Starbucks firm has 2 million shares of common stock outstanding. The common stoc

Question

Starbucks firm has 2 million shares of common stock outstanding. The common stock just paid a dividend of $1. It is expected to grow by 30% per year for the next 2 years. After that, the dividend is expected to grow at a constant rate of 5% per year forever. The market value of debt is $20 million. The current risk-free rate is 3% and the market premium is 10%. The company’s equity beta is 1.4 and the corporate tax rate is 35%. Do not use excel to solve the problem.

a. What is Dave’s current stock price per share?

b. What is the company’s WACC?

c. Suppose you have a project that’s going to cost $7 million initially, and it will generate cash flow of $1.5 million every year for 6 years, starting from year 3. Assume the project is as risky as the firm, will you take it?

Explanation / Answer

(a) Let’s first calculate the required rate of return on the common stock

= risk free rate + * market premium

Where we have, risk free rate = 3% or 0.03

Market Premium = 10% or 0.1

And of the stock = 1.4

Now required rate of return on the common stock = 0.03 + 1.4 * 0.1 = 0.03 +0.14 = 0.17 or 17%

Required rate of return or Cost of common equity is 17%

now we have
D0 = $1.00
g1 (dividend growth rate, year 2) = 30%
g2 (dividend growth rate, year 2) = 30%
gn (dividend growth rate thereafter) = 5%

Since we have estimated the dividend growth rate, we can calculate the actual dividends for year 1 and 2.
D1 = $1.00 * 1.30 = $ 1.30
D2 = $1.30 * 1.30 = $1.69

We then calculate the present value of each dividend for period 1 and 2; (cost of equity, we have 17%) so;
$1.30 / (1.17) = $1.11
$1.69 / (1.17)^2 = $1.23

Then, we value the dividends occurring in the stable growth period, starting by calculating the third year's dividend:
D3 = $1.69*(1.05) = $1.77

We then apply the stable-growth Gordon Growth Model formula to these dividends to determine their value in the third year:
$1.77 / (0.17-0.05) = $14.78

The present value of these stable growth period dividends are then calculated:
$14.78 / (1.17)^3 = $9.23

Now add the present values of future dividends to get current stock price
$1.11+$1.23+$9.23 = $11.57

The current stock price = $ 11.57

(b) WACC = {rd (1- Tc )*( D / V )}+{ re *( E / V )}

rd = The required return of the firm's Debt financing (assuming it 10% as it is not given the the question); 10% = 0.1

Tc = Tax rate = 35% = 0.35

Market value of the debt = $ 20 Million

Market Value of the Equity = No. of outstanding shares * Share Price = 2,000,000 * $ 11.57

= $ 23.14 million

(D/V) = (Debt/Total Value) = 20/(20+23.14) = 20/43.14

re= the firm's cost of equity = 17% = 0.17

(E/V) = (Equity/Total Value) = 23.14/43.14

Therefore

WACC = {0.1* (1-0.35) * (20/43.14) } + { 0.17 *(23.14/43.14)}

          = 0.030 + 0.091 = 0.1306 = 12.10%

(c) Assuming the project is as risky as the firm, we can take WACC = 12.10% as required rate of return for the project and can use it in discounting factor. The project is not viable as its NPV is negative.

Period

Cash Flow from the Project ($)

Discounting factor

PV of cash Flows ($)

0

-7,000,000

1

-7000000

1

0

1/(1+0.121)^1

0

2

0

1/(1+0.121)^2

0

3

1,500,000

1/(1+0.121)^3

1064815.64

4

1,500,000

1/(1+0.121)^4

949880.14

5

1,500,000

1/(1+0.121)^5

847350.71

6

1,500,000

1/(1+0.121)^6

755888.23

NPV

- $3382065.28

Period

Cash Flow from the Project ($)

Discounting factor

PV of cash Flows ($)

0

-7,000,000

1

-7000000

1

0

1/(1+0.121)^1

0

2

0

1/(1+0.121)^2

0

3

1,500,000

1/(1+0.121)^3

1064815.64

4

1,500,000

1/(1+0.121)^4

949880.14

5

1,500,000

1/(1+0.121)^5

847350.71

6

1,500,000

1/(1+0.121)^6

755888.23

NPV

- $3382065.28

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