Coca-Cola (KO) is the world’s largest producer of soft-drink concentrates, syrups, and juices. Its soft-drink brands include Coke, Diet Coke, Cherry Coke, Sprite, Tab, Nestea, and Barq’s. The firm sells about 59% of its concentrates and syrups to company-owned and independent bottlers in the United States and abroad, who distribute them to end users. Coca-Cola also makes fruit juices sold under names like Minute Maid.

Follow the Two-Stage DDM method presented in class in order to answer the following question. You MUST show all of your calculation in the question below is order to receive credit for any numerical answers. All six questions are worth 16 points each (6 x 16 = 96 points + 3 free point for turning in A2).

Two-Stage Dividend Discount Model (DDM)

Q1. The first step in using the Two-Stage DDM is to estimate a first-stage growth rate in dividends (g1) and the period that you expect the g1 level of growth to persist. One way to estimate g1 is to base your estimate on the most recent historic growth in dividends over the past five (5) years. You can use most recent 5-year growth rate in dividends as your estimate for g1 OR you may revise it based on any other information you feel is relevant (new products, increased competition, etc.). LIST your estimate for g1, the period (number of years) you expect it to persist and EXPLAIN your reasoning. An important learning point here is that any estimate of future growth will generally NEVER equal the actual growth that results after time passes. All financial valuation estimates are subject to forecast error, which is also referred to as estimation risk.

Q2. The second step is to estimate a required return on equity, Re, for use in the Two-Stage DDM. While not absolutely necessary, most analysts assume that Re remains constant in stage 1 and stage 2. Two often used methods for estimating Re is use 1) the CAPM and 2) by adding a 3-5% equity risk premium to the YTM on bond that has at least 20 years to maturity. If KO does not have a 20 year bond outstanding, then add 3-5% to the YTM on a 20 year corporate bond with the same bond rating (i.e. A, AA, or AAA). You must find the YTM on a KO 20-year bond or the YTM on a comparable corporate 20-year bond. Realize that a risky 20-year corporate bond must have a YTM that is greater than a risk-free 20-year Treasury bond. Again, keep in mind that Re estimates are nothing more than estimates and subject to forecast error. LIST your estimates for Re then select the estimate that YOU believe is the most appropriate for use in the DDM and EXPLAIN your reasoning.

Websites for bond information:

FINRA Bond Market Data

www.finra.org/marketdata

Yahoo Finance:

http://finance.yahoo.com/bonds

Q3. The third step is to estimate a second stage (also called the stable stage) growth rate in dividends, g2, for use in the Two-Stage DDM. Your estimate for g2 should not be greater than the expected future growth in the overall economy (expected growth in GDP). Why? LIST your estimate for g2 and EXPLAIN your reasoning.

Q4. LIST KO’s current dividend (dividend just paid) and use this value as D(0) in the Two-Stage DDM.

Q5. SHOW your calculations and LIST your value (price per share) estimate for KO using the Two-Stage DDM.

Q6. Perform Sensitivity Analysis (SA) on your estimated price per share in by varying both your expected growth rates and discount rates by +/- 2.0 percent in .5 percent increments while holding one of the two parameters (growth or discount rate) constant. DISCUSS your results. That is, describe in words how your value estimates change as you change your growth and discount rate estimates.

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