Nike Inc Cost of Capital Case Study Essay
Nike Inc. Case Number 2 Nike Incorporated’s cost of capital is a vital element when addressing opportunities regarding top-line growth and operating performance. Weighted Average Costs of Capital (WACC) is an essential estimation that is needed in order to determine the amount of interest that will be paid for each additional dollar financed. This translates to be the minimum overall required rate of return that the firm will keep. We disagree with Johanna Cohen’s assessment of Nike due to two factors. The first distinction we have made is in the way in which Cohen calculates the cost of debt.
As she stated in her memo, Cohen calculates the cost of debt by taking the total interest expense for the year and dividing it by the company’s average debt balance; whereas we calculated the yield to maturity (YTM) of a twenty year debt using the 6. 75% coupon paid semi-annually as seen on the third page in our calculations. The second distinction that was made is Cohen’s use of the book value of equity in determining its percentage of total capital. Cohen’s use of book values gives her an equity weight of 27% and debt weight of capital of 73%.
We, instead, calculated the weights of equity based upon the market value of equity, which gave us an equity weight of 89. 8% along with a debt weight of 10. 2% as we also illustrate in our calculation page. The difference in weights for the equity and debt in the capital structure changes the WACC calculation along with the different value for the cost of debt. The CAPM model is a valuable tool used in the estimation of cost of equity but as with many models, there are advantages and disadvantages. The advantages to this model are inherent to its portfolio management principles.
The CAPM only considers systematic risk which can be realized in diversified portfolios. A disadvantage of the CAPM can be the difficulting of finding the equity risk premium and the timely beta of the equity. We believe this is a safe method to use in assessments and can complement the WACC Another model we used to calculate the cost of equity was the Dividend Discount Model (DDM). This DDM is a model strictly used for companies or institutions that pay out dividends. The advantage of using the DDM is that we can value the price of a stock by using forecasted dividends and discounting them back to present value.
There are a few inherent flaws to the DDM such as its assumptions of dividend payouts going into the future. The case discuss new market-expansion projects proposed with the expectation of company growth. We chose to not use the DDM due to its inputs and assumptions. However, we did still solve for the DDM as we illustrate in our calculation page. The last model used to compute the cost of capital was the earning capitalization model (ECM). The advantages of this model apply only when examining a firm with no growth. Since Nike Inc. s growing this is a disadvantage for us because we do not take the growth into consideration, and as well as the DDM, we reject this model. From our calculations we did find ECM is equal to 5. 13% In order to reassess the WACC of Nike, we will be using a calculation that involves the weights of debt and equity, the cost of debt, the tax rate on the debt, the weight of equity, and the cost of equity. We used three different formulas to help us make the conclusion we’ve made. First, we calculated the Capital Asset Pricing Model (CAPM), with a solution of 10. 5%.
Next we calculated the Cost of Debt and our solution was 7. 16%. The prescribed WACC percentage was 11. 17%, when we calculated the WACC our solution was 9. 88%. Any estimate below the prescribed discount rate means the stock is undervalued; because the discount rate we have given based upon our WACC calculation is lower, the stock is undervalued. This brings us to our outcome that that Nike is a buy stock along with a good investment. Therefore, our calculations of the cost of debt and the capital structure of the company differ from Cohen’s analysis that gave her a discount rate of 8. 4%.
Cohen’s discount rate would also put the current price as undervalued just more so than our analysis would predict. Conservatism of outlook regarding discretionary usage of models could be an important consideration also. Our Calculations Cost of Debt: YTM of Nike Bonds PV = -95. 6 FV = 100 N= 40 20 yr * 2 for semi-annual parts PMT= 6. 75/2 (semiannual) =7. 1627% YTM=kd= 7. 16% =3. 5837*2 Debt: Current portion debt5. 4 NP 855. 3 LT Debt 435. 9 Total of Capital 1296. 10. 2% Equity $11,427. 435 89. 8% CAPM Equation: ra = rf + ? a(rm – rf) Where, rf = Risk free rate ?a = Beta of the security rm = Expected market return 5. 74+. 8(MRP) 5. 74% +. 8 (5. 9%) = 10. 46% or 10. 5% WACC Calculation: E/(E+D) * Re + D/(E+D) *Rdebt(1-Tc), Where, E = market value of equity AndD = book value of debt 11427. 436/12,724. 035 * 10. 55% + 1269. 6/12,724. 035 * 7. 16%*. 62= 9. 88% 11427. 435 = shares (271. 5) * market price (42. 09) 1296. 6= 5. 4 + 855. 3 + 435. 9 12724. 035 = 11427. 435 + 1296. 6