# Pepsi coke case solution

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A. The implied earnings forecasts are calculated in two steps. First, reverse engineer the RE
valuation model to get the implied growth rate in residual earnings. Second, reverse engineer
the residual earnings calculation to get forecasted eps.
The pro forma to calculate the growth in RE is as follows:
PepsiCo
2003 2004 2005
Earnings 2.310 2.560
Dividends (payout = 42.4%) 0.980 1.086
Book value 6.98 8.31 9.784
Residual earnings (9%) 1.682 1.812
Growth rate in RE 7.74%
Reverse engineer the RE model:
+
+++=
g
g
V
E
09.1
)1(812.1
09.1
1
09.1
812.1
09.1
682.1
98.6
22
2003
Setting
E
V
0
= \$49.80, then g = 1.0497 (a 4.97% growth rate)
With this growth rate, the RE for 2006 onwards can be forecasted. For example, RE for 2006
= 1.812 × 1.0497 = 1.902. RE forecasts are then reversed engineered to deliver earnings
forecasts:
Earnings
t
= (Book value
t-1
× 0.09) + RE
t
So, for 2006, EPS = (9.784 × 0.09) + 1.902 = 2.783.
The following pro forma gives the conversion for years, 2006-2008.
2005 2006 2007 2008
RE (growing at 4.97%) 1.902 1.997 2.096
Book value 9.784
B
t-1
× 0.09 0.881 1.025 1.181
Eps 2.783 3.022 3.277
Dps (payout = 42.4%) 1.180 1.282 1.389
Book value 11.387 13.127 15.105

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Coca Cola
2003 2004 2005
Earnings 1.990 2.100
Dividends (payout = 50.3%) 1.000 1.056
Book value 5.77 6.760 7.804
Residual earnings (9%) 1.471 1.492
Growth rate in RE 1.43%
Reverse engineer the RE model:
2003
22
1.471 1.492 1 1.492
5.77
1.09 1.09
1.09 1.09
E
g
V
g

= + + +


Setting
E
V
0
= \$40.70, then g = 1.0492 (a 4.92% growth rate)
Now, again, reverse engineer the residual earnings formula:
Earnings
t
= (Book value
t-1
× 0.09) + RE
t
The following pro forma gives the conversion for years, 2006-2008.
2005 2006 2007 2008
RE (growing at 4.92%) 1.565 1.642 1.723
Book value 7.803
B
t-1
× 0.09 0.702 0.804 0.913
Eps 2.267 2.446 2.636
Dps (payout = 50.3%) 1.140 1.230 1.326
Book value 8.930 10.146 11.456
B. From the pro forma in part a, EPS growth rates for each year are:
PepsiCo 2004 2005 2006 2007 2008
EPS 2.31 2.56 2.783 3.022 3.277
Growth rates (%) 10.83 8.71 8.59 8.44
________________________________________________________________________
Coke Cola 2004 2005 2006 2007 2008
EPS 1.99 2.10 2.267 2.446 2.636
Growth rates (%) 5.53 7.95 7.47 7.77
These growth rates can be depicted in a plot, like that in Figure 5.4 for Nike. This plot

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A. The implied earnings forecasts are calculated in two steps. First, reverse engineer the RE valuation model to get the implied growth rate in residual earnings. Second, reverse engineer the residual earnings calculation to get forecasted eps. The pro forma to calculate the growth in RE is as follows: PepsiCo 2003 Earnings Dividends (payout = 42.4%) Book value 6.98 Residual earnings (9%) Growth rate in RE 2004 2.310 0.980 8.31 2005 2.560 1.086 9.784 1.682 1.812 7.74% Reverse engineer the RE model: E V2003 = 6.98 + 1.682 1.812 1 1.812  (1 + g )  + +   2 1.09 1.09 1.09 2  1.09 − g  Setting V E0 = \$49.80, then g = 1.0497 (a 4.97% growth rate) With this growth rate, the RE for 2006 onwards can be forecasted. For example, RE for 2006 = 1.812 × 1.0497 = 1.902. RE forecasts are then reversed engineered to deliver earnings forecasts: Earningst = (Book valuet-1 × 0.09) + REt So, for 2006, EPS = (9.784 × 0.09) + 1.902 = 2.783. The following pro forma gives the conversion for years, 2006-2008. 2005 RE (growing at 4.97%) Book value Bt-1 × 0.09 Eps Dps (payout = 42.4%) Book value 2006 2007 2008 1.902 1.997 2.096 0.881 2.783 1.180 11.387 1.025 3.022 1.282 13.127 1.181 3.277 1.389 15.105 9.784 ← Coca Cola 2003 Earnings Dividends (payout = 50.3%) Book value 2005 2.100 1.056 7.804 1.471 1.492 1.43% 5.77 2004 1.990 1.000 6.760 Residual earnings (9%) Growth rate in RE Reverse engineer the RE model: E V2003 = 5.77 + 1.471 1.492 1 + + 1.0 ...
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