This portion of the Starbucks Integrative Case applies the techniques of this chapter to compute Starbucks’ required rate of return on equity and Starbucks’ share value using the dividends based 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. Assume the market equity beta for Starbucks at the end of 2012 was 0.75. Assume that the risk-free interest rate was 3.0% and the market risk premium was 6.0%. Starbucks had 749.3 million shares outstanding at the end of 2012, and the share price was $50.15.

 
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 $550 million in outstanding interest-bearing 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% on debt capital and that Starbucks’ average tax rate is 33.0%.

 
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 minus 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% in Year +6 and beyond.

 
e. Using the required rate of return on common equity capital from Requirement 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 Requirement a as a discount rate and a 3.0% long-run growth rate, compute the continuing value of Starbucks as of the beginning of Year þ6 based on Starbucks’ continuing dividends in Year +6 and beyond. After computing continuing value, discount it to present value at the start of Year +1.

 
g. Compute the value of a share of Starbucks’ common stock, as follows:

(1) Compute the sum of the present value of dividends including the present value of continuing value.

(2) Adjust the sum of the present value using the midyear discounting adjustment factor.

(3) Compute the per-share value estimate.

 
h. Using the same set of forecast assumptions as before, recompute the value of Starbucks’ shares under two alternative scenarios. To quantify the sensitivity of your estimate of share value for Starbucks to variations in long-run growth and discount rates, compare (in percentage terms) your value estimates under these two scenarios with your value estimate from Requirement g.

 
• Scenario 1: Assume that Starbucks’ long-run growth will be 2%, not 3% as before, and assume that Starbucks’ required rate of return on equity is 1 percentage point higher than the rate you computed using the CAPM in Requirement a.

 
 • Scenario 2: Assume that Starbucks’ long-run growth will be 4%, not 3% as before, and assume that Starbucks’ required rate of return on equity is 1 percentage point lower than the rate you computed using the CAPM in Requirement a.

 
 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?  

Answer rating: 100% (QA)

a The required rate of return on equity capital for Starbucks using the CAPM is 10 b The weightedave... View the full answer