Example 2: Evaluating Teavana acquisition by Starbucks Corp.

In sum, the capital budgeting process is the tool by which a company administers its investment

opportunities in additional fixed assets by evaluating the cash inflows and outflows of such

opportunities. Once such opportunities have been identified or selected, management is then

tasked with evaluating whether or not the project is desirable. 

Depending on the business, the competitive environment and industry forces, companies will

certainly have some unique desirability criteria. As noted earlier, it's very crucial to remember

that the capital budgeting process involves two sets of decisions, investment decisions and

financial decisions; given the unique business and market environments that exist at the time,

each decision may not initially be seen as worthwhile individually, but could be worthwhile if

both were to be undertaken. 

Consider an example involving the coffee chain Starbucks. On Nov. 14, 2012, Starbucks

announced its intent to acquire Teavana, a high-end specialty retailer of tea, for $620 million.

The offer price for Teavana represented a 50% premium over the then market value of Teavana.

Based on the acquisition price, Starbucks would paying over 36 times earnings for Teavana.

Looking at this capital investment today, one can suggest that the financial decision – paying

$620 million for a company that generated $167 and $18 million in sales and profits in 2011 –

was not a desirable one for Starbucks. 

On the other hand, from an investment perspective, Starbucks is paying $620 million for

ownership of a fast-growing, leading tea retailer. Teavana gives Starbucks direct access to the

fast-growing underpenetrated tea market. In addition, Teavana instantly gives Starbucks

approximately 200 high-traffic retail locations and, more importantly, a very visible, high-quality

tea brand to complement its coffee offerings. Had Starbucks merely evaluated Teavana from a

purely financial perspective, the decision would have ignored that highly-valuable benefit of

combining the most well-known coffee brand with the highest-quality tea brand. 

Generally speaking however, businesses will consider the following questions when evaluating

whether or not a project is desirable and should be pursued.

What Will the Project Cost?

This is the first and most basic question a company must answer before pursuing a project.

Identifying the cost, which includes the actual purchase price of the assets along with any future

investment costs, determines whether or not the business can afford to take on such a project.

How Long Will It Take to Re-coup the Investment?

Once the costs have been identified, management must determine the cash return on that

investment. An affordable project that has little chance of recouping the initial investment, in a

reasonable period of time, would likely be rejected unless there were some unique strategic

decisions involved. For Starbucks, it is counting on the fact that when Teavana's brand is

matched with Starbucks vast distribution network, the rapid growth in sales of tea and tea related

projects will deliver tremendous cash flows to Starbucks. Of course, there is no guarantee that

management's forecast will prove accurate or correct; nevertheless, forecasting future cash

inflows and outflows are a vital exercise in the capital budgeting process.

Mutually Exclusive or Independent? 

All investment projects are considered to be mutually exclusive or independent. An independent

project is one where the decision to accept or reject the project has no effect on any other

projects being considered by the company. The cash flows of an independent project have no

effect on the cash flows of other projects or divisions of the business. For example the decision

to replace a company's computer system would be considered independent of a decision to build

a new factory. 

A mutually-exclusive project is one where acceptance of such a project will have an effect on the

acceptance of another project. In mutually exclusive projects, the cash flows of one project can

have an impact on the cash flows of another. Most business investment decisions fall into this

category. Starbucks decision to buy Teavana will most certainly have a profound effect on the

future cash flows of the coffee business as well as influence the decision making process of other

future projects undertaken by Starbucks.

The Analysis

Using a discounted cash flows analysis, Piper Jaffray calculated an estimated range of theoretical values for the Company using the Company’s Base Case Forecast and Upside Case Forecast described below under “The Merger—Summary of Teavana’s Projections,” based on the net present value of (i) implied free cash flows from July 29, 2012 through fiscal year 2017; and

(ii) a terminal value at fiscal year 2017 based upon a multiple of EBITDA consistent with transaction analysis multiples. The free cash flows for each year were calculated from the Company’s projections as operating income less taxes plus depreciation and amortization, less capital expenditures, plus/less change in net working capital.

Using the Company’s Base Case Forecast, Piper Jaffray calculated the range of net present values based on terminal value multiples ranging from 7.0x to 9.0x and discount rates ranging from 11.0% to 16.0%, based on a weighted average cost of capital analysis, which was adjusted upward to account for small Company premiums as provided by Ibbotson and inherent business risk relative to the Company, and a tax rate ranging from 40.5% in 2012 to 37.3% in 2017 based on the Company’s projections. The range of discount rates is based at the midpoint of the Company’s weighted average cost of capital with a sensitivity range, which is based on Piper Jaffray’s professional judgment. This analysis resulted in implied per share values of the Company’s Common Stock ranging from a low of $10.84 per share to a high of $16.18 per share.

Using the Company’s Upside Case Forecast, Piper Jaffray calculated the range of net present values based on terminal value multiples ranging from 8.0x to 10.0x and discount rates ranging from 11.0% to 16.0%, based on a weighted average cost of capital analysis, which was adjusted upward to account for small Company premiums as provided by Ibbotson and inherent business risk relative to the Company, and a tax rate ranging from 40.5% in 2012 to 37.3% in 2017 based on the Company’s projections. The range of discount rates is based at the midpoint of the Company’s weighted average cost of capital with a sensitivity range, which is based on Piper Jaffray’s professional judgment. The higher exit multiple range used for the analysis based on the Upside Case Forecast is based on the assumption that the higher proven growth of this case would command a higher exit multiple. This analysis resulted in implied per share values of the Company’s Common Stock ranging from a low of $14.98 per share to a high of $22.53 per share. Piper Jaffray observed that the Merger Consideration was within the range of values derived from this analysis.

The following tables provide historical and projected (for the Base Case Forecast and Upside Case Forecast) comparable store sales growth, new stores net, total Company owned stores and percent store growth for fiscal year 2010 through fiscal year 2017:

Piper Jaffray calculated free cash flows based on the Company’s projections that were also used in its analyses. The free cash flows from July 29, 2012 through 2017 used by Piper Jaffray in its analyses for the Base Case Forecast were $19.2 million, $28.1 million, $27.6 million, $34.0 million, $46.1 million and $46.6 million, respectively. The free cash flows from July 29, 2012 through 2017 used by Piper Jaffray in its analyses for the Upside Case Forecast were $19.2 million, $22.3 million, $18.7 million, $31.1 million, $39.3 million and $49.3 million, respectively. Greater investment for future growth in the Upside Case Forecast results in higher capital expenditures and depreciation costs, and therefore less free cash flow, in 2013 through 2016, but more in 2017.