U.S. Economy and its growth rate
The U.S. economic growth indicator shows stable growth from 2010 onwards. The economy reported a negative growth rate in 2009. The gross domestic product (GDP) growth rates in 2010, 2011, 2012, and 2013 were 2.5%, 1.8%, 2.8%, and 3.0% respectively (The World Bank, 2014). The U.S. economy indicates that it has recovered from the 2008 financial crisis. A high GDP growth rate results in higher aggregate demand.
Higher investment and higher aggregate demand make the macro-environment favorable for SodaStream. They may influence its revenues when higher purchasing power results in more sales. A stable economy and a high growth rate are able to sustain investor confidence that may have an impact on capital gains. Forecasts indicate that the U.S. economy will grow at a rate of 2.8% in 2014, and 3.0% in 2015 (IMF, 2014). SodaStream may be able to maintain its sales growth rate.
Industry and sub-industry
The company operates in the beverage industry and soft drinks sub-industry. Most of the companies are large in size and operate globally. They include companies such as Coca-Cola and Pepsi. SodaStream sells its products in 45 countries (SodaStream, 2014). The intensity of rivalry is very strong because there are very many companies producing soft drinks, and flavors. The industry is characterized by a variety of products that are either complements or substitutes.
Having a good reputation for one brand may help to build synergies with other brands if they belong to the same company. Mergers and acquisitions are also common in the industry. Large companies are supporting small firms with unique products to capture a large market share. Pepsi had once considered using SodaStream’s market niche through a merger (Wong & Stock, 2014). During the current year, Coca-Cola has bought stakes in Green Mountain Coffee Roasters so that it can compete directly with SodaStream (Wong & Stock, 2014).
Company background and competitors
SodaStream has operated in the beverage industry since 1903 (SodaStream, 2014). Its headquarters are located in Israel. The company has been able to obtain protection for 65 patents and 198 trademarks for its products across the globe (SodaStream, 2014). The firm has positioned itself as a manufacturer of machines used for making drinks at home. It produces flavors to support the home-production of drinks. It sells carbonation bottles to give homemade drinks a similar feature as industrial soft drinks.
Close substitutes are a threat to revenues because customers may not purchase another product once they have purchased from one brand. When most firms focus on soft drinks, SodaStream has positioned itself as a firm that supports the production of drinks at home. It provides flavors and devices for the production of flavored drinks at home. It also sells manufactured soft drinks. Green Mountain is one of the direct competitors producing similar products that support the production of drinks and juices at home (Wong & Stock, 2014).
Both firms make devices that assist customers to make their drinks at home. The company has a strong environmental policy that provides discounts for customers who return the empty bottles to the company. Other competitors include Nestle Waters, Heineken NV, and SABMiller among others.
Analysis
Initial Pro Forma Financial Statements
The pro forma income statements begin with a forecast of sales. Besley & Brigham (2008) discuss that one method to create pro forma financial statements is to start by forecasting sales (see Appendix A and B).
The net present value of the stream of incomes is $480.21 million discounted at 7%, which is derived from the WACC (see calculations below). If the amount is used as retained earnings, the value of equity will be $811.82 million. It is the NPV added to the current book value of equity. The company has about 22 million shares. Using the number of shares, the value per share is about $36.90. It is almost similar to its current market share price. It shows that investors have accurately considered the net present value of its future streams of income in bidding for the company’s shares. The balance sheet value of equity will be $1038.51 million in five years. The book value will be $47.21. It follows the current trend where the book value is lower than the market value. In the forecast, the gap between the book value and the market value will be greatly reduced.
Determination of the Cost of Debt
The cost of debt is determined by the interest rate that a firm is paying to obtain loans (Mayo, 2012). The effective cost of debt is reduced by the tax rate because interest expense on debt reduces the amount that is paid as tax. The cost of debt can be obtained as Kd = I (1 – t) (Mayo, 2012). The current risk-free rate is about 3.6%, and the bank prime rate is 3.25% (Board of Governors of the Federal Reserve System, 2014). The cost of a new loan can be assumed to be 6.85%. Mayo (2012) explains that the “current cost is the interest rate that firm must incur to borrow money adjusted for the current tax deduction” (p. 404). The company is likely to be charged a 38% corporate tax rate for income that falls between 15M and 18M (KNV, 2014).
Kd = 0.0685 (1 – 0.38) = 0.04247 = 4.247%
The calculation shows that the cost of debt is lower than the cost of equity mainly because it has been reduced by the tax rate. It also shows that the firm would reduce the cost of capital by using more debt and less equity.
Determination of the Cost of Equity
Capital Assets Pricing Model
The CAPM model is used to find the rate of return expected on holding a stock based on the risk that cannot be diversified (Pahl, 2009). It is known as market risk. Grossman & Livingstone (2009) discuss that the CAPM model expresses the risk of holding a single asset in a portfolio.
Expected Rate of Return on a Security
The expected rate of return of a security is calculated using the CAPM model.
Ks = Krf + (Km – Krf) * β, “where Ks is the return on the stock, Km is the expected return on the overall market, β is beta” (Pahl, 2009, p. 24).
Ks = 0.0325 + (0.045044 – 0.0325) * 0.03726 = 0.0329673 = 3.3%
Risk-free Rate
Grossman & Livingstone (2009) discuss that the 30-year bond rate is usually considered to represent the risk-free rate. As discussed above, the current risk-free rate is 3.25%.
Beta Coefficient
The beta can be calculated as shown below.
β = Covariance (i, m) / Variance (m)
β = 0.001513/ 0.040601 = 0.03726 (see Appendix C)
Alternatively, beta can be obtained using the SLOPE formula in Excel. SodaStream has a small beta, which may indicate less market risk.
Expected Return on the Market
Grossman & Livingstone (2009) discuss that the expected return on the market is not observable. As a result, historical data on the market return is used as an estimation of the expected market return.
Market Risk Premium
Grossman & Livingstone (2009) explain that the market premium is “the difference between the overall stock market and the risk-free rate” (p. 141). The market risk premium, for the sake of calculations, is assumed to be 4.5%.
Calculation of Cost of Capital
The cost of capital is calculated using the weighted average cost of capital (WACC). Grossman & Livingstone (2009) explain that the cost of capital of a firm is the weighted average cost of the financial instruments used for financing the firm.
WACC = [K debt * W debt * (1 – t)] + (K common equity * W common equity) + (K preference equity * W preference equity), where K represents the cost of capital associated with the labeled source of capital, and W is the weight associated with the source of capital.
Using year 2013
W debt = 11.88M/ 337.54M = 0.035
W equity = 331.61M/ 337.54M = 0.982
The cost of equity is supposed to be higher than the cost of debt (Mayo, 2012). In reality, returns are supposed to cover debt and provide a premium for shareholders. Assuming the cost of equity is the expected return and the risk-free rate, the cost of equity becomes 6.9%.
WACC = (0.04247 * 0.035) + (0.069 * 0.982) = 0.06924 = 6.924%
Determination of the Weighted Cost of Capital
Per Share Market Value of the Firm
Per share market value of a firm is the price of the stock in the market (Baker & Powell, 2005). The price was $39.48 in March 2014. On April 8, 2014, it was $40.61 in midday real-time (SodaStream International Ltd. NASDAQ: SODA GO, 2014). The market price is compared with the book value, assuming that the company uses the fair value in its balance sheet. The book value of its share at the beginning of 2014 was $15.47, which shows that the market value of the shares almost triples the book value of shares (see Appendix C for further details). According to ISI Group, SodaStream’s fair value was estimated at $34 on January 13, 2014 (theflyonthewall, 2014). The market value is higher than the fair value, which may explain the fall of its price from $49.64 in January to $39.48 in March 2014. The market value of the shares shows that investors have placed a higher value on the expected return on the firm’s security than the value of its cumulative retained earnings. The high growth rate and the NPV of future streams explain the high investor expectation.
Market Value of the firm’s Equity
The market value of equity is obtained by multiplying the market stock price with the outstanding number of shares (Baker & Powell, 2005). Using the size of the stock at the end of 2013, and the price of the stock in December, the market value of the firm’s equity can be calculated as shown below.
Market value of equity = 21,430,000 shares * $57.48 = $1,232,010,700 = $1.232 billion.
The market value of the firm’s equity was very high in the middle of the year 2011, and the whole of 2013 (see Appendix C).
Market Value of the Firm’s Debt
The market value of a firm’s debt is calculated using the procedure used for the calculation of the market value of a bond (Grossman & Livingstone, 2009). Baker & Powell (2005) discuss that most analysts use the book value of debt as a substitute for the market value of debt because of the difficulty in estimating the market value of debt. Using the bond approach, the market value of debt would be the present value of the sum of future streams of interest expenses and the principal payment.
Calculation of the Cost of Capital
Grossman & Livingstone explain that the cost of capital is the “sum of its debt capital, and the cost of its common equity and preferred equity, weighted by their relative amount” (p. 142). It is the description of WACC.
Optimal capital structure and the adjusted optimal capital structure
The minimum cost of capital is expressed as K = Wd (Kd * (1 – t)) + (We * Ke), where K is the cost of capital, and W is the weight associated with the proportion of debt and equity (Mayo, 2012).
The calculations assume that the cost of equity changes as debt increases. It means that investors expect more returns. The cost of debt has been held constant, but in reality, the cost of debt increases as a firm uses more debt. The firm has the lowest cost when it uses 100% debt (see Appendix D). The cost of capital is highest when it uses an equal proportion of debt and equity.
The adjusted cost of capital
A firm raising capital with a larger proportion of debt would reduce the overall cost of capital if the stock price were insensitive to the size of the debt. Debt has a lower cost than equity, but firms are unstable with using a debt size that exceeds the value of equity. Mayo (2012) explains that the optimal capital structure reduces the cost of capital to the firm. High debt proportion is associated with an increased risk that reduces investor confidence in security. Returns on assets are calculated based on dividends, and capital gains. Capital gains are obtained when the stock price appreciates. A financial manager balances low capital costs, which require more debt, and the expected capital gains, which require less debt (Mayo, 2012).
The firm has to use the lowest amount of debt that minimizes the cost of capital. In the table, a debt proportion that is lower than 25% of the size of capital lowers the cost of capital (see Appendix D). It also increases capital gains through stock prices. A higher leverage ratio increases the chance of defaulting, followed by bankruptcy. The firm has to maintain a higher ability to meet its debt obligations by using less debt. Based on its low leverage, SodaStream is unlikely to experience bankruptcy.
References
Baker, H., & Powell, G. (2005). Understanding financial management: A practical guide. Oxford: Blackwell Publishing.
Besley, S., & Brigham, E. (2008). Essentials of managerial finance (14th ed.). Mason, OH: Thomson/ South-Western.
Board of Governors of the Federal Reserve System. (2014). Selected Interest Rates (Daily) – H.15. Web.
Grossman, T., & Livingstone, J. (2009). The portable MBA in finance and accounting (4th ed.). Hoboken, NJ: John Wiley & Sons.
IMF. (2014). World Economic Outlook (WEO) Update: Is the tide rising. Web.
KNV. (2014). U.S. Federal Corporate tax rate table. Web.
Mayo, H. (2012). Basic Finance: An introduction to financial institutions, investments, and management. Mason, OH: South-Western Cengage Learning.
Pahl, N. (2009). Principles of the capital asset pricing model and the importance of firm valuation. Norderstedt.
SodaStream (2014) About SodaStream. Web.
SodaStream International Ltd. NASDAQ: SODA GO (2014). Web.
Theflyonthewall. (2014). Stock market & financial investment news. Web.
The World Bank. (2014). GDP growth (annual %). Web.
Wong, V., & Stock, K. (2014). SodaStream’s new mainstream rivals: Coke and Green Mountain [Press release]. Web.
Appendices
Appendix A
Vertical common-size analysis
Pro Forma Income statement
Source of income statement: SodaStream International Ltd. NASDAQ: SODA GO (2014).
Appendix B
Pro Forma Balance Sheet
Balance Sheet Vertical Common-size Analysis
Source of financial statement: SodaStream International Ltd. NASDAQ: SODA GO (2014).