SESSION 7&8: VALUATION: CASH-FLOW-BASED APPROACH

Case Study: Free Cash Flows Valuation of Starbucks’ Common Equity

*Extra information: The market equity beta for Starbucks at the end of 2012 is 0.75. Assume that
the risk-free interest rate is 3.0% and the market risk premium is 6.0%. Starbucks has 749.3
million shares outstanding at the end of 2012, and the share price was $50.15.
REQUIRED: Using your result of projected financial statements of Starbucks for Years þ1
through þ5 and the required rate of return on common equity using CAPM estimated in
Session5&6, answer the following questions:
Part I—Computing Starbucks’ Share Value Using Free Cash Flows to Common Equity
Shareholders
a. Using your projected financial statements, begin with projected net cash flows from operations
and derive the projected free cash flows for common equity shareholders for Starbucks for Years
þ1 through þ5. You must determine whether your projected changes in cash are necessary for
operating liquidity purposes. (Calculation – Home preparation)
b. Project the continuing free cash flow for common equity shareholders in Year þ6. Assume that
the steady-state, long-run growth rate will be 3% in Year þ6 and beyond. Project that the Year þ5
income statement and balance sheet amounts will grow by 3% in Year þ6; then derive the
projected statement of cash flows for Year þ6. Derive the projected free cash flow for common
equity shareholders in Year þ6 from the projected statement of cash flows for Year þ6.
(Calculation – Home preparation)
c. Using the required rate of return on common equity from session 5&6 as a discount rate,
compute the sum of the present value of free cash flows for common equity share holders for
Starbucks for Years þ1 through þ5. (Calculation – Home preparation)
d. Using the required rate of return on common equity from Requirement a as a discount rate and
the long-run growth rate from Requirement c, compute the continuing value of Starbucks as of
the start of Year þ6 based on Starbucks’ continuing free cash flows for common equity
shareholders in Year þ6 and beyond. After computing continuing value as of the start of Year þ6,
discount it to present value at the start of Year þ1.
e. Compute the value of a share of Starbucks common stock. (Calculation – Home preparation)
(1) Compute the total sum of the present value of free cash flows for equity shareholders (from
Requirements c and d).
(2) Adjust the total sum of the present value using the midyear discounting adjustment factor.
(3) Compute the per-share value estimate.
Note: If you computed Starbucks’ share value using the dividends valuation approach in session
5&6, compare your value estimate from that case with the value estimate you obtain here. They
should be the same.

Part II—Computing Starbucks’ Share Value Using Free Cash Flows to All Debt and
Equity Stakeholders
g. At the end of 2012, Starbucks had $1,263 million in outstanding interest-bearing short-term
and long-term debt on the balance sheet and no preferred stock. Assume that the balance sheet
value of Starbucks’ debt equals the market value of the debt. Starbucks faces an interest rate of
roughly 6.25% on its outstanding debt. Assume that Starbucks will continue to face the same
interest rate on this outstanding debt capital over the remaining life of the debt. Assume that
Starbucks will continue to face a 33% income tax rate over the forecast horizon. Compute the
weighted-average cost of capital for Starbucks as of the start of Year þ1. Compare your
computation of Starbucks’ weighted-average cost of capital with your estimate of Starbucks’
required return on equity from Requirement a. Why do the two amounts differ? (In-class
discussion – Group presentation & Defense)
h. Based on your projections of Starbucks’ financial statements, begin with projected net cash
flows from operations and derive the projected free cash flows for all debt and equity
stakeholders for Years þ1 through þ5. Compare your forecasts of Starbucks’ free cash flows for
all debt and equity stakeholders Years þ1 through þ5 with your forecast of Starbucks’ free cash
flows for equity shareholders in Requirement b. Why are the amounts not identical—what causes
the difference each year? (In-class discussion – Group presentation & Defense)
i. Project the continuing free cash flows for all debt and equity stakeholders in Year þ6. Use the
projected financial statements for Year þ6 from Requirement c to derive the projected free cash
flows for all debt and equity stakeholders in Year þ6. (Calculation – Home preparation)
j. Using the weighted-average cost of capital from Requirement g as a discount rate, compute the
sum of the present value of free cash flows for all debt and equity stakeholders for Starbucks for
Years þ1 through þ5. (Calculation – Home preparation)
k. Using the weighted-average cost of capital from Requirement g as a discount rate and the
long-run growth rate from Requirement c, compute the continuing value of Starbucks as of the
start of Year þ6 based on Starbucks’ continuing free cash flows for all debt and equity
stakeholders in Year þ6 and beyond. After computing continuing value as of the start of Year þ6,
discount it to present value at the start of Year þ1. (Calculation – Home preparation)
l. Compute the value of a share of Starbucks common stock. (Calculation – Home preparation)
(1) Compute the value of Starbucks’ net operating assets using the total sum of the
present value of free cash flows for all debt and equity stakeholders (from
Requirements j and k).
(2) Subtract the value of outstanding debt to obtain the value of equity.
(3) Adjust the present value of equity using the midyear discounting adjustment factor.
(4) Compute the per-share value estimate.
m. Compare your share value estimate from Requirement e with your share value estimate from
Requirement l. These values should be similar. (In-class discussion – Group presentation &
Defense)