Background Information about Starbuck
Starbuck Company is an American coffee firm and coffeehouse chain. The company was inaugurated in Seattle, Washington DC in the year 1971. By the end of fiscal year 2016, Starbuck operated more than 23,770 stores globally. Starbuck is believed to be the chief envoy for the “second wave coffee” (Starbucks, 2016). This was enhanced by it capacity to differentiate itself from other United State coffee-serving chains in terms of quality, taste and customer experience. Starbucks has been using the automated espresso machines in ensuring that there is safety and efficiency (Starbucks, 2016).
Starbucks store serves hot and cold drinks, micro-ground coffee, whole-bean coffee, espresso, teas and Teavana tea products, Frappuccino, La Bouglande Pastries, Evolution Fresh juices and snacks such as crackers and chips. Other stores provide pre-packaged food commodities, sandwiches and Starbuck Evenings stores provide beer, appetizers and wine (Starbucks, 2016). Currently, Starbuck is number one in core areas of innovation, utilization of firm resources, people management, financial stability, quality and standard products and services. As at 2016, the company has employed 238,000 employees (Starbucks, 2016).
Weighted Average Cost of Capital
Weighted Average Cost of Capital (WACC) is the calculation of a company cost of capital where all category of capital are proportionately weighted. Sources of capital are preferred stock, common stock, bonds and other long-term debts (Brusov et al., 2011). A company WACC tends t increased with increase in beta and rate of return on equity whereas an increases in WACC marks decrease in valuation and increased risks. In calculating WACC, cost of each capital component must be multiplied by the proportional weight ad sum the results.
WACC formula:
WACC= (E/V) * RE + (D/V) * (Rd)*(1-Tc)
Where E: Total market value of the company’s equity
D: Total market value of the company’s debt
V: Total market value of the company (E+D)
RE: Cost of equity
RD: Cost of debt
Tc: Corporate tax rate
Starbuck’s total equity = $ 5,884,000
Starbuck’s total debt = $ 3,202,200
Starbucks total market value: total equity + total debt = $ 5,884,000 + $ 3,202,200 = $ 9,086,200
Starbucks cost of equity = Rf +β (Rm-Rf) = -0.30 + 0.82(7.09-(-0.30)) = -0.30 + 0.82(7.09+0.30) = -0.30 + 0.82(7.39) = -0.30 + 6.0598 = 5.7598%
Starbuck’s cost of debt = (Interest expense/Total debt) = (81,300/9,086,200) = 8.94%
Corporate tax in United States = 39.19%
The WACC for Starbuck is:
(5,884,000/9,086,200) x 5.7598% + (3,202,200/9,086,200) x 8.94% x (1 – 0.3919)
= (0.6476) x 5.7598% + (0.3524) x 8.94% x (0.6081)
=3.7300 + 1.9158 =5.6458%
(Starbucks, 2016)
Total Market Value of Equity (E): this is the value of the firm great stock or shares when measure in terms of market prices. In addition, market value of equity is the total value of the company exceptional stock in the stock market at a given instance. According to the Starbuck annual reports, the total equity is $ 5,884,000 for the year ended September 2016. Total equity has been arrived at after adding up the parent company shareholders that comprises of elements such as treasury shares, share capital, reserves and retaining earnings and non-controlling interests (Pennacchi, 2008).
Total Market Value of Debt (D): Starbuck total value of debt has been estimated via adding up the firm contract amount that consists of bonds, commercial papers and any other financial debt. In definition, firm commercial paper is unsecure short term debt that is issued in financing, inventories, accounts receivables and any other short term liabilities (Fernandez, 2007). On the other hand, bond is security issued by a public company or government aimed at raising capital. A company bond may be short term or long term. Short term bond comprises bond that can be redeemed within two years or less. Long term bonds have a maturity period of more than 7 years. According to Starbuck annual reports, the total financial debts amount is $ 3,202,200 comprising of the short term debts and long terms debts. However, the company has not issued short term debts such as commercial papers (Starbucks, 2016).
Total Market Value (V): total market value is also known as the total capital. Total market value for the company has been calculated via adding up the total debt (short term and long term debts) and the total equity. Starbucks total market value has been calculated as follows:
Total debt + Total equity = $ 5,884,000 + $ 3,202,200 = $ 9,086,200
Cost of Equity (RE): the cost of equity is considered as the required or expected return by the shareholders for having invested in the company shares. In this case, two methods can be employed in calculation of cost of equity:
Dividend growth model: dividend model is only used when a company is paying dividends at a given constant or fixed rate. The formula in this model is as:
RE= (D1/P0) + g
In which RE= Cost of equity
D1= Expected dividend in a single period
P0 = Current share price
g = dividend growth rate
Capital Asset Pricing Model (CAPM): this model is functional for firms if the beta value is provided and is able to adjust to systematic risks. The formula used in this model is as below:
RE= RF + βE (E(RM) – RF)
Where RE= Cost of equity
RF= Risk-free rate
βE= Beta i.e. asset’s exposure to systematic risk
E(RM) – RF= Market risk premium
According to the company annual reports, Starbuck has not been paying constant dividends; CAPM has been used in calculating for the values. The values are as follows:
Risk-free rate (RF) = -0.30
Beta value (βE) = 0.82
Market free rate (E(RM)) = 7.09
Market risk premium = E(RM) – Rf = 7.09- (-0.30)= 7.09 + 0.30
Hence, Starbucks cost of equity = Rf +β (Rm-Rf) = -0.30 + 0.82(7.09-(-0.30)) = -0.30 + 0.82(7.09+0.30) = -0.30 + 0.82(7.39) = -0.30 + 6.0598 = 5.7598%
Starbuck cost of equity of 5.7598% means that the company stockholders will expect a return on investment of at least 5.7598%, for every dollar invested in the company, requiring a return of 5.7598%.
Cost of Debt (RD): the cost of debt is defined as the effectual rate in which the company has to pay for the current debt liabilities. When calculating the company cost of debt, there is the need to account for the interest amount paid on each short-term and long-term debt in a given period. The formula used when calculating for the cost of debt is: (Interest expense/ Total Debt).
Starbuck cost of debt = (81,300/9,086,200) = 8.94% (Starbucks, 2016).
The cost of debt of 8.94 percent means that for every dollar invested in the company, the investor requires a return totaling to 8.94 cents. This is an indication that Starbuck is highly leveraged company which has resulted to the higher cost of debt. Considering Modigliani and Miller argument, conclusion drawn in this case is that, ignoring the chance of bankruptcy; adding the chances of cost of debt increase while percentage of debt increase, hence the firm has a minimum WACC; indicating the optimal capital structure for the company. Despite this, the rule is that the cost of debt must be lower that the cost of equity (Cochrane, 2014).
Debt in this case is contractual agreement between the Starbuck and the creditors. The agreement set it out that the repayment of the borrowed amount with interest and fee to creditors when paying for the use of capital. The company equity holder will not accept any return on investment that is low than the debt holder. The reason behind this is that the equity holders are secondary to the debt holders and have no contract agreement of being repaid their capital. In case such an offer exists then, the equity holders may consider purchasing debt due to its quality protection of capital and excellent returns when compared to equity investment (Fama & French, 2004).
Gearing Ratio Analysis:
Gearing ratio is used in measuring how a company day to day operation tends to be funded by merge of owner’s fund being the equity and creditors funds (debt). According to analysis, firms with high gearing ratio tend to be impacted by economic downturns. The reason behind this is that, firms with high leverage have higher amount of debts when compared to equity (Hann, Ogneva & Ozbas, 2013). Despite this, companies with higher gearing ratios do not basically imply that they are operating under poor financial conditions. Instead, such firms tend to have riskier financial structure when compared to low geared firms. Starbucks gearing ratio are as follows:
Leverage ratio = Total debt/ Total equity = $ 3,202,200/$ 5,884,000 = 0.5442
Debt ratio = Total debt/Total assets = $ 3,202,200/ $ 14,329,500 = 0.2235
Equity ratio = Total equity/ Total assets = $ 5,884,000 / $ 14,329,500 = 0.4106
(Starbucks, 2016)
Starbucks leverage ratio is 0.5442 meaning that for every dollar of shareholder equity; Nestle owns 0.5442 cents in debt. Generally, a debt to equity ratio that is higher than 2.0 is an indicator of risky case for the investors since they may end up with unpredictable earnings caused by the additional interest expenses that are caused by issuance of debt. If the ratio is higher, the company may get bankrupt (Brusov et al., 2011). On the other hand, the equity value is slightly lower than the debt value indicating that Starbucks leveraging ratio is not risky and the firm capital structure is contributing to higher rates of returns. Debt ratio indicates the total value of the assts that must be sold to cover the underlying debt. Starbuck debt ratio is 0.2235 indicating that the company has highly relied upon debt but the assets are 6.32 times the total debt value. In case the debt ratio emerged to be stable, the firm has to cut back the debt financing to ensure it avoid equity financing.
Recommendation
Starbucks current WACC rate is 5.6458% and the gearing ratio is 0.5442. If the company is considering maximizing shareholder wealth, it is worth to consider maximizing further the WACC rate by lowering the debt financing and increasing equity financing. It has been noted that Starbuck amount of debt has been on the rise and the firm need to keep it under control to avoid default payments of the debts. With a slightly higher WACC, Starbucks would be able to finance other operations and growth process while lowering debt financing and increasing equity financing.
References:
Brusov, P., Filatova, T., Orehova, N., & Brusova, N. (2011). Weighted average cost of capital in the theory of Modigliani–Miller modified for a finite lifetime company. Applied Financial Economics, 21(11), 815-824.
Cochrane, J. H. (2014). A Mean‐Variance Benchmark for Intertemporal Portfolio Theory. The Journal of Finance, 69(1), 1-49.
Fama, E. F., & French, K. R. (2004). The capital asset pricing model: Theory and evidence. The Journal of Economic Perspectives, 18(3), 25-46.
Fernandez, P. (2007). Valuing companies by cash flow discounting: ten methods and nine theories. Managerial Finance, 33(11), 853-876.
Hann, R. N., Ogneva, M., & Ozbas, O. (2013). Corporate diversification and the cost of capital. The journal of finance, 68(5), 1961-1999.
Pennacchi, G. G. (2008). Theory of asset pricing. Boston: Pearson/Addison-Wesley.
Starbucks, (2016). Annual Financial Report. Retrieved online on 21st September 2017, from: https://s21.q4cdn.com/369030626/files/doc_financials/2016/Annual/FY16-Annual-Report-on-Form-10-K.pdf