FREE-CASH-FLOWS-BASED VALUATION. The Coca-Cola Company is a global soft drink beverage company (ticker symbol = KO) that is a primary and direct com- petitor with PepsiCo. The data in Exhibits 12.13-12.15 (see pages 980-983) include the actual amounts for 2006, 2007, and 2008 and projected amounts for Year +1 to Year +6 for the income statements, balance sheets, and statements of cash flows for Coca-Cola (in millions). The market equity beta for Coca-Cola at the end of 2008 is 0.61. Assume that the risk-free interest rate is 4.0 percent and the market risk premium is 6.0 percent. Coca-Cola has 2,312 million shares outstanding at the end of 2008, when Coca-Cola's share price was $44.42.
Required:
Part I-Computing Coca-Cola's Share Value Using Free Cash Flows to Common Equity Shareholders
a. Use the CAPM to compute the required rate of return on common equity capital for Coca-Cola.
b. Derive the projected free cash flows for common equity shareholders for Coca-Cola for Years +1 through +6 based on the projected financial statements. Assume that Coca-Cola's changes in cash each year are necessary for operating liquidity purposes. The financial statement forecasts for Year +6 assume that Coca-Cola will experience a steady-state long-run growth rate of 3 percent in Year +6 and beyond.
c. Using the required rate of return on common equity from Part a as a discount rate, compute the sum of the present value of free cash flows for common equity share- holders for Coca-Cola for Years +1 through +5.
d. Using the required rate of return on common equity from Part a as a discount rate and the long-run growth rate from Part b, compute the continuing value of Coca- Cola as of the start of Year +6 based on Coca-Cola's continuing free cash flows for common equity shareholders 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 future free cash flows for equity shareholders (from Parts c and d). (2) Adjust the total sum of the present value using the midyear dis- counting adjustment factor. (3) Compute the per-share value estimate.
Part II-Computing Coca-Cola's Share Value Using Free Cash Flows to All Debt and Equity Stakeholders
f. At the end of 2008, Coca-Cola had $9,312 million in outstanding interest-bear- ing short-term and long-term debt on the balance sheet and no preferred stock. Assume that the balance sheet value of Coca-Cola's debt is approximately equal to the market value of the debt. The forecasts assume that Coca-Cola will face an interest rate of 4.5 percent on debt capital and that Coca-Cola's average tax rate will be 23.2 percent (based on the past five-year average effective tax rate). Compute the weighted average cost of capital for Coca-Cola as of the start of Year +1.
g. Beginning with projected net cash flows from operations, derive the projected free cash flows for all debt and equity stakeholders for Coca-Cola for Years +1 through +6 based on the projected financial statements. Assume that the change in cash each year is related to operating liquidity needs.
h. Using the weighted average cost of capital from Part f as a discount rate, compute the sum of the present value of free cash flows for all debt and equity stakeholders for Coca-Cola for Years +1 through +5.
i. Using the weighted average cost of capital from Part f as a discount rate and the long-run growth rate from Part b, compute the continuing value of Coca-Cola as of the start of Year +6 based on Coca-Cola's continuing free cash flows for all debt and equity stakeholders in Year +6 and beyond. After computing continuing value as of the start of Year +6, discount it to present value as of the start of Year +1.
j. Compute the value of a share of Coca-Cola common stock. (1) Compute the total value of Coca-Cola's net operating assets using the total sum of the present value of free cash flows for all debt and equity stakeholders (from Parts h and i). (2) Subtract the value of outstanding debt to obtain the value of equity. (3) Adjust the present value of equity using the midyear discounting adjustment factor. (4) Compute the per-share value estimate of Coca-Cola's common equity shares.
Note: Do not be alarmed if your share value estimate from Part e is slightly different from your share value estimate from Part j. The weighted average cost of capital computation in Part f used the weight of equity based on the market price of Coca-Cola's stock at the end of 2008. The share value estimates from Parts e and j likely differ from the market price, so the weights used to compute the weighted average cost of capital are not internally consistent with the estimated share values.
Part III-Sensitivity Analysis and Recommendation
k. Using the free cash flows to common equity shareholders, recompute the value of Coca-Cola shares under two alternative scenarios. Scenario 1: Assume that Coca- Cola's long-run growth will be 2 percent, not 3 percent as before, and assume that Coca-Cola's required rate of return on equity is 1 percent higher than the rate you computed for Part a. Scenario 2: Assume that Coca-Cola's long-run growth will be 4 percent, not 3 percent as before, and assume that Coca-Cola's required rate of return on equity is 1 percent lower than the rate you computed in Part 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 Part e.
l. Using these data at the end of 2008, 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 investment strategy (buy, hold, or sell) would you have recommended?
Text Book: Financial Reporting, Financial Statement Analysis and Valuation: A Strategic Perspective By James Wahlen, Stephen Baginski, Mark Bradshaw.