Analysis of Starbucks Capital Structure

Capital Structure issues that the Starbucks Corporation may presently face, revolve around organizational expansion, protection against external financial crisis and preservation of a low tax position. Starbucks has shown significant growth in cash and short term investments every year for the past five years. This category grew (in millions) from $666 in 2009 to $3234 in 2013 (Fidelity 2014). With consideration to various capital structure theories, it is in Starbucks’ best interest to continue to use a capital structure that exploits low levels of debt. This will allow Starbucks to maximize the profitability generated by expansion.

The company currently has a long term debt/equity of 21.76%, versus the industry average of 106.12% (Fidelity 2014). The debt portion of this percentage is (in millions) $7,034 and the equity portion is $4,480. Starbucks should maintain this debt/equity position, as it will provide the company with the cash flow it needs to continue expansion. “High levels of debt bond the cash flow, the firm’s optimal capital structure is related to its set of investment opportunities (Brigham & Ehrhardt 2013).” In 2012 Starbucks announced a plan to add 3,000 stores within the next five years (Isidore 2012), substantially increasing the sales and profitability potential of the organization. Additionally, Starbucks needs to protect itself against external financial circumstances that could damage the company. Maintaining a low debt capital structure will provide Starbucks with a competitive advantage in this way.

While no organization is immune to certain macroeconomic conditions such as equity market collapses, changes in the opinion of a nation’s creditworthiness or recession (Rose & Spiegel 2009); Starbucks can utilize a low debt capital structure to make it less susceptible to some of the conditions that created the financial crisis of 2008. Specifically, some conditions of securitization can encourage high-risk issuance of debt. “Another difficulty with securitization was that it broke the link between those who had originated the loan and those who were bearing the risk, reducing the incentives for loan originators to conduct proper due diligence prior to extending credit (Rose & Spiegel 2009)”. A comparatively low debt capital structure relative to its industry can shield Starbucks from this condition and could provide a competitive advantage.

Bankruptcy is the worst risk associated with a proportionately high debt capital structure. The benefits of debt in a capital structure are related to the perception of value related to taxation. “Companies can deduct interest expenses when calculating taxable income, which reduces the government’s piece of the pie and leaves more pie available to debt holders and investors” (Brigham & Ehrhardt 2013). However, the risk of bankruptcy risk associated with the addition of debt to a capital structure is important to consider. “Bankruptcy-related costs have two components: (1) the probability of financial distress and (2) the costs that would be incurred if financial distress does occur (Brigham & Ehrhardt 2013).” Financial distress can discourage investors and reduce the value of equity in a given company. Starbucks’ low fixed costs: reliance on unskilled labor, low-cost R&D, and little automation create a position low operating leverage. These circumstances create significant liquidity. However, there is a large degree of demand variability associated with the nature of the Starbucks business.

The financial risk of debt assumption is at odds with the goals of the business (i.e. the expansion of sales and profitability) and potentially more damaging than the strength of its low operational leverage. “A firm whose sales are relatively stable can safely take on more debt and incur higher fixed charges than a company with volatile sales (Brigham & Ehrhardt 2013).” While Starbucks sales are growing (as evidenced in their increased cash flow) there is a significant amount of volatility associated with their perception as a luxury item. Sales could be impacted by numerous external forces. By taking on more debt, Starbucks could erode its ability to expand and become more vulnerable to a potential decrease in sales. This relationship could become an expensive cycle that places the company’s future in jeopardy. For Starbucks, a low debt capital structure is in line with the goals of the business.

When we consider Starbucks’ capital structure it is important to understand how it relates to Modigliani and Miller’s (MM) capital structure theory. MM showed theoretically that two portfolios producing the same cash flow must have the same value (Brigham & Ehrhardt 2013).” With this in mind, capital structure becomes irrelevant. If this is applied to Starbucks, the company could fund its expansion through unlimited debt with no consequence. In this scenario, Starbucks’ equity value would also increase. “Modigliani and Miller (1958) argue that any attempt to reduce the proportion of equity in the firm’s overall capital structure by substituting debt for equity would equivalently raise the price of equity thus preserving the overall cost of capital constant and vice versa (Harrison & Widjaja 2013). MM’s work was groundbreaking but unrealistic. The assumptions in their theory make the model inapplicable to real capital structures. The following notions were part of their theory (Brigham & Ehrhardt 2013).

1. There are no brokerage costs.

2. There are no taxes.

3. There are no bankruptcy costs.

4. Investors can borrow at the same rate as corporations.

5. All investors have the same information as management about the firm’s future investment opportunities.

6. EBIT is not affected by the use of debt.

Each of these items is at odds with the reality of the business world. In the case of Starbucks, focus on the cost of bankruptcy is a prime concern in the use of debt as part of its capital structure. Starbucks has chosen to use little debt in its capital structure as its business model’s top line is vulnerable to sudden changes in demand and macroeconomic conditions. Taking on large amounts of debt could be disastrous to the company if sales abruptly declined.

There is a relationship between the value of a company, the way it is taxed and the amount of debt that it owns. In the MM model “a firm’s value increases linearly for every dollar of debt (Brigham & Ehrhardt 2013). In simple terms, a company’s value increases by $0.01 per dollar of debt for each percent it is taxed. More debt and high taxes will translate to an increase in value. However, the impact of asymmetrical information is one example of how MMs model can be successfully criticized.

If a company has information that they know will lead to increased earnings in the future, the stock price will not yet reflect this value. In this situation, the company should use debt for finance, and use equity in the future to remove the debt (Brigham & Ehrhardt 2013). MM would say that this situation will not affect the value of the company. It is clear that if a company did use equity to finance under these circumstances its future value would be reduced. The company would have sold stock at a price that is lower than its future value thus reducing the company’s future market cap.

The implication of Starbucks' capital structure is that the company has adopted a strategy that seeks to use cash to finance its business goals rather than debt or equity and is being taxed at a low rate. Two of Starbucks' primary goals are to protect its business and investors from the risk of bankruptcy and to continue expanding its retail operations. The company’s capital structure has been shown to be successful in working towards these goals. Additionally, Starbucks' capital structure suggests that the company is benefiting from lower taxes than other companies in its industry. Isidore (2013) names Starbucks as one of several companies that are escaping taxes by utilizing cross border taxation loopholes. Currently, the multinational Group of 20 (an organization comprised of many of the world’s top economies) is seeking to tighten international banking regulations for the purpose of globalization. The purpose of the Group of 20’s effort is preventing “so-called Base Erosion and Profit Shifting by multinationals that exploit(s) gaps and mismatches in national tax rules to make profits "disappear" from high tax regimes and shift to low tax locations (Isidore 2013)”. Given the comparatively small amount of debt in Starbucks’ capital structure; we can infer that the company may be exploiting the international banking laws that the Group of 20 is seeking to regulate. MMs model shows us that utilization of debt as a means of finance can positively impact the value of a company; if the company is taxed. Starbucks may not be paying enough tax to reap the benefit of using significant debt in its capital structure. We can surmise that this may be the case if the Group of 20 is successful in achieving its regulatory goals and at approximately the same time Starbucks begins to add debt to its capital structure.

Starbucks may have achieved its optimal capital structure. Brigham and Ehrhardt (2013) state: “a firm’s optimal capital structure is the mix of debt and equity that maximizes the stock price (Brigham & Ehrhardt 2013)”. With this in mind, the value of Starbucks’ stock reached its all-time high in November 2013 (Fidelity 2014). If Brigham and Ehrhardt are correct, we can estimate how close Starbucks has come to optimization by examining how the following categories influence the company’s capital structure.

1. Business risk

2. Tax position

3. The need for financial flexibility

4. Managerial conservativeness

5. Growth opportunities

(1) The nature of Starbucks’ business carries some risk. Sales are vulnerable to significant demand variability and macroeconomic conditions. The optimal capital structure needed to address this will use little debt as a means of finance. “A firm whose sales are relatively stable can safely take on more debt and incur higher fixed charges than a company with volatile sales (Brigham & Ehrhardt 2013)”. In estimating Starbucks' optimal capital structure, this should be accounted for by keeping levels of debt relatively low. (2) The firm’s capital structure will also need to address its tax position. The implications of Starbucks' current capital structure may provide insight into the firm’s tax position. We can estimate that the company’s current capital structure is approaching optimization relative to the tax position, due to the small amount of debt that is being used. (3) Starbucks’ need for financial flexibility is significant with consideration to its business goal of retail expansion. The company needs capital to build new stores and cannot afford to have its cash tied up in debt. (4) The company is being managed conservatively. Starbucks has a significant amount of profitable investment opportunities. Their retail operations continue to be profitable and expanding this revenue stream at a conservative pace allows the company to grow safely with minimal debt. This “is also consistent with maintaining reserve borrowing capacity, since much of it is pre-committed to servicing the debt (Brigham & Ehrhardt 2013)”. Starbucks management’s conservative approach to its business has resulted in a significant year over year cash flow growth; which the company is using instead of debt to finance its expansion. The capital structure can be estimated to be nearly optimal with regard to the company’s conservative management. (5) Starbucks' capital structure can be estimated at close to optimal with regard to growth opportunities. This is evidenced by the number of new stores that the company is building in addition to new product lines being introduced (e.g. LaBoulange bakery, Evolution Fresh juice and snack line and Starbucks Via Latte). Without proper financing, growth does not occur. This is not the case with Starbucks and its strong capital structure has contributed to this.

References

Baker, M., & Wurgler, J. (2002). Market Timing and Capital Structure. The Journal of Finance, 57, 1-32.

Brigham, E. F., & Ehrhardt, M. C. (2013). Financial management, theory and practice, 14th edition. United States: Cengage Learning. Fidelity. “eresearch.” Fidelity.com. Retrieved February 28, 2014, from fidelity.com

Harrison, Barry & Theodorus Wisnu WIdjaja. (2013) Did the financial crisis impact on the capital structure of firms?. Discussion Papers in Economics, 1-45.

Isidore, Chris (2013, December 5). RPT-G20 Agrees on Push to Close Tax Loopholes Make Multinationals Pay. CNN.com. Retrieved March 2, 2014 from http://money.cnn.com

Modigliani, F., & Miller, M. H. (1958). The Cost of Capital, Corporate Finance and the Theory of Investment. The American economic Review, 48, 261-297.

Rose, Andrew K. & Spiegel, Mark M. (2009) Cross-Country Causes and Consequences of the 2008 Crisis: Early Warning. National Bureau of Economic Research, 1-42.