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 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 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 outstanding

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 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.

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 common

equity using the midyear discounting adjustment factor.

(4) Compute the per-share value estimate.

Part IISensitivity Analysis and Recommendation

f. 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 flows to common equity shareholders

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 benefit from doing so now.