13.19 Residual Income Valuation. The Coca-Cola Company is a global soft drink beverage company (ticker: KO) that is a primary and direct competitor with Starbucks. The data in Chapter 12s Exhibits 12.14, 12.15, and 12.16 (pages 806809) include the actual amounts for 2013, 2014, and 2015 and projected amounts for Year 1 to Year 6 for theincome statements, balance sheets, and statements of cash ows, respectively, for Coca-Cola. The market equity beta for Coca-Cola at the end of 2015 is 0.75. Assume that the risk-free interest rate is 3.0% and the market risk premium is 6.0%. Coca-Cola had 4,324 million shares out-standing at the end of 2015, when Coca-Colas share price was $42.96.

REQUIRED Part IComputing Coca-Colas 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 nancial statements. The nancial statement forecasts for Year 6 assume that Coca-Cola will experience a steady-state, long-run growth rate of 3% in Year 6 and beyond.

c. Using the required rate of return on common equity from Requirement 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 Requirement a as a discount rate and the long-run growth rate from Requirement b, compute the continuing value of Coca-Cola as of the start of Year 6 based on Coca-Colas 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 Requirements c and d).

(2) Add the book value of equity as of the beginning of the valuation (that is, as of the end of 2015, or the start of Year + 1).

(3) Adjust the total sum of the present value of residual income plus book value of com-mon equity using the midyear discounting adjustment factor.

(4) Compute the per-share value estimate.

Using the residual income valuation approach, compute the value of Coca-Cola shares under two alternative scenarios. Scenario 1: Assume that Coca-Colas long-run growth will be 2%, not 3% as above, and that Coca-Colas required rate of return on equity is 1% higher than that calculated in Requirement a.

Scenario 2: Assume that Coca-Colas long-run growth will be 4%, not 3% as above, and that Coca-Colas required rate of return on equity is 1% lower than that calculated in Requirement 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 Requirement e.g. Using these data at the end of 2015, 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 Requirement e of that problem (using the free cash ows to common equity share-holders valuation approach) with the value estimate you obtained here using the residual income valuation approach. The value estimates should be the same. If you have not completed Problem 12.16, you would benet from doing so now.