11308911 Finance – Cost of Capital for Starbucks Coffee
1) Cost of Capital Section Calculate the cost of capital (show calculations) for Starbucks using the following:
a) Weighted average cost of capital;
b) Capital-asset pricing model (beta).
Weighted average cost of capital
Cost of equity: Re = Rf + Beta (Rm-Rf).
Rf= risk free rate
Rm-Rf =equity risk premium
Using the latest date from Yahoo finance:
Risk free rate=5%;
Equity risk premium=4.5%
Re = cost of equity
Rd = cost of debt
E = the market value of the firm’s equity
D = the market value of the firm’s debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = the corporate tax rate
Capital-asset pricing model (beta)
Kc = Rf + beta x (Km – Rf)
Kc is the risk-adjusted discount rate (also known as the Cost of Capital);
Rf is the rate of a “risk-free” investment, i.e. cash;
Km is the return rate of a market benchmark, like the S&P 500.
Return available on an appropriate market benchmark investment (like the S&P 500):20%
Return available on a risk-free investment (cash, or government bond): 7.5%
Beta (relative to the market benchmark above): 0.557
Kc = 7.5%+. 557*(20%-7.5%)
Kc = 14.46%
Cost of capital for Starbucks calculated by weighted average methods equals to 15.9% and the cost of capital calculated by the capital-asset pricing model method equals to 14.46%
2) Discuss the relative strengths and weaknesses of the methods above as to the appropriate discount rate for the firm.
The usage of weighted average cost of capital method may look more complex because it requires a lot of calculations and data that has to be available to make exact calculations. Still it seems to be more reliable by many economists because it gives the most approximated value of the discount rate.
The usage of capital-asset pricing model seems to be an easier one, because it doesn’t require that many data set for the calculations, but just return of “risk-free” investment, beta and return rate of market benchmark.
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Still the results of the both methods may be different if different people calculate them. It depends on the objectivism of risk factors calculations that depend upon different financial indexes and conditions.
In the case with weighted average cost of capital method it may appear tricky to calculate cost of equity that doesn’t really exist in a difference to the cost of debt.
The cost of equity is primary based on what it really costs the company to achieve a share price that will theoretically satisfy the investors. Moreover it’s rather complicated and difficult to make an exact calculation of the tax rate. It adds additional risks of under or over estimating tax liabilities for the businesses.
3) Describe why these two methodologies may produce different results.
Because two methodologies use different techniques in calculation methods of capital costs, the results can differ to some extend. WACC is calculated on the base of data set that gives information about company’s debt and its equity in the capital structure. As it was mentioned about it’s not easy to calculate the cost of the equity because this cost is not fixated, but still the formulas used give a clear approximation.
Another method- capital-asset pricing model is primary based on calculation of more abstract values as risks. Because the risks are calculated on the base of statistical facts there can always be errors in the finals calculations that mostly depend on the amount of the initial data available. If the set of data is not big enough the errors will be quite considerable.
4) Identify specific reasons why the cost of capital may differ among the selected companies. What does this say about their past financial performances and future prospects?
There are many reasons for difference of the capital cost for companies who work in the same business. These reasons include the financial situation of the company, the amount of its debt, the amounts of profits, etc. Because every company his its own financial, marketing and other policies, the risks that should been taken into the consideration will differ.
And as the planning of the capital costs is a very important aspect in business planning their strategies for capital costs are made individually by each company to make equilibrium between the possibilities and risks in business.
Capital costs are model on the experience of previous indexes and experiences so that the development of the company will look stable and will not give any background to possible anxiety about its reliability.
Fort example a company with big debt will not make a small capital cost because it will look suspicious to the investors, who will possible start to returning stocks when they find out that there financial issues with that business.
5) How would you recommend that the firm lower its cost of capital?
The modeling of the capital costs for businesses gives quite objective costs of capital, but nowadays the role of the information and the role of informational influence on the investors is suggested to be a good tool to make the capital costs lower. It’s well known that risks that are taken into consideration when modeling and calculating the capital costs mostly include the processes of the stock market that depend on different factors, but the human factor is not always included. If to include and manipulate the human factor that it would be possible a better way for the capital regulations.
It means that if the stock owners will be better informed about the strategies of the company, its policy for future and its priorities of the development there will be a smaller risk that they’ll start to sell the stocks, and that will reduce the possible risks of human factor. It means that traders who are better informed about the stocks are more likely to hold them, that will result in the increases of price and as the result the capital costs will fall.
So as it’s proposed by modern economists, the availability of private information about accounting and marketing strategies to the investors can teach the companies how to manage with informative functions of the company to regulate its financial climate.