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 PepsiCo. The data in Chapter 12s Exhibits 12.14, 12.15, and 12.16 (pages 943946) include the actual amounts for 2010, 2011, and 2012 and projected amounts for Year 1 to Year 6 for the income statements, balance sheets, and statements of cash flows, respectively, for Coca-Cola. The market equity beta for Coca-Cola at the end of 2012 is 0.75. Assume that the risk-free inter- est rate is 3.0% and the market risk premium is 6.0%. Coca-Cola had 4,469 million shares out- standing at the end of 2012, when Coca-Colas share price was $35.48.

Part IComputing Coca-Colas Share Value Using the Residual Income Valuation Approach

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

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% in Year 6 and beyond.

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

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, dis- count it to present value at the start of Year 1.

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 2012, or the start of Year1).

(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 IISensitivity Analysis and Recommendation

Using the residual income valuation approach, recompute 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 calcu- lated 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.

Using these data at the end of 2012, 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?

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 flows to common equity share- holders 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.

Forecasts 2010 2011 2012 Year +1 Year +2 Year +3 Year +4 Year +5 Year +6 Accounts payable-trade Current accrued liabilities Notes payable and short-term debt 8,100 12,871 16,297 17,113 18,118 19,158 20,233 21,347 21,987 Current maturities of long-term debt 1,276 2,041 1,577 1,656 1,753 1,854 1,958 2066 2128 Income taxes payable Liabilities of segments held for sale $ 1,887 $ 2,172 $ 1,969 $ 2,222 $ 2,339 $ 2456 $ 2,579 $ 2,708 2,789 6,972 6,837 6,711 7,0477,399 7,769 8,157 8,565 8,822 362 471 448 470 492 515 538 554 Current Liabilities Long-term debt 5 18,508 $24.283 $27,821 $28,485 $ 30,079 $31.729 33,442 35.223 36280 14,041 13,656 14,736 15,474 16,383 17,323 18,295 19302 19,88 rred tax liabilities-noncurrent 4.261 4,694 4,981 5,181 5433 5,690 5,953 6221 6408 4,794 5420 5,46857460286330 6646 69797,188 69,757 Other noncurrent liabilities 41.604 $48,053 $53,006 $54,881 $57,923 $61,072 $ $41,604 $48.053 3,006 554881 57923 $612 643 62225 69757 Total Liabilities 64,337 $ 67,725 $ SHAREHOLDERS' EQUITY 12092 $ 13,139 $ 13,665 $ 14,331 $ 15,011 $ 15703 16410 16,902 Common stock+ paid-in capital $ 10.937 Retained earnings Accum. other comprehensive s 14,331 $ 15,011 $ 15,703 S 16410 s 16,902 49,278 53,621 58,045 62,369 66,917 71,688 76,695 81,950 84409 (1450) (2.774) (3,385) (3,385) (3,385) (3385) (3,385) (3,385) (3,385) 737) (55,450) (57,215) income (loss) reasury stock Noncontrolling interests (27,762) (31,304) (35,009) (38,283) (42,170) (46,315) Treasury stock Common Shareholders' Equity $ 31,003 $ 31,635 $ 32.790 $ 34,367 $ 35,693 $ 36.999 38277 $ 39,525 40,711 Total Equity Total Liabilities and Equities $72.921 $79974 $86,174 $89,626 $93,995 $98,449 $102.992 $107.629 $110.857 314 286 378 378378 378 31,317 $31,921 $33,168 $34,745 $36,071 $37.377 378 378 389 38,655 $ 39,903 $ 41.100 Source for Actuals: The Coca-Cola Company. Form 10-K for the Fiscal Year Ended December 31, 2012 Forecasts 2010 2011 2012 Year +1 Year +2 Year +3 Year +4 Year +5 Year +6 Accounts payable-trade Current accrued liabilities Notes payable and short-term debt 8,100 12,871 16,297 17,113 18,118 19,158 20,233 21,347 21,987 Current maturities of long-term debt 1,276 2,041 1,577 1,656 1,753 1,854 1,958 2066 2128 Income taxes payable Liabilities of segments held for sale $ 1,887 $ 2,172 $ 1,969 $ 2,222 $ 2,339 $ 2456 $ 2,579 $ 2,708 2,789 6,972 6,837 6,711 7,0477,399 7,769 8,157 8,565 8,822 362 471 448 470 492 515 538 554 Current Liabilities Long-term debt 5 18,508 $24.283 $27,821 $28,485 $ 30,079 $31.729 33,442 35.223 36280 14,041 13,656 14,736 15,474 16,383 17,323 18,295 19302 19,88 rred tax liabilities-noncurrent 4.261 4,694 4,981 5,181 5433 5,690 5,953 6221 6408 4,794 5420 5,46857460286330 6646 69797,188 69,757 Other noncurrent liabilities 41.604 $48,053 $53,006 $54,881 $57,923 $61,072 $ $41,604 $48.053 3,006 554881 57923 $612 643 62225 69757 Total Liabilities 64,337 $ 67,725 $ SHAREHOLDERS' EQUITY 12092 $ 13,139 $ 13,665 $ 14,331 $ 15,011 $ 15703 16410 16,902 Common stock+ paid-in capital $ 10.937 Retained earnings Accum. other comprehensive s 14,331 $ 15,011 $ 15,703 S 16410 s 16,902 49,278 53,621 58,045 62,369 66,917 71,688 76,695 81,950 84409 (1450) (2.774) (3,385) (3,385) (3,385) (3385) (3,385) (3,385) (3,385) 737) (55,450) (57,215) income (loss) reasury stock Noncontrolling interests (27,762) (31,304) (35,009) (38,283) (42,170) (46,315) Treasury stock Common Shareholders' Equity $ 31,003 $ 31,635 $ 32.790 $ 34,367 $ 35,693 $ 36.999 38277 $ 39,525 40,711 Total Equity Total Liabilities and Equities $72.921 $79974 $86,174 $89,626 $93,995 $98,449 $102.992 $107.629 $110.857 314 286 378 378378 378 31,317 $31,921 $33,168 $34,745 $36,071 $37.377 378 378 389 38,655 $ 39,903 $ 41.100 Source for Actuals: The Coca-Cola Company. Form 10-K for the Fiscal Year Ended December 31, 2012