The cost of equity

Q.1 As was mentioned in the paper, I was required to use the Capital-Asset-Pricing-Model to calculate a value for the cost of equity of Starbucks - The cost of equity introduction. Essentially the CAPM equation is:

Rj = RF + βj [RM – RF]

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The above equation contains the following key figures: A) RF = Risk Free Rate or the YTM of US treasury Bond. B) βj = The beta or the market risk coefficient of the firm. C) RM = Return on the market portfolio.

We use the above equation as well as the key figures to calculate a value for the cost of equity of Starbucks. Therefore the first step was to figure out the beta coefficient of Starbucks as well as the YTM of US treasury Bonds. Using Yahoo Finance, I was able to get a very recent and exact figure for both previously mentioned items.

Beta = 0.76

YTM = 2.91%

It is customary to assume that the expression [RM – RF] is equal to 7.0%. Hence the next step was to multiply the beta value with 7.0%. Therefore βj [RM – RF] = 7 x 0.76 = 5.32

Rj = RF + βj [RM – RF] = 5.32 + 2.91 = 8.23

Therefore using the CAPM method, the cost of equity for Starbucks turned out to be 8.23% as calculated above.

Q.2 The majority of revenues earned by Starbucks are from its company owned stores as well as from countries where there is no additional risk premium. The fact of the matter is that Starbucks cost of equity is moderately lower than other firms and hence its cost of capital will also be significantly lower. This is mainly due to the fact that Starbucks has very little leverage which essentially means that there is no other extraneous factor which would drive up the beta coefficient resultantly driving up the cost of equity and consequently the cost of capital.

Another factor is that Starbucks derives the crux of its revenues from the US and other such countries which basically do not add to the risk premium. It’s debt to equity ratio is .21 while the industry’s debt to equity ratio is 29.77. This means that Starbucks currently has a very low level of debt.

Q.3 In order to compare Starbucks cost of equity with other firms in the industry, we will consider 2 companies; Mcdonalds and Yum! Brands Inc. The beta for the firms is :

Mcdonalds Beta = 0.8  Yum Brands Beta = 1.19

Mcdonalds Cost of Equity = 2.91 + 0.8(7) = 8.51

Yum Brands Cost of Equity = 2.91 + 1.19(7) = 11.24

Mcdonalds has a slightly higher cost of equity than Starbucks but that is understandable because it has more debt than Starbucks which can be seen from the beta value. Yum Brands on the other hand has a pretty high cost of equity. This is because it has a lot of financial leverage owing to its level of debt. Hence the stock is riskier and therefore slightly more expensive.

Q.4 Lets consider the dividend growth model first. The formula for calculating stock price through this model is

P = (D)/ (K-G)

P = Price of Share   D = Dividend Per share K = Required Rate of Return G = Growth rate of Dividend

Hence in order to calculate the value of the stock through the above formula we would first need to calculate the dividend per share value of Starbucks. We would then compute the required rate of return of the investor as well as the annual growth rate of the Dividend.

Now let’s consider the Arbitrage Pricing Model or Arbitrage Pricing Theory. The APT is often taken as an alternative to the CAPM because of its inherently flexible assumptions. If we were to use the APT to estimate a cost of equity we would require Starbucks expected return as well as the risk premium of a number of macro-economic factors which would affect Starbucks stock price. These macro-economic factors would essentially be as specific as supply and demand and as broad as the inflation rate. Therefore the calculation of equity through APT would require us to gather a lot of additional information as has been mentioned above.

 

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