Coca-Cola (KO) is the world's largest producer of soft-drink concentrates, syrups, and juices.Its soft-drink brands include Coke, Diet Coke, Cherry Coke, Sprite, Tab, Nestea, and Barq's.The firm sells about 59% of its concentrates and syrups to company-owned and independent bottlers in the United States and abroad, who distribute them to end users.Coca-Cola also makes fruit juices sold under names like Minute Maid.For the first time in its history, Coca-Cola launched a lemon-flavored alcoholic drink in the southwestern island of Kyushu in Japan.Coca-Cola's drink, called Lemon-Do, will be available with 3%, 5%, and 7% alcohol, placing itself in a highly competitive market comprised of giants such as Suntory, Kirin, and Asahi.

All eight (10) questions are worth 10 points each (10 x 10 = 100 points).You MUST show all of your calculation in the questions below is order to receive credit for any numerical answers.

Two-Stage Dividend Discount Model

Follow the Two-Stage DDM method for estimating stock price as presented in class.If you need a further review, remember that you studied the Two-Stage DDM in F371.

Q1.

The First Step in using the Two-Stage DDM is to estimate an annual expected first-stage growth rate in dividends during stage 1, g1, AND the number of years, N, that you expect the first stage to persist.Two (2) popular methods for estimating g1 that were discussed in class are:

A. (Method 1):Form an estimate for g1, the growth rate in dividends based on the average annual historical growth in dividends over the past five (5) years.The assumption in Method 1 is that the historical average growth rate in dividends over the past five years is a good estimate for g1 over the number of years, N, that you have assumed for stage 1.

B. (Method 2): Use the formula provide in the AAII article "Methods for Valuing a Stock" for estimating the sustainable growth rate* in EACH of the past five years (formula is shown below) then take a simple average of these five annual sustainable growth estimates in order to arrive at a second estimate for g1.

*sustainable growth rate = ROE x retention ratio

The assumption in Method 2 is that the historical average sustainable growth rate, which is essentially the expected sustainable growth rate in net income for a given level of ROE and a given retention ratio, is a good estimate for g1 (the growth rate in dividends).The sustainable growth rate formula assumes the capital structure remains constant and no new common stock is issued.You were introduced to this concept in F371.

SELECT the ONE (1) single estimate from Q1A and Q1B above that YOU believe is the most appropriate value of g1 for valuing KO using the Two-Stage DDM.Further, LIST the number of years, N, you expect g1 to persist.Provide a short paragraph (at least three sentences) that EXPLAINS your reasoning for selecting these values of g1 AND N.

*Key Learning Point:Any estimate of the future growth in dividends will never equal the actual growth in dividends. All financial valuation estimates are subject to forecast error, which is also referred to as estimation risk.

Q2.

The Second Step in using the Two-Stage DDM is to estimate an annual required return on equity, Re.For this assignment, assume that Re remains constant in stage 1 and stage 2.Three (3) popular methods for estimating Re that were discussed in class are:

A. (Method 1): Calculate the arithmetic average of the historical annual returns over the past five (5) years.The assumption in Method 1 is that the historical average annual return is a good estimate of future annual returns. This is not a law of nature.It is an assumption.To do this you will need to calculate annual total returns from the most recent 5-year period using Monthly Historical Prices.Calculate the annual total returns based on the December-ending Adj Close* price found under Historical Prices on the www.finance.yahoo.com website.

Annual Total Return = [Adj Close* Price December (t) - Adj Close* Price December (t-1)] / Adj Close* Price December (t-1)

Example:

Annual Total Return 2017 = [Adj Close* Price December 2017 - Adj Close* Price December 2016] / Adj Close* Price December 2016

The Adj Close* price is adjusted for dividends and splits, so this price is all that you need to calculate a total return.

B. (Method 2): Use the CAPM to estimate Re.The assumption in Method 2 is that the CAPM is an appropriate required return generating model.We know, however, there are other models, such as the Fama-French Three-Factor Model.

CAPM:E(Re) = Rf + Beta x [E(Rm) - Rf]

As you know, the CAPM requires an estimate of Rf, Beta and an appropriate expected Market Risk Premium (MRP = E(Rm) - Rf).Once again, more estimation risk!For this assignment, ASSUME that:

i)Rf = 3.00%

ii) Beta for KO = .80

iii) MRP = [E(Rm) - Rf) = 5.50%

*IMPORTANT:Keep in mind that you are estimating a value for Re the will hold forever (or at least over the life of the firm).As such, current values for Rf, Beta and MRP MAY NOT BE APPROPRIATE for the long-term. You will see the effect of estimation risk in Q4.

C. (Method 3) Add a 2% - 4% equity risk premium (ERP) to the Yield to Maturity (YTM) on a KO long-term bond that has AT LEAST 20 years to maturity.The assumption in Method 3 is that the required return on equity MUST be greater than the required return on debt for any firm.If KO does not have a 20-year+ bond outstanding, then add 2% - 4% to the YTM on a 20-year+ corporate bond with the same bond rating (i.e. A, AA, or AAA). You must find the YTM on a KO 20-year+ bond or the YTM on a comparable corporate 20-year+ bond.

IMPORTANT:Realize that any risky 20-year corporate bond must have a YTM that is greater than the YTM on a risk-free 20-year Treasury bond.So, DO NOT list the YTM on a KO or risk equivalent 20+ coporate bond as being less than the YTM on a 20-year Treasury bond!

Websites for bond information:

FINRA Bond Market Data

www.finra.org/marketdata

FINRA is an independent regulator for the securities industry.In the bonds section of the Market Data Center, you can get general bond market information, as well as price information with intraday transaction prices (delayed 15 minutes) for corporate bonds, municipal bonds, U.S. Treasury and government agency bonds.A bond screen lets you search by issuer name, CUSIP, type, maturity, yield, coupon type, trade activity and other criteria.

Click on Bonds.

Click on Search.

Click on Corporate in the Quick Search box.

Type Coca Cola in the Issuer Name box (not KO).

E. SELECT the ONE (1) single estimate of Re from Q2A - Q2D above that YOU believe is the most appropriate for valuing KO using the Two-Stage DDM and provide a short paragraph (at least three sentences) that EXPLAINS your reasoning.

Q3.Estimate a second stage (also called the stable stage) growth rate in dividends, g2, for use in the Two-Stage DDM.Your estimate for g2 is the growth rate that you expect will continue "forever" in the second stage.Your estimate for g2 should not be much greater than the expected future growth in the overall economy (expected growth in GDP).Why?LIST your estimate for g2 and provide a short paragraph that EXPLAINS your reasoning AND the source of your estimate for long-term growth in GDP.Finally, estimate and LIST a price per share for KO using your estimates for g1, N, Re, g2 and KO's current annual dividend (most recent quarterly dividend x 4) as D(0) in the Two-Stage DDM (show your work or provide a screen shot of your spreadsheet).

Q4.Perform Sensitivity Analysis (SA) on your estimated price per share in by varying EACH of your three (3) estimated input parameters (g1, g2 and Re) by +/- 2.0 percent in .5 percent increments while holding the other two parameters constant.Next, using your original estimates for g1, g2 and Re, double your estimate for the number of g1 years, N, and calculate a new price for KO.Provide two (2) short paragraphs (at least three sentences in each paragraph) that LISTS and DISCUSSES your results.That is, describe in words how your value estimates change as you change your growth estimates, discount rate estimate and your estimate for N.Always remember that estimates are nothing more than estimates and subject to forecast error.This is why 1000 analysts can easily arrive at 1000 different estimates of value.

* LIST:Write out the specific value.

*SHOW:Provide a spreadsheet or hand-written copy of your calculations.

*EXPLAIN:Provide verbal statement that supports your estimate(s).

*DISCUSS:Describe your results in words.Do not simply just list your numerical results.

*JUSTIFY:Provide sources of information, methods used to form assumptions and data used for estimating input variables.