Question

Expanding the number of stores in a foreign market, such as the expansion plan launched by Starbucks in China (announced in 2018), is a major capital budgeting project. A project of this scale requires coordinated planning across all functions of a business that you are studying in your Integrated Core classes. Choose and discuss three items on the income statement and balance sheet (a total of six items) that you think this new undertaking will effect. Explain why you chose those particular items, and how the marketing, management and operations decisions of the company will affect them. 2. Choose and calculate three ratios for Starbucks for the last two years. Make sure to select ratios that you think that expanding into a new market will effect, and explain your reasoning. Identify a competitor of Starbucks and contrast these three ratios for the two companies. Explain why you selected this competitor. Describe how the decisions made by management, marketing and operations functions of the company can impact, and hopefully improve, the components of firm operations that these financial ratios measure. 3. Explain how the financial decisions regarding opening a new store are related to management, marketing or operations decisions that the company must make (or has made)?

Answer 1

1. China has a population of 1.4 billion. Starbucks is focusing on a tea loving nation and trying to drive the huge middle class population to the western habit of drinking coffee. The company intends to win over the consumers through friendly pricing. Therefore, the increase in capital expenditure accompanied with store openings will lead to higher depreciation and amortization costs. The operating costs will increase driven by higher marketing and selling costs (like loyalty programs) which might put the operating income into pressure for sometime. The revenue is expected to witness growth driven by higher store openings and friendly discounts and other pricing options to drive ore customers. Thus the pricing strategies might affect the gross margins initially as the gross margins are usually driven by volumes and it might take sometime to drive the volumes. The interest expenses will also increase due to higher capital expenditure.

The balance sheet will witness a growth in assets associated with store openings leading to a corresponding increase in the capital in the form of debt and equity (as decided by the company). There will be an increase in the current assets (like debtors, inventories, cash and cash equivalents) and non-current assets upon the opening of higher number of stores. The increase in the current assets and non current assets will lead to an increase in the current (accounts payable) and non current liabilities (debt). The company's stock repurchases have led to a stockholder deficit in 2019 and higher liabilities associated with higher debt issue might increase the stockholder deficit.

2. Starbucks noted a gross margin of 29.6% in 2018 and 28.2% in 2019. Therefore, just like we had discussed above the gross margins might be impacted in the medium term due to competitive pricing strategies to win market share in China and competition from McDonald's. McDonald's noted a gross margin of 46.5% and 51.3% in the last two fiscal years. Starbucks deals with premium coffee and other food products and therefore has a lower gross margin compared to McDonald's whose volumes are driven by its friendly pricing.

The debt to capital ratio rose from 86.8% in 2018 to 216.4% in 2019. Expansion in a new market comes with higher capital which leads to an increase in the costs in the form of interest expenses. McDonald's debt to capital ratio for the last two fiscals were 107.8% and 119.4% respectively. The increase in debt was driven by the ongoing efforts towards bringing innovations to the company's menu, restaurants and other related matters to drive the revenue and profits.

The return on equity stood at 136.2% in 2018 and turned into a negative 142.2% in 2019 due to the stockholder deficit. The higher capital issue associated with the expansion might worsen the returns further. McDonald's noted a negative return on equity of 189.8% and 124.4% in the last two fiscals.

Starbucks and McDonald's have noted a spike in their capital expenditure to increase their market share. Both the companies are focused on their respective strategies of geographical expansion and store and menu renovation. The gross margin expansion of Starbucks will be intially driven by higher volumes from friendly pricing and loyalty programs. Once it has gained market share it will take the help of pricing power to drive revenue in the 1.4 billion Chinese economy. McDonald's has already won market share through its friendly pricing policies leading to higher volumes. The store and menu renovation and loyalty programs will further add value to the margins.

The growth in revenue and profits will help the companies to gradually repay and lower their debt levels. All of which will drive their net incomes and convert their stockholder deficit into a positive stockholder equity.

Once the companies start expanding their profits and margins then the return on equity will also turn positive and will witness growth.

3. A company’s assets and resources are limited and therefore it requires optimum utilization of the same for the best returns on investment. All of which requires a holistic selection of assets where the company puts its money. A new venture requires huge capital investment and so the organisation expects a minimal level of cash flow to carry out the day to day operations. The organisation will choose that particular project which yields the highest return. The organisation need to carefully evaluate the amount of investment, interest rates, cash flows and rate of returns associated with the project.

The organisation focuses on the most cost efficient source of finance which may include a holistic mixture of debt and equity. But debt do come with higher risk of repayment compared to equity which needs to be factored in. The organisational cash flow situation and the amount of control that the investors are ready to forego are also important deciding factors. During a boom period an organisation prefers equity financing and prefers debt financing during recession to decrease the cost of capital.

An organisation will either focus on a product catering to the masses or the classes and so the marketing procedure also depends on that. Starbucks deals with premium products and has a snobbish value. It caters to the niche market of rich teenagers, business and high income categories. Therefore it shells out more costs in maintaining the rich aristocratic look of its stores, products and workforce. While McDonald's has a more humble marketing campaign which is targeted at the children and teenagers and family by selling the concept of more value at less cost. The McDonald's stores appear more humble compared to the Starbucks stores.