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Using Coca-Cola, page 1
Table 1
Capital Structure
Net Operating Income Approach
Wd
Rd
Ws
Rs
WdRd WsRs Ro
Wd/Ws Ro
Rd
0.0
4
1.0 10.00
0.00 10.00 10.00
0.00 10.00 4.00
0.1
4
0.9 10.60
0.40
9.54 10.00
0.10 10.00 4.00
0.2
4
0.8 11.20
0.80
8.96 10.00
0.20 10.00 4.00
0.3
4
0.7 11.80
1.20
8.26 10.00
0.30 10.00 4.00
0.4
4
0.6 12.40
1.60
7.44 10.00
0.40 10.00 4.00
0.5
4
0.5 13.00
2.00
6.50 10.00
0.50 10.00 4.00
0.6
4
0.4 13.60
2.40
5.44 10.00
0.60 10.00 4.00
0.7
4
0.3 14.20
2.80
4.26 10.00
0.70 10.00 4.00
0.8
4
0.2 14.80
3.20
2.96 10.00
0.80 10.00 4.00
0.9
4
0.1 15.40
3.60
1.54 10.00
0.90 10.00 4.00
1.0
4
0.0 10.00
4.00
0.00 10.00
Rs
10.00
10.60
11.20
11.80
12.40
13.00
13.60
14.20
14.80
15.40
Figure 1
Capital Structure
Net Operating Income Approach
18
P
e
r
c
e
n
t
a
g
e
16
14
12
10
Ko
Kd
Ks
4
2
0
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1
Total Debt Ratio
Rs
10.00
10.00
10.00
10.00
10.00
10.00
10.00
10.00
10.00
10.00
10.00
12
Figure 2
Capital Structure
Net Income Approach
P
e 10
r
8
c
e
6
n
t 4
a
g 2
e
0
Ko
Kd
Ks
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1
Total Debt Ratio
Rs
WdRd WsRs Ro
Wd/Ws Ro
Rd
10.00
0.00 10.00 10.00
0.00 10.00 4.00
10.27
0.40
9.24 9.70
0.10 9.70 4.00
10.48
0.80
8.38 9.40
0.20 9.40 4.00
10.63
1.20
7.44 9.10
0.30 9.10 4.00
10.72
1.60
6.43 8.80
0.40 8.80 4.00
11.20
2.00
5.60 8.80
0.50 8.80 4.00
12.64
2.40
5.06 9.40
0.60 9.40 4.00
14.06
2.94
4.22 10.00
0.70 10.00 4.20
15.56
3.52
3.11 10.60
0.80 10.60 4.40
17.14
4.14
1.71 11.20
0.90 11.20 4.60
18.80
4.80
0.00 11.80
1.00 11.80 4.80
Rs
10.00
10.27
10.48
10.63
10.72
11.20
12.64
14.06
15.56
17.14
18.80
Figure 3
Capital Structure
Traditional Approach
P
e
r
c
e
n
t
a
g
e
20
18
16
14
12
10
8
6
4
2
0
Ko
Kd
Ks
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1
Total Debt Ratio
The implications of the traditional approach are straightforward. For small increases
in financial leverage, measured by the total debt ratio, WACC decreases. Beyond a certain
point, the cost of debt begins to increase and the cost of equity increase more rapidly.
Beyond the point, WACC begins to increase. In the middle area, the increased cost of debt
and equity offset and the WACC remains constant. This area is the optimal range. For the
example, WACC remains constant when the total debt ratio is between 40% and 50%.
AAA
0.124
4.64%
AA
0.283
4.79%
A
0.375
5.14%
BBB
0.425
5.74%
BB
0.537
7.49%
B
0.758
9.14%
Table 5KO shows the computations to calculate the CAPM beta for Coke at different
levels of financial leverage. Currently, KOs beta is 0.57. Similar Tables for Pepsi are in
Appendix A. The empirical results for Pepsi are similar. KOs total assets (book value) are
$72,921 million for 12/31/2010, owners equity (book value) is $31,317 million, and debt
(book value) is $41,604 million. KOs market premium for outstanding debt as published in
Morningstar (December 2010) is 9.785829%. Thus, the market value of KOs outstanding
bonds for 12/31/2010 is $45,675 million. KOs market capitalization for 12/31/2010 was
$150.56 billon. KOs market based debt to equity ratio is 0.29 and KOs total debt ratio is
0.2264.
KOs unlevered beta, using Hamada (1969) is 0.4789
levered =
[1+(1-Tc)(D/E)]* unlevered
Table 5KO
Relevered
Betas
Coca-Cola
1 Unlevered
Beta
2
Bond Rating
3
Debt/Equity
4 Re-Levered
Beta
0.4789
No
Debt
AAA
AA
BBB
BB
Table 6KO shows the computations required to calculate the CAPM required rate of
return for KO at various bond ratings. These computations assume a risk free rate of 4.14%
which is the Treasury bond yield for the month of December 20102 and an equity risk
premium of 6.0% taken from Stocks, Bonds, Bills, and Inflation, Market Results for 1926 2010, 2011 Yearbook, published by Morningstar (2011) which is the difference between the
long-term equity market return of 11.9% and the Treasury bond rate of 5.9%. A beta of .57
Coca-Cola is from Yahoo! Finance at the end of December 2010. The unlevered beta is
0,4789 and the CAPM required rate of return for KO is 7.01% with no debt and increases to
17.16% at a bond rating of B.
ks
Table 6KO
Computing Require Rate of Return for Equity
Coca-Cola
Bond Rating
No Debt AAA
AA
BBB
BB
Rf
4.14%
4.14%
4.14%
4.14%
4.14%
4.14%
4.14%
Rm-Rf
6.00%
6.00%
6.00%
6.00%
6.00%
6.00%
6.00%
Beta
CAPM
Required ROR
0.4789
0.5230
0.6679
0.7663
0.8329
1.0344
1.9790
7.01%
7.28%
8.15%
8.74%
9.14%
10.35% 16.01%
1
2
3
4
http://www.federalreserve.gov/releases/h15/data/Monthly/H15_TCMNOM_Y30.txt
1
2
3
4
5
6
7
8
9
Table 7KO
Computing WACC
Coca-Cola
Bond Rating
Cost of Debt
Tax Rate (%)
Cost of Debt times (1-tax)
Total Debt/(TD + TE) (%)
Wd*Kd
CAPM Required ROR
Total Equity/(TD+TE) (%)
Ws*Ks
WACC
No Debt
0.00%
35%
0.00%
0.0000
0.00%
7.01%
1.0000
7.01%
7.01%
AAA
4.64%
35%
3.02%
0.1240
0.37%
7.28%
0.8760
6.38%
6.75%
AA
4.79%
35%
3.11%
0.2830
0.88%
8.15%
0.7170
5.84%
6.72%
A
5.14%
35%
3.34%
0.3750
1.25%
8.74%
0.6250
5.46%
6.71%
BBB
5.74%
35%
3.73%
0.4250
1.59%
9.14%
0.5750
5.25%
6.84%
BB
7.49%
35%
4.87%
0.5370
2.61%
10.35%
0.4630
4.79%
7.40%
B
9.14%
35%
5.94%
0.7580
4.50%
16.01%
0.2420
3.88%
8.38%
Rs
WACC
16.0%
10.3%
8.38%
7.40%
5.94%
4.87%
1.50
2.00
Debt to Equity Ratio
2.50
3.00
3.50
Unlevered Beta
Bond Rating
0.4114
No
Debt
AAA
AA
BBB
BB
Debt/Equity
0.000
0.142
0.395
0.600
0.739
1.160
3.132
Re-Levered Beta
0.4114
0.449
0.574
0.658
0.716
0.889
1.700
No
Debt
AAA
AA
BBB
BB
Table 6PEP
Computing Require Rate of Return for Equity
Pepsico
Bond Rating
Rf
4.14%
4.14%
4.14%
4.14%
4.14%
4.14%
4.14%
Rm-Rf
6.00%
6.00%
6.00%
6.00%
6.00%
6.00%
6.00%
Beta
0.4114
0.4493
0.5738
0.6583
0.7155
0.8886
1.7001
6.61%
6.84%
7.58%
8.09%
8.43%
9.47%
14.34%
1
2
3
4
5
6
7
8
9
Table 7PEP
Computing WACC
Pepsico
Bond Rating
Cost of Debt
Tax Rate (%)
Cost of Debt times (1-tax)
Total Debt/(TD + TE) (%)
Wd*Kd
CAPM Required ROR
Total Equity/(TD+TE) (%)
Ws*Ks
WACC
No Debt
0.00%
35%
0.00%
0.0000
0.00%
6.61%
1.0000
6.61%
6.61%
AAA
4.64%
35%
3.02%
0.1240
0.37%
6.84%
0.8760
5.99%
6.36%
AA
4.79%
35%
3.11%
0.2830
0.88%
7.58%
0.7170
5.44%
6.32%
A
5.14%
35%
3.34%
0.3750
1.25%
8.09%
0.6250
5.06%
6.31%
BBB
5.74%
35%
3.73%
0.4250
1.59%
8.43%
0.5750
4.85%
6.43%
BB
7.49%
35%
4.87%
0.5370
2.61%
9.47%
0.4630
4.39%
7.00%
B
9.14%
35%
5.94%
0.7580
4.50%
14.34%
0.2420
3.47%
7.97%
Figure 5
WACC for Pepsico
18%
16%
R
a
t
e
o
f
15.3%
14%
12%
10%
10.0%
8.8%
8.5%
7.9%
8%
6%
8.21%
7.1%
6.85%
6.8%
6.67%
6.59%6.56%
6.55%
7.24%
5.94%
4.87%
R
e
t
u
r
n
4%
3.73%
3.34%
3.02%
3.02%3.11%
2%
0%
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
Rs
WACC
REFERENCES
Brigham, Eugene F. and Michael C. Ehrhardt. Financial Management, Theory and Practice,
Twelth Edition, Thomson/Southwestern, Mason, OH, 2008.
Damodaran, Aswath. Applied Corporate Finance, Second Edition, John Wiley& Sons, Inc.,
2006.
Gardner, John C., Carl B. McGowan, Jr., and Susan E. Moeller. Using Microsoft
Corporation to Demonstrate the Optimal Capital Structure Trade-off Theory, Journal
of Economic and Financial Education, Winter 2010, Volume 9, Number 2, pp. 29-37.