Assignment 3 – Submit One (1) Hard Copy per Team
Continue your price per share estimation process for KO from Assignment 2.
Use the FCFFM and RV spreadsheets and follow the Two-Stage FCFFM valuation method presented in class in order to answer the following questions. You MUST show all of your calculation in the questions below is order to receive credit for any numerical answers. All five questions are worth 20 points each (20 x 5 = 100 points).
Two-Stage Free Cash Flow to the Firm Model (FCFFM)
Q2. Estimate KO’s WACC as the appropriate discount rate in the FCFF Model. This is relatively simple since the FCFF spreadsheet template will estimate a weighted average cost of capital for you! You can use your best estimates for Re and YTM from Assignment 2 (unless points were deducted for these estimates in Assignment 2) as inputs for calculating the WACC for KO. As you learned in F371, you should use market value weights for both debt and equity and not book value weights when calculating a firm’s WACC. The problem here is that you do not have the time or resources to calculate KO’s market value of debt or the average YTM on that debt. Therefore, make sure that you include the reported book value of debt as shown on the most current balance sheet statement as a proxy for the market value of debt. Assume that KO’s WACC remains constant in stage 1 and stage 2. LIST your estimate for KO’s WACC.
Q3. Estimate second stage or stable stage growth, g2, in the FCFFM. As in Assignment 2, your estimate for g2 should not be much greater than the expected future growth in the overall economy (growth in GDP) for a very long time. Why? Stable stage growth need not be exactly the same in the DDM and FCFFM because dividends and free cash flow to the firm are two different series. They should, however, be relatively similar because dividends are paid from net income, which is an important component of FCFF. LIST your estimate for g2 and provide a short paragraph that EXPLAINS your reasoning.
Q4. LIST and and provide a short paragraph that EXPLAINS your estimate of KO’s FCFF(0) for use in the FCFM. Be careful in this step. Unlike using the current dividend as D(0) in the DDM, the current year’s FCFF may not be appropriate for using a base FCFF(0) value! Consider using the most recent 5-year average FCFF value as your estimate for a base FCFF(0) OR a value based on the 5-year trend in FCFF. Remember, your estimate of FCFF(0) is the value on which you believe all future annual FCFF estimates are based given your estimates of g1 and g2 (notice how many times the word “estimates” is used). You cannot avoid estimation risk!
SHOW your calculations and LIST your value (price per share) estimate for KO using the Two-Stage FCFFM.
*IMPORTANT: There is nothing magic about using a 5-year historical averages as a starting point for estimating future values for input parameters. Using the most recent years of financial data does NOT prevent you from using additional historical financial information when forming your expectations about the future. You should realize, however, that if you simply use only the most recent annual statement (only one year of data), your estimates for future cash flows (particularly free cash flow) will be biased by the most recent one-year period. This is why you should consider using an average of recent time series of historical values for your base FCFF(0) estimate.
As we discussed in class, current and historical cash flows can be observed. Today’s stock value, however, is a function of “EXPECTED” (estimated) future cash flows. It should be obvious from the sensitivity analysis results that SMALL variations in expected growth rates and discount rates can have a LARGE impact on present value estimates. One thousand analysts can easily arrive at 1000 different valuation estimates because they will all form different expectations about future growth rates, discount rates, etc. As you progress through the course, always remember that financial valuation is subject to estimation risk!
Q5. As is Assignment 2, perform Sensitivity Analysis (SA) on your estimated price per share in by varying EACH of your three (3) input parameters (g1, g2 and WACC) by +/- 2.0 percent in .5 percent increments while holding the other two parameters constant. LIST and DISCUSS your results. That is, describe in words how your value estimates change as you change your growth and discount rate estimates.
