Question

Bonus Homework on Residual Income Model Assume that the COS and Occupancy Costs as a percentage of total revenues increases by 0.2% every year from 2019 to 2023 for Starbucks. The table below shows the updated net income and stockholders' equity in each year over the five years. Please use a simple calculator to complete the following requirement. Please do not use excel as you cannot access excel in the final. 1. Assume that the cost of capital for Starbucks is 5%. How much are the normal and abnormal earnings for each of the next five years? How much is the present value of the abnormal earnings for each of the next five years? 2019 2020 2021 2022 2023 Beginning BV 1.170 172 918 1.711 2.551 2.947 3,181 3.238 3,314 3,384 + net income - Dividends and stock repurchase 3,945 2,415 2.444 I 2.474 2.502 Ending BV 172 9181 .711 2551 3.434 Normal earnings Abnormal earnings 0.9524 0.9070 0.8638 0.8227 0.7835 Present value factor Present value of abnormal earnings 2. Assume that the abnormal earnings will grow 3% each year after 2023. How much is the present value of the terminal value? 3. How much is the estimated value of Starbucks? 4. Is this estimated value greater or less than the value we estimated under the assumption that COS and Occupancy Costs as a percentage of total revenues do not change from 2019 to 2023? Why?

Answer 1

Part (1)

Please see the table below and pay attention to the linkage column. That explains how each item has been calculated. You can reproduce the same thing using calculator if you understand the linkage column.

Normal earnings = Cost of capital x Net income

Abnormal earnings = Net income - Normal earnings

Present value of abnormal earnings = Abnormal earnings x Present value factor

The cells in yellow contain your answers.

	Linkage	2019	2020	2021	2022	2023
Beginning BV		1,170	172	918	1,712	2,552
[+] Net income	A	2,947	3,161	3,238	3,314	3,384
[-] Div & repurchase		3,945	2,415	2,444	2,474	2,502
Ending BV		172	918	1,712	2,552	3,434
Cost of capital	B	5%	5%	5%	5%	5%
Normal Earnings	C = A x B	58.50	8.60	45.90	85.60	127.60
Abnormal earnings	D = A - C	2,888.50	3,152.40	3,192.10	3,228.40	3,256.40
Present value factor	E	0.9524	0.9070	0.8638	0.8227	0.7835
Present value of abnormal earnings	F = D x E	2,751.01	2,859.23	2,757.34	2,656.00	2,551.39

Part (2)

Terminal value at the end of year 2023 = Abnormal earnings of year 2023 x (1 + g) / (Cost of capital - g) = 2,551.39 x (1 + 3%) / (5% - 3%) =   131,396.55

Present value of terminal value = Terminal value x Present value factor for the year 2023 =  131,396.55 x 0.7835 = $  102,949.20

Part (3)

Estimated value of Starbucks = Beginning book value of year 2019 + sum of present value of abnormal earnings + present value of terminal value =  1,170 + ( 2,751.01 + 2,859.23 + 2,757.34 + 2,656.00 + 2,551.39) + 102,949.20 = $  117,694.16

Part (4)

In order to answer this question, we need to know the earlier estimated value. You are the only one who knows this. Hence you are the only one who can answer this. Please do answer this yourself.