Task

This case is an application of a valuation method, the dividend discount model, for PepsiCo. In this case, students will learn how to use a company's dividend estimates in the coming years to

estimate its share value. Students will first discuss the three possible scenarios for dividend growth: the zero-growth model, the constant growth model, and the supernormal growth model.

They will discuss each model's advantages and disadvantages. Then, they will proceed with their valuation using the assumptions given in the case. PepsiCo's most recent financial statements are

provided in the case for students' use. After estimating the company

's share value; students will compare it to the company's current share price to reach an investment decision. It is a real-world application for students who want to learn how to use dividends in valuation.

Introduction

John was a newly hired security analyst of AJJ Minnesota

Investment Company. His job was to evaluate financial securities based on asset pricing models and fundamental analysis. He worked

with portfolio managers to support their buy, hold or sell decisions on

financial securities. It was 2:30 p.m. in the afternoon; John really needed some boost after the long meeting with his clients.

Headed towards the staff's lounge, he was looking forward to grab

his favorite Coca Cola. To his disappointment, he found the whole refrigerator was filled with low calories, healthy drinks. As

he pushed through those low sodium V8, Naked Juice, Gatorade and La Croix Sparkling Water with natural flavors, he managed to find a can of Pepsi Cola at the back of the rack.

Fierce Competition

While John was indulging in his favorite Doritos, his Pepsi rival,

Mary Ann, walked in. Mary Ann was a senior security analyst, and she was a devoted Pepsi fan.

"Hi Polar bear, I am glad that you finally take the Pepsi Challenge! Be young, have fun and drink Pepsi," said Mary Ann.

John replied, "Nothing can beat the real thing." "The decade old cola war has a new front. Those healthy products, that are occupying our fridge right now, are pushing down the demand for carbonated soft drinks. It went from 46 to 38 gallons per capita in the past 10 years. May be it's time to re-evaluate your Pepsi stocks," John

added (StreetAuthority 2014).

John continued: "Have you noticed the sudden increase in PepsiCo's shares from February to November 2014? It jumped from a low of $78.09 on February 10, 2014 to $100.10 on November

24, 2014. When I checked Coke's shares for the same period, I noticed that there was only a 7% increase in Coke shares. It was $88.42 on March 9 and later it went up to only $94.56 on

November 24. The S&P500 ETF went up by only 10%, from 188.26 to 207.20".

"Pepsi is a much bigger company, with more than twice as many

employees as Coke globally. Even though the predicted soft drink consumption per capita going down each year, I am glad

that soda is only 25% of Pepsi's US sales," Mary Ann exclaimed

(Flanagan 2013).

"Moreover, Pepsi has the edge of understanding the changing consumer taste. The new CEO has Pepsi refocused on water, tea, juice and sports drinks as well as Quaker Oats and Gatorade.

(StreetAuthority 2014).

"Numbers don't lie. Let us take a look at the value of Pepsi's stock

and compared to its price," John suggested. "John, my portfolio holds quite a bit of Pepsi stocks, our discussion made me a

bit nervous about my investment. Let us run some valuation models to figure out whether it is a good time to buy, sell or hold those Pepsi stocks. Both of us may be able to make some money if

we find any significant discrepancy between the current selling

price and the stock's intrinsic value," Mary Ann answered.

Financial Analysis

The surprising increase of stock price of Pepsi compared to the

growth of its competitors and the market triggered the curiosity of these two analysts. They would be able to take advantage of the

rise of stock price if the market value of the stock greatly diverted from intrinsic value. A buy, hold or sell decision can be made based on the comparison. In order to compare the market price with the intrinsic value, John had to find the current stock price. He looked up PepsiCo, Inc.'s stock price as of 12/31/2013 from the internet. It was $82.94

(nasdaq.com/symbol/pep/historical).

The next step was to find out what evaluation models can be used to

find the intrinsic value of the stock. "The well-known method for the valuation of stocks is the dividend discount mode. Since Pepsi is a publicly traded stock paying dividends each year, it will not be difficult to obtain the dividends and earnings data from their financial statement," said Mary Ann. She suggested using the dividend discount method to come up with the investment decision of buy, hold or sell because each of the methods had their limitations and drawbacks.

Dividend Discount Model

To start, John would like to focus on gathering data for the dividend discount model first. From Pepsi's income statement from 2008 to 2013, John was able to collect dividends per share data from 2008 to 2013 (www.nasdaq.com/symbol/pep/dividend-history).

2008

2009

2010

2011

2012

2013

$1.65

$1.78

$1.89

$2.03

$2.13

$2.24

"In addition to dividends, what else do we need?" John asked. "We will need to know the growth rate of the dividends as well as the discount rate to discount the dividends. Moreover, the growth rate in the future may change. Let's try to use the annual growth rate of dividends in 2008-2013 to predict the growth for the next year (2014).

John, can you verify for me to see what was the growth rate between 2008-2013? With the new CEO, I would expect only a slight decrease of growth rate.

"Yes, Madam," John added, "I know how to find the discount rate to discount those dividends. The discount rate should be the cost of common stock, right?" John got excited and continued, "I remember the constant growth model says r= (D1/P)+g where D1 will be the dividend in 2014." Where r= the required rate of return by an investor (cost of common stock).

"But for the dividend discount model, should I use the zero growth, constant growth or supernormal growth assumptions? How does the growth assumption impact the price valuation?" John puzzled.

"Well, may be, we can run all those models to see the impact of the growth rate on the price. Logically, the value of the stock is going to be higher when there is more growth because the intrinsic value is based on the present value of future dividends," Mary Ann explained. "Our investment decision will be based on the comparison of the intrinsic value and the current market price. We may come up with different trading strategies with different assumptions," Mary Ann continued. John agreed. So John pulled the formula for those three models:

1. Zero-growth: P = D/r Where P is the value estimate, D is the current dividend amount, and r is the cost of common stock (or the required return by the shareholders).

2. The constant-growth: P = D1/(r-g) Where P is the value estimate, D0 is the current dividend amount, D1 is the estimated dividend in year 1, r= is the cost of common stock (or the required return by the shareholders), and g is the constant growth rate.

3. Supernormal growth model: P = (D0*(1+g1))/(1+r) + (D0*(1+g1) 2 )/(1+r)2 + and so on ,P = the value estimate, D0 is the current (most recent) dividend amount, r is the cost of common stock (or the required return by the shareholders), g1 is the initial growth rate, and g2 is the second growth rate and so on.

"Are we ready to start now?" Mary Ann asked. "Wow, thank you so much for your insights. I look forward to run some numbers and see if we can make any money out of all this. However, before we get to get busy working on these two models and three growth assumptions, I want to get enjoy the rest of my Cola and Doritos," John replied with a smile.

"I hope Pepsi will still be the choice of a new generation!" Mary Ann exclaimed. The two colleagues went to lunch and then worked on their computers for a while. After two hours, Mary Ann visited John in his office. She said with a smiling face: "I think, in order to value the company's shares, we will need to answer the following questions:

What is the purpose of the dividend discount model?

What are the advantages and the disadvantages of the method?

What are the zero-growth, the constant-growth, and the supernormal growth models under the dividend discount model? How do we proceed with each of them?

Which model would give a higher estimated value: the zero-growth model or the constant-growth model? With which model would we have a higher chance of giving a "buy" recommendation for the stock? You might need to results from question 5 to answer this question.

Estimate the annual growth rate in PepsiCo's dividends over the 2008-2013 period using the data given in the case. Calculate both the arithmetic average and the geometric average annual growth rates in PepsiCo's dividends over the period, and then take the average of those two measures as your best estimate for PepsiCo's expected growth over the next 4 years (i.e. 2014-2017)

What are the ways to estimate the cost of common stock (i.e. or the required return on common stock)? We can use the dividend growth model formula P=D1/(r-g) to estimate the cost of common stock (r). We know PepsiCo's actual closing stock price on 12/31/2013. For g, we can use the number that we will find in question #5. For D1, again we can use the growth number that we will find in #5.

Estimate the value of PepsiCo shares using the following models: The zero-growth model The constant-growth model The supernormal growth model

Based on each model, what would be our investment advice for potential investors in PepsiCo shares?

If we want to go ahead with the supernormal growth model, what would be our decision? Is the stock a good buy?" Mary Ann concluded. John was excited: "Wow, you are so organized! Now, I think these questions will better guide us through this process. Let's get to work then!"

Task.

Jan 1 Doodles Inc. engaged in the following transactions in 2018. The owner invested $70,000 into the company in exchange for 5,000 shares of no-par common stock. Jan 1 Purchased a computer system for $32,000. Jan 14 Purchased $1,200 of supplies on account. Feb 25 Invoiced clients for services provided on account, $36,000. Mar 31 Paid rent for two years, $19,200, April 1 The company borrowed $50,000 from Bank of America. May 14 Collected $8,500 on account June 1 Purchase a delivery van to delivery copies to customers, the van had a purchase price of $53,000, taxes on the van were $5,000 and document charges of $1,500 were paid. July 31 Paid $800 on account for supplies purchased on January 14. Aug 10 Received cash for services provided, $10,200. Sept 1 Paid utilities of $4,000. Oct 1 Received $30,000 in advance for services to be provided in the future. Nov 15 Paid for an ad in the local newspaper, $1,500. Nov 27 Processed employee payroll and employer taxes, gross earnings was $4,000. Nov 30 Paid the employee salaries, taxes are not due until January. Dec 15 The company declared and paid $6,000 in dividends. Dec 30 Invoiced clients for services performed totaling $9,000. Dec 27 Processed employee payroll and employer taxes, gross earnings was $4,000. Dec 30 Paid the employee salaries, taxes are not due until January. Doodles Inc. Chart of Accounts Account Names Cash Common Stock Accounts Receivable Retained Earnings Allowance for Uncollectible Accounts Dividends Supplies Service Revenue Prepaid Rent Advertising Expense Equipment-Computer Utilities Expense Accumulated Depreciation - Computer Salaries Expense Delivery Van Depreciation Expense Accumulated Depreciation - Delivery Van Rent Expense Interest Expense Accounts Payable Supplies Expense Interest Payable Bad Debt Expense Deferred Revenue Payroll Tax Expense Salaries Payable Federal Income Taxes Payable State Income Taxes Payable FICA Taxes Payable Unemployment Taxes Payable Notes Payable Page 2 of 12When reconciling the bank ledger account and the bank statement, if both are in overdraft, unpresented cheques will be: Select one: O a. deducted from the bank statement balance in the reconciliation. O b. added to the bank statement balance in the reconciliation O c. added to the general ledger bank balance O d. deducted from the general ledger bank balance.PART III. MEASURING STOCK PERFORMANCE This part of the project enables you to analyze the risk and return characteristics of one particular stock that you own or would like to purchase. You should input your data on Excel or an alternative electronic spreadsheet. Perform the following tasks. a. Obtain stock price data at the end of each of the last 16 quarters, and fill in that information in Column A of your electronic spreadsheet. Historical stock price data are available on the Yahoo! finance website and on other websites. Your professor may offer some suggestions on where to obtain this information. b. Obtain the data on dividend per share for this firm for each of the last 16 quarters, and input that information in Column B of your electronic spreadsheet. When you obtain dini- dend data, recognize that the dividend is often listed on an annual basis. In this case, divide the annual dividend by 4 to obtain the quarterly dividend. C. Use "compute" statements to derive the quarterly return on your stock in Column C of your electronic spreadsheet. The return on the stock during any quarter is computed as follows. First, compute the stock price at the end of that quarter minus the stock price at the end of the previous quarter, then add the quarterly dividend, and then divide by the stock price at the end of the previous quarter. d. Input the S&P 500 stock index level as of the end of each of the 16 quarters in Column D of your electronic spreadsheet. e. Use "compute" statements to derive the quarterly stock market return in Column E which is equal to the percentage change in the S&P 500 index level from the previous quarter. f. Using the tools in an electronic package, run a regression analysis in which your quarterly stock return (Column C) represents the dependent variable and the stock market return (Column E) represents the independent variable. This analysis can be easily run by Excel g. Based on your regression results, what is the relationship between the market return and your stock's return? (The slope coefficient represents the estimate of your firm's beta, which is a measure of its systematic risk.) h. Based on your regression results, does it appear that there is a significant relationship between the market return and your stock's return? (The t-statistic for the slope coefficient can be assessed to determine whether there is a significant relationship.) i. Based on your regression results, what proportion of the variation in the stock's returns can be explained by movements (returns) in the stock market overall? (The R-SQUARED statistic measures the proportion of variation in the dependent variable that is explained by the independent variable in a regression model like the one described previously.) Does it appear that the stock's return is driven mainly by stock market movements or by other faction that are not captured in the regression model? j. What is the standard deviation of your stock's quarterly returns over the 16-quarter period? (You can easily compute the standard deviation of your column of stock return data by using a "compute" statement.) What is the standard deviation of the quarterly stock market returns (as measured by quarterly returns on the S&P 500 index) over the 16-quarter period? Is your stock more volatile than the stock market in general? If so why do you think it is more volatile than the market? K. Assume that the average risk-free rate per quarter over the 16-quarter period is 15 Pe cent. Determine the Sharpe index for your stock. (The Sharpe index is equal to your stocks average quarterly return, minus the average risk-free rate, divided by the standard deviation of your stock's returns.) Determine the Treynor index for your stock. (The Treynor inder equal to your stock's average quarterly return, minus the average risk-free rate, divided by the estimated beta of your stock.)9) You aim to immunize a portfolio of $1 mil in today's term, with a target duration of 10 years, using a zero-coupon bond with maturity of 4 years and a perpetuity, each currently yields 6%. How much of the zero-coupon bond and the perpetuity will you hold in your portfolio? A. $560,000 and $440,000 for zeros and perpetuity, respectively. B. $330,000 and $670,000 for zeros and perpetuity, respectively. C. $700,000 and $300,000 for zeros and perpetuity, respectively. D. $500,000 and $500,000 for zeros and perpetuity, respectively. 10) Profitable momentum trading strategy is a direct evidence against the notion of A. Weak-form market efficiency. B. Semi-strong form market efficiency. C. Strong-form market efficiency. D. All of the above. 11) Consider two strategies from options, which have the same maturities and are written on the same stock. The firm does not pay dividends. Strategy A: Long a call with X1 = $20 and long a put with X2 = $30 Strategy B: Long a put with X, = $20 and long a call with X2 = $30 Which strategy is more expensive? Hint: Draw the payoff diagrams for both strategies A. Strategy A is more expensive. B. Strategy B is more expensive. C. Both strategies are equally costly. D. There is insufficient information to conclude. 12) Which of the following statements is true? A. Empirically, the market implied volatility is higher than the market realised volatility. B. Empirically, the market implied volatility is lower than the market realised volatility. C. Empirically, the market implied volatility is higher (lower) than the market realised volatility during normal (bad) times. D. None of the above