STARBUCKS

Dividends-Based Valuation of Starbucks’ Common Equity

Integrative Case 10.1 projected financial statements for Starbucks for Years 1 through 5. This portion of the Starbucks Integrative Case applies the techniques in Chapter 11 to compute Starbucks’ required rate of return on equity and share value based on the dividends valuation model. This case also compares the value estimate to Starbucks’ share price at the time of the case development to provide an investment recommendation.

The market equity beta for Starbucks at the end of 2008 was 0.58. Assume that the risk free interest rate was 4.0 per cent and the market risk premium was 6.0 per cent. Starbucks had 735.5 million shares outstanding at the end of 2008, and share price was $14.17.

Required

a. Use the CAPM to compute the required rate of return on equity capital for Starbucks.

b. Compute the weighted average cost of capital for Starbucks as of the start of Year 1. At the start of Year 1, Starbucks had $1,263 million in outstanding interestbearing debt on the balance sheet and no preferred stock. Assume that the balance sheet value of Starbucks’ debt is approximately equal to the market value of the debt. Assume that at the start of Year 1, Starbucks will incur interest expense of 6.25 per cent on debt capital and that Starbucks’ average tax rate is 36.0 per cent.

c. From your forecasts of Starbucks’ financial statements for Years 1 through 5, derive the projected dividends using the projected amounts for the plug to dividends less the net amounts of common stock issued each year (if any). Then compute projected dividends for Starbucks for Years 1 through 5 using the clean surplus accounting approach based on projected amounts for comprehensive income and common shareholders’ equity. The projected amounts of dividends under the two approaches should be identical.

d. Use the clean surplus accounting approach to project the continuing dividend in Year 6. Assume that the steady-state long-run growth rate will be 3 per cent in Year 6 and beyond.

e. Using the required rate of return on common equity capital from Part a as a discount rate, compute the sum of the present value of dividends for Starbucks for Years 1 through 5.

f. Using the required rate of return on common equity capital from Part a as a discount rate and a 3.0 per cent long-run growth rate, compute the continuing value of Starbucks as of the beginning of Year 6 based on Starbucks’ continuing dividends in Year 6 and beyond. After computing continuing value, bring continuing value back to present value at the start of Year 1.

g. Compute the value of a share of Starbucks’ common stock. (i) Compute the sum of the present value of dividends including the present value of continuing value. (ii) Adjust the sum of the present value using the midyear discounting adjustment factor. (iii) Compute the per-share value estimate.

h. Using the same set of forecast assumptions as before, re compute the value of Starbucks shares under two alternative scenarios. Scenario 1: Assume that Starbucks’ long-run growth will be 2 per cent, not 3 per cent as before, and assume that Starbucks’ required rate of return on equity is 1 per centage point higher than the rate you computed using the CAPM in Part a. Scenario 2: Assume that Starbucks’ long-run growth will be 4 per cent, not 3 per cent as before, and assume that Starbucks’ required rate of return on equity is 1 per cent age point lower than the rate you computed using the CAPM in Part a. To quantify the sensitivity of your estimate of share value for Starbucks to variations in long-run growth and discount rates, compare (in per cent age terms) your value estimates under these two scenarios with your value estimate from Part f.

i. What reasonable range of share values would you expect for Starbucks’ common stock? Where is the current price for Starbucks’ shares relative to this range? What do you recommend?

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