# principles and skills associated with valuation approaches

# The purpose of this assignment is to apply principles and skills associated with valuation approaches. Using what you have learned from the topic resources, complete the following problems and cases f

13.19 Residual Income Valuation.

The Coca-Cola Company is a global softdrink beverage company (ticker: KO) that is a primary and direct competitor with Starbucks.The data in Chapter 12’s Exhibits 12.14, 12.15, and 12.16 (pages 806–809) include the actualamounts for 2013, 2014, and 2015 and projected amounts for Year þ1 to Year þ6 for theincome statements, balance sheets, and stateme nts 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 inter-est rate is 3.0% and the market risk premium is 6.0%. Coca-Cola had 4,324 million shares out-standing at the end of 2015, when Coca-Cola’s share price was $42.96.REQUIREDREQUIREDPart I—Computing Coca-Cola’s Share Value Using the Residual Income Valuation Approacha. Use the CAPM to compute the required rate of return on common equity capital forCoca-Cola.b. Derive the projected resid ual income for Coca-Cola for Years þ1 through þ6 based onthe projected ﬁnancial statements. The ﬁnancial stateme nt forecasts for Year þ6 assumethat Coca-Cola will experience a steady-state, long-run growth rate of 3% in Year þ6 andbeyond.c. Using the required rate of return on common equity from Requirement a as a discountrate, compute the sum of the present value of residual income for Coca-Cola for Yearsþ1 through þ5.d. Using the required rate of return on common equi ty from Requirement a as a discountrate and the long-run growth rate from Requirement b, compute the continuing value ofCoca-Cola as of the start of Year þ6 based on Coca-Cola’s continuing residual income inYear þ6 and beyond. After computing continuing value as of the start of Year þ6, dis-count it to present value at the start of Year þ1.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 Requirementsc and d).(2) Add the book value of equity as of the beginning of the valuation (that is, as of theend of 2015, or the start of Year þ1).(3) Adjust the total sum of the present value of residual income plus book value of com-mon equity using the midyear discounting adjustment factor.(4) Compute the per-share value estimate

Part II—Sensitivity Analysis and Recommendation. Using the residual income valuation approach, compute the value of Coca-Cola sharesunder two alternative scenarios. Scenario 1: Assume that Coca-Cola’s long-run growth will be 2%, not 3% as above,and that Coca-Cola’s required rate of return on equity is 1% higher than that calcu-lated in Requirement a.Scenario 2: Assume that Coca-Cola’s long-run growth will be 4%, not 3% as above,and that Coca-Cola’s required rate of return on equity is 1% lower than that calculatedin Requirement a.To quantify the sensitivity of your share value estimate for Coca-Cola to these variationsin growth and discount rates, compare (in percentage terms) your value estimates underthese 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 youhave expected for Coca-Cola common stock? At that time, what was the market price forCoca-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 obtainedin Requirement e of that problem (using the free cash ﬂows to common equity share-holders valuation approach) with the value estimate you obtained here using the resid-ual income valuation approach. The value estimates should be the same. If you have notcompleted Problem 12.16, you would beneﬁt from doing so now

14.18 Interpreting Market-to-Book Ratios. Exhibit 14.10 presents data onmarket-to-book (MB) ratios, ROCE, the cost of equity capital, and price-earnings (PE) ratios forseven pharmaceutical companies. (No te that PE ratios for these ﬁrms typically fall in the 30–35range.) Exhibit 14.10 also provides historical data on the ﬁve-year average rate of grow th inearnings and dividend payout ratios for each ﬁrm. The data on excess earnings years representthe number of years that each ﬁrm would need to earn a rate of return on common sharehold-ers’ equity (ROCE) equal to that in Exhibit 14.10 in order to produce value-to-book ratios thatequal the market-to-book ratios shown. For example, Bristol-Myers Squibb would need toearn an ROCE of 48.9% for 58.3 years in order for the present value of the excess earnings overthe cost of equity capital to produce a value-to-book ratio that matches the market-to-bookratio of 13.9.REQUIREDREQUIREDAssume that market share prices for each ﬁrm are reasonably efﬁcient. That is, do not simplyassume that the market has over- or undervalued these ﬁrms. Considering the theoretical deter-minants of the market-to-book ratio, discuss the likely reasons for the relative ordering of theseseven companies on their market-to -book ratios

14.20 Market Multiples and Reverse Engineering Share Prices. In2000, Enron enjoyed remarkable success in the capital markets. During that year, Enron’sshares increased in value by 89%, while the S&P 500 index fell by 9%. At the end of 2000,Enron’s shares were trading at roug hly $83 per share, and all of the sell-side analysts followingEnron recommended the shares as a ‘‘buy’’ or a ‘‘strong buy.’’ With 752.2 million shares out-standing, Enron had a market capitalization of $62,530 million and was one of the largest ﬁrms(in terms of market capital) in the United States. At year-end 2000, Enron’s book value of com-mon shareholders’ equity was $11,470 million . At year-end 2000, Enron posted earnings pershare of $1.19. Among sell-side analysts followi ng Enron, the consensus forecast for earningsper share was $1.31 per share for 2001 and $1.44 per share for 2002, with 10% earnings growthexpected from 2003 to 2005. At the time, Enron was paying dividends equivalent to roughly40% of earnings and was expected to maintain that payout policy. At year-end 2000, Enron hada market beta of 1.7. The risk-free rate of return was 4.3%, and the market risk premium wasLO 14-4Questions, Exercises, Pr oblems, and Cases 907Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.5.0%. (Note: The data provided in this problem, and the inference s you draw from them, do notdepend on foresight of Enron’s declaring bankruptcy by the end of 2001.)REQUIREDREQUIREDa. Use the CAPM to compute the required rate of return on common equity capital forEnron.b. Use year-end 2000 data to compute the following ratios for Enron:(1) Market-to-book(2) Price-earnings (using 2000 earnings per share)(3) Forward price-earnings (using consensus forecast earnings per share for 2001)c. Reverse engineer Enron’s $83 share price to solve for the impli ed expected return onEnron shares at year-end 2000. Do the reverse engineering under the followingassumptions:(1) Enron’s market price equals value.(2) The consensus analysts’ earnings-per-share forecasts through 2005 are reliable prox-ies for market expectations.(3) Enron will maintain a 40% dividend payout rate.(4) Beyond 2005, Enron’s long-run earnings growth rate will be 3.0%.d. What do these analyses suggest about investing in Enron’s shares at a price of $83? © Cengage