Valuation Exercise Scharfinkel had been exposed to the residual income valuation approach during her MBA, and recalled the following list of the major steps that would be required: Obtain the balance sheet and income statement from the firm's 10-K Create a condensed balance sheet and income statement Derive the key assumptions for forecasting Calculate the valuation Scharfinkel had already obtained the balance sheet and income statement for Coca-Cola (see Exhibits la and 1b). She had also prepared a condensed balance sheet and income statement (see Exhibits 2a and 2b), and derived a list of the key assumptions necessary to forecast the valuation (see Exhibit 3). To simplify the valuation exercise for her audience, she had only forecast two years and considered the period after that as the terminal value period. Scharfinkel recognized that her audience would be unfamiliar with the steps used in the valuation process. As such, she would have to elaborate on the role each step played. This would include discussing the benefits of standardizing the firm's financial statements in a condensed form. Then, she would have to perform the remaining step of calculating the valuation. Scharfinkel knew that to convince her audience on the merits of this calculation, she would also need to build up the pro forma balance sheets and income statements for the forecasted years. Further, since she knew that her audience would have likely used the more familiar discounted cash flow method, she would have to demonstrate how it mapped into the DCF approach. BALANCE SHEET December 31, 2009 December 31, 2010 $ 9,409 3,758 2,354 2,030 17,551 11,511 4,430 2,650 2,988 21,579 11,441 12,828 6,755 31,024 $ 48,575 16,672 26,909 7,663 51,244 $ 72,823 ASSETS Cash and Marketable Securities Accounts Receivable Inventory Other Currents Assets TOTAL CURRENT ASSETS Long-Term Tangible Assets Long-Term Intangible Assets Other Long-Term Assets TOTAL LONG-TERM ASSETS TOTAL ASSETS LIABILITIES Accounts Payable Short-Term Debt Other Current Liabilities TOTAL CURRENT LIABILITIES Long-Term Debt Deferred Taxes Other Long-Term Liabilities TOTAL LONG-TERM LIABILITIES SHAREHOLDERS' EQUITY Minority Interest Common Shareholders' Equity (2,303 and 2,292 million shares outstanding) TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 1,410 6,800 5,511 13,721 1,887 9,376 7,245 18,508 5,059 1,484 2,965 9,508 14,041 4,163 4,794 22,998 547 24,799 $ 48,575 314 31,003 $ 72,823 INCOME STATEMENT December 31, 2008 December 31, 2009 December 31, 2010 For the years ended SALES Cost of Goods Sold GROSS PROFIT Selling, General, and Administrative Other Operating Expenses OPERATING INCOME Other Income Other Expense Interest Income Interest Expense Minority Interest PRETAX INCOME Tax Expense Unusual Gains, Net of Unusual Losses NET INCOME Source: Capital IQ $ 31,944 10,146 21,798 11,774 1,283 8,741 53 (1,976) 333 (438) 0 6,713 1,632 726 $ 5,807 $ 30,006 9,864 21,142 11,381 1,343 8,418 92 (253) 249 (341) (82) 8,083 2,040 781 $ 6,824 $ 35,200 11,234 23,966 13,179 1,703 9,084 5,312 (887) 317 (608) (50) 13,168 2,384 1,025 $ 11,809 As of January 1, 2009 January 1, 2010 January 1, 2011 $ $ $ Beginning Net Working Capital Beginning Net Long-Term Assets NET OPERATING ASSETS 740 24,065 24,805 1,221 26,028 27,249 936 41,973 42,909 Net Debt Preferred Stock Shareholders' Equity NET CAPITAL 4,333 0 20,472 24,805 2,450 0 24,799 27,249 11,906 0 31,003 42,909 $ $ $ Exhibit 2b Coca-Cola, Condensed Income Statement (in $ millions) For the year ending December 31, 2008 December 31, 2009 December 31, 2010 Sales $ 31,944 $ 31,006 $ 35,200 NOPAT Net Interest Expense After Tax NET INCOME Less: Preferred Dividends NET INCOME TO COMMON SHAREHOLDERS Source: Casewriter. 5,886 79 5,807 0 $ 5,807 6,892 69 6,824 0 6,824 12,047 238 11,809 0 $ 11,809 $ Exhibit 3 Coca-Cola, Forecasting Assumptions Panel A. Cost of Capital Parameters Market Risk Premium Risk-Free Rate Tax Rate Cost of Debt Common Equity Beta 5.0% 3.0% 35.0% 4.5% 0.6 2011 10.0% 20.0% Panel B. Future Performance Forecasts Sales Growth Rate NOPAT/ Sales Beginning Net Operating Working Capital / Sales Beginning Net Operating Long-Term Assets / Sales Net Debt / Book Value of Net Capital Preferred Equity / Book Value of Net Capital Shareholders' Equity / Book Value of Net Capital Source: Casewriter. 2012 8.0% 20.0% 3.0% 105.0% Terminal 3.0% 15,0% 3.0% 100.0% 27.75% 0.0% 72.25% 27.75% 0.0% 72.25% 27.75% 0.0% 72.25% Valuation Exercise Scharfinkel had been exposed to the residual income valuation approach during her MBA, and recalled the following list of the major steps that would be required: Obtain the balance sheet and income statement from the firm's 10-K Create a condensed balance sheet and income statement Derive the key assumptions for forecasting Calculate the valuation Scharfinkel had already obtained the balance sheet and income statement for Coca-Cola (see Exhibits la and 1b). She had also prepared a condensed balance sheet and income statement (see Exhibits 2a and 2b), and derived a list of the key assumptions necessary to forecast the valuation (see Exhibit 3). To simplify the valuation exercise for her audience, she had only forecast two years and considered the period after that as the terminal value period. Scharfinkel recognized that her audience would be unfamiliar with the steps used in the valuation process. As such, she would have to elaborate on the role each step played. This would include discussing the benefits of standardizing the firm's financial statements in a condensed form. Then, she would have to perform the remaining step of calculating the valuation. Scharfinkel knew that to convince her audience on the merits of this calculation, she would also need to build up the pro forma balance sheets and income statements for the forecasted years. Further, since she knew that her audience would have likely used the more familiar discounted cash flow method, she would have to demonstrate how it mapped into the DCF approach. BALANCE SHEET December 31, 2009 December 31, 2010 $ 9,409 3,758 2,354 2,030 17,551 11,511 4,430 2,650 2,988 21,579 11,441 12,828 6,755 31,024 $ 48,575 16,672 26,909 7,663 51,244 $ 72,823 ASSETS Cash and Marketable Securities Accounts Receivable Inventory Other Currents Assets TOTAL CURRENT ASSETS Long-Term Tangible Assets Long-Term Intangible Assets Other Long-Term Assets TOTAL LONG-TERM ASSETS TOTAL ASSETS LIABILITIES Accounts Payable Short-Term Debt Other Current Liabilities TOTAL CURRENT LIABILITIES Long-Term Debt Deferred Taxes Other Long-Term Liabilities TOTAL LONG-TERM LIABILITIES SHAREHOLDERS' EQUITY Minority Interest Common Shareholders' Equity (2,303 and 2,292 million shares outstanding) TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 1,410 6,800 5,511 13,721 1,887 9,376 7,245 18,508 5,059 1,484 2,965 9,508 14,041 4,163 4,794 22,998 547 24,799 $ 48,575 314 31,003 $ 72,823 INCOME STATEMENT December 31, 2008 December 31, 2009 December 31, 2010 For the years ended SALES Cost of Goods Sold GROSS PROFIT Selling, General, and Administrative Other Operating Expenses OPERATING INCOME Other Income Other Expense Interest Income Interest Expense Minority Interest PRETAX INCOME Tax Expense Unusual Gains, Net of Unusual Losses NET INCOME Source: Capital IQ $ 31,944 10,146 21,798 11,774 1,283 8,741 53 (1,976) 333 (438) 0 6,713 1,632 726 $ 5,807 $ 30,006 9,864 21,142 11,381 1,343 8,418 92 (253) 249 (341) (82) 8,083 2,040 781 $ 6,824 $ 35,200 11,234 23,966 13,179 1,703 9,084 5,312 (887) 317 (608) (50) 13,168 2,384 1,025 $ 11,809 As of January 1, 2009 January 1, 2010 January 1, 2011 $ $ $ Beginning Net Working Capital Beginning Net Long-Term Assets NET OPERATING ASSETS 740 24,065 24,805 1,221 26,028 27,249 936 41,973 42,909 Net Debt Preferred Stock Shareholders' Equity NET CAPITAL 4,333 0 20,472 24,805 2,450 0 24,799 27,249 11,906 0 31,003 42,909 $ $ $ Exhibit 2b Coca-Cola, Condensed Income Statement (in $ millions) For the year ending December 31, 2008 December 31, 2009 December 31, 2010 Sales $ 31,944 $ 31,006 $ 35,200 NOPAT Net Interest Expense After Tax NET INCOME Less: Preferred Dividends NET INCOME TO COMMON SHAREHOLDERS Source: Casewriter. 5,886 79 5,807 0 $ 5,807 6,892 69 6,824 0 6,824 12,047 238 11,809 0 $ 11,809 $ Exhibit 3 Coca-Cola, Forecasting Assumptions Panel A. Cost of Capital Parameters Market Risk Premium Risk-Free Rate Tax Rate Cost of Debt Common Equity Beta 5.0% 3.0% 35.0% 4.5% 0.6 2011 10.0% 20.0% Panel B. Future Performance Forecasts Sales Growth Rate NOPAT/ Sales Beginning Net Operating Working Capital / Sales Beginning Net Operating Long-Term Assets / Sales Net Debt / Book Value of Net Capital Preferred Equity / Book Value of Net Capital Shareholders' Equity / Book Value of Net Capital Source: Casewriter. 2012 8.0% 20.0% 3.0% 105.0% Terminal 3.0% 15,0% 3.0% 100.0% 27.75% 0.0% 72.25% 27.75% 0.0% 72.25% 27.75% 0.0% 72.25%