analysis based on HBR framework-theories, framework, process and quantitative methods.Valuation.

  1. Harvard Case Study Coca Cola Residual Income Valuation Method

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 1–3 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 riskfree 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

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the Residual Income Valuation Approach

Harvard Case Study Coca Cola Residual Income Valuation

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 percent 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 residual 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

Harvard Case Study Coca Cola Residual Income Valuation Method

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 calculated 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 ould 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 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, you would benefit from doing so now.

Problem

FREE-CASH-FLOWS-BASED VALUATION. The Coca-Cola Company is a global soft drink beverage company (ticker symbol + KO) that is a primary and direct competitor with PepsiCo. The data in Exhibits 1–3 (see pages 980–983) 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 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 Free Cash Flows to Common Equity Shareholders

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

b. Derive the projected free cash flows for common equity shareholders for Coca-Cola for Years +1 through +6 based on the projected financial statements. Assume that Coca-Cola’s changes in cash each year are necessary for operating liquidity purposes. The financial statement forecasts for Year +6 assume that Coca-Cola will experience a steady-state long-run growth rate of 3 percent 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 free cash flows for common equity shareholders 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 free cash flows for common equity shareholders 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 future free cash flows for equity shareholders (from Parts c and d). (2) Adjust the total sum of the present value using the midyear discounting adjustment factor. (3) Compute the per-share value estimate.

Part II—Computing Coca-Cola’s Share Value Using Free Cash Flows to All Debt and Equity Stakeholders

f. At the end of 2008, Coca-Cola had $9,312 million in outstanding interest-bearing short-term and long-term debt on the balance sheet and no preferred stock. Assume that the balance sheet value of Coca-Cola’s debt is approximately equal to the market value of the debt. The forecasts assume that Coca-Cola will face an interest rate of 4.5 percent on debt capital and that Coca-Cola’s average tax rate will be 23.2 percent (based on the past five-year average effective tax rate). Compute the weighted average cost of capital for Coca-Cola as of the start of Year +1.

g. Beginning with projected net cash flows from operations, derive the projected free cash flows for all debt and equity stakeholders for Coca-Cola for Years +1 through +6 based on the projected financial statements. Assume that the change in cash each year is related to operating liquidity needs.

h. Using the weighted average cost of capital from Part f as a discount rate, compute the sum of the present value of free cash flows for all debt and equity stakeholders for Coca-Cola for Years +1 through +5.

i. Using the weighted average cost of capital from Part f 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 free cash flows for all debt and equity stakeholders in Year +6 and beyond. After computing continuing value as of the start of Year +6, discount it to present value as of the start of Year +1.

j. Compute the value of a share of Coca-Cola common stock. (1) Compute the total value of Coca-Cola’s net operating assets using the total sum of the present value of free cash flows for all debt and equity stakeholders (from Parts h and i). (2) Subtract the value of outstanding debt to obtain the value of equity. (3) Adjust the present value of equity using the midyear discounting adjustment factor. (4) Compute the per-share value estimate of Coca-Cola’s common equity shares.

Note: Do not be alarmed if your share value estimate from Part e is slightly different from your share value estimate from Part j. The weighted average cost of capital computation in Part f used the weight of equity based on the market price of Coca-Cola’s stock at the end of 2008. The share value estimates from Parts e and j likely differ from the market price, so the weights used to compute the weighted average cost of capital are not internally consistent with the estimated share values.

Part III—Sensitivity Analysis and Recommendation

k. Using the free cash flows to common equity shareholders, 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 before, and assume that Coca-Cola’s required rate of return on equity is 1 percent higher than the rate you computed for Part a. Scenario 2: Assume that Coca-Cola’s long-run growth will be 4 percent, not 3 percent as before, and assume that Coca-Cola’s required rate of return on equity is 1 percent lower than the rate you computed 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.

l. 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 investment strategy (buy, hold, or sell) would you have recommended?

Exhibit 1 The Coca-Cola Company Income Statements for 2006 through 2008 (Actual) and Year +1 through +6 (Protected) (amounts in millions) (Problem)

Exhibit 2 The Coca-Cola Company Balance Sheet for 2006 through 2008 (Actual) and Year +1 through +6 (Projected) (amounts in millions) (Problem)

Exhibit 3 The Coca-Cola Projected Implied Statements of Cash Flows for Year +1 through +6 (Projected) (amounts in millions) (Problem)

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113-056- Coca-Cola: Residual Income Valuation Exhibit 1 Coca-Cola, Balance Sheet and Income Statement (in $ millions) December 31, 2010 December 31, BALANCE SHEET 2009 ASSETS 11,511 4,430 2,650 9,409 3,758 2,354 2,030 17,551 5 Cash and Marketable Securities Accounts Receivable Inventory Other Currents Assets 2,988 21,579 TOTAL CURRENT ASSETS 11,441 12,828 6,755 31,024 48,575 16,672 26,909 7,663 Long-Term Tangible Assets Long-Term Intangible Assets Other Long-Term Assets TOTAL LONG-TERM ASSETS 51.244 72,823 $ TOTAL ASSETS LIABILITIES 1,887 9,376 S S 1,410 Accounts Payable Short-Term Debt 6,800 5,511 13,721 7,245 Other Current Liabilities 18,508 TOTAL CURRENT LIAB1ILITIES 14,041 Long-Term Debt Deferred Taxes Other Long-Term Liabilities TOTAL LONG-TERM LIABILITIES 5,059 4.163 1,484 2,965 9,508 4,794 22,998 SHAREHOLDERS' EQUITY Minority Interest Common Shareholders' Equity (2,303 and 2,292 million shares outstanding) TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY 547 314 24.799 31,003 S S 48,575 72,823 December 31, December 31, December 31, INCOME STATEMENT For the vears ended 2008 2009 2010 S 31,944 $ 30,006 $ 35,200 11,234 23,966 SALES Cost of Goods Sold GROSS PROFIT 10,146 9,864 21,142 11,381 21,798 Selling, General, and Administrative Other Operating Expenses OPERATING INCOME 11,774 13,179 1,703 9,084 5,312 (887) 317 1,283 1,343 8,418 8,741 Other Income 53 92 Other Expense (1,976) (253) Interest Income 333 249 Interest Expense Minority Interest PRETAX INCOME Tax Expense Unusual Gains, Net of Unusual Losses (438) 0 (341) (82) 8,083 2,040 (608) (50) 13,168 2,384 6,713 1,632 726 781 1,025 S 11,809 NET INCOME S 5,807 $ 6,824 Source: Capital IQ 3 This document is authorized for use onlvin loal DICieon'e Eli FOOC DUOID Coca-Cola: Residual Income Valuation 113-056 Coca-Cola, Condensed Balance Sheet (in $ millions) Exhibit 2a January 1, 2011 January 1, 2010 January 1, 2009 As of 936 1,221 26.028 740 24,065 24,805 Beginning Net Working Capital Beginning Net Long-Term Assets NET OPERATING ASSETS S 41,973 42,909 27,249 11,906 2,450 0 24,799 27,249 Net Debt Preferred Stock Shareholders' Equity NET CAPITAL 4,333 C 31,003 20,472 42,909 $ S 24,805 Coca-Cola, Condensed Income Statement (in $ millions) Exhibit 2b December 31, 2010 December 31, 2009 For the year ending December 31, 2008 $ 35,200 31.006 Sales 4 S 31,944 5,886 6,892 12,047 238 NOPAT Net Interest Expense After Tax NET INCOME Less: Preferred Dividends NET INCOME TO COMMON SHAREHOLDERS 79 69 5,807 6,824 11,809 0 6,824 5,807 11,809 Source: Casewriter. Coca-Cola, Forecasting Assumptions Exhibit 3 Panel A. Cost of Capital Parameters Market Risk Premium. Risk-Free Rate Tax Rate Cost of Debt 5.0% 3.0% 35.0% 4.5% Common Equity Beta 0.6 Panel B. Future Performance Forecasts Terminal 2011 2012 Sales Growth Rate NOPAT /Sales Beginning Net Operating Working Capital /Sales Beginning Net Operating Long-Term Assets / Sales 8.0% 3.0% 15.0 % 10.0% 20.0 % 20.0% 3.0% 105.0% 3.0% 100.0% Net Debt / Book Value of Net Capital Preferred Equity / Book Value of Net Capital Shareholders' Equity / Book Value of Net Capital 27.75% 27.75% 27.75% 0.0% 0.0% 0.0% 72.25% 72.25% 72.25% Source: Casewriter. Please show your work for partial credit. Simply providing me answers from spreadsheet calculations will not suffice unless explained. a) Using the information provided in the case study, calculate the Weighted Average Cost of Capital. b) Using the information provided in the case study, please calculate the value of Coca-Cola stock using the Income Method taught in class. (NOTE: The case stated the Residual Income Method-DO NOT USE THAT APPROACH. IT WAS NOT EVEN TAUGHT).
Coca cola business case study

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