Renowned Cola, Inc.'s 2011 annual report explains that Renowned Cola's investments are expected to generate cash returns that exceed its "long-term cost of capital", which Renowned Cola estimated to be approximately 13% at year-end 2011. Renowned Cola has three main lines of business, soft drinks, notably Dr. Cola; snack foods, such as Fritos; and restaurants. Restaurant investments have a beta of 0.80 and a debt-to-firm value ratio is 0.31. Renowned Cola did not report costs of capital separately for these three businesses. Below, we have available year-end data for 2011 provided by Renowned Cola.
Renowned Cola’s Items Values (M = millions)
Cash and marketable securities $3,000 book value ($ 2,500 market value - assumed)
Short-term debt (to be liquidated in 3 days) $750M book value ($700 market value - assumed)
Long-term debt $9,500M book value ($8,000 market value - assumed)
Common shares outstanding 950M
Year-end share price
Dividends per share
Company’s Growth Rate
Adjusted Growth Rate $75.25
$8.75 (constant dividend policy over the last three years)
4.5% (growth rate for 2010)
3.5% (adjusted rate after considered IMF economic outlook)
Income tax rate 35%
Renowned Cola's beta 1.75
Long-term borrowing rate 8.75%
Short-term riskless rate 3.15%
Intermediate-term riskless rate 4.70%
Long-term riskless rate 4.95%
Short-term market return 4.50%
Intermediate-term market risk premium 7.50%
Long-term market return 6.25%
Given the above information, answer the below questions.
(1) Calculate the market value of Renowned Cola's debt at year-end 2011. What is the book value of debt? Why do usually use market or book values for debt? Support your answer with appropriate examples and explanations.
(2) To the nearest million, calculate the market value of Renowned Cola's stockholders' equity at year-end 2011.
(3) Renowned Cola subtracts the value of its short-term debt from its total debt when calculating its "net debt ratio." Renowned Cola believes that the market values for its traded debt are not accurate because the bonds trade infrequently. Given this belief and their treatment of short-term debt, compute Renowned Cola's net debt ratio using book values or market values, as you consider appropriate. Justify your choice and its implications.
(4) Compute L keeping the short-term debt as part of total debt. Discuss your result and identify which net debt ratio you have considered more appropriate to assess Renowned Cola’s Capital structure.Considering a long-term capital investment project, which WACC would you use and why? You can assume that the asset's risk profile for the project mirrors Renowned Cola's overall risk profile.
(5) Should Renowned Cola use its overall cost of capital to evaluate its restaurant capital investments? Under what circumstances would it be correct to do so? With the information available, can you calculate an initial cost of capital for long term investments for the restaurant?
(6) Compute Renowned Cola Share Price value suing the Gordon Growth model. Interpret your results.