Nike Inc Cost of Capital Essay
Introduction Kimi Ford is a portfolio manager at NorthPoint Group, a mutual-fund management firm - Nike Inc Cost of Capital Essay introduction. She is evaluating Nike, Inc. (“Nike”) to potentially buy shares of their stock for the fund she manages, the NorthPoint Large-Cap Fund. This fund mostly invests in Fortune 500 companies, with an emphasis on value investing. This Fund has performed well over the last 18 months despite the decline in the stock market. Ford has done a significant amount of research through analysts’ reports, which had mixed reviews.
She found no clear guidance from the analysts and decided to develop her own discounted cash flow forecast to come to a conclusion. Her forecast showed that Nike was overvalued at its current share price causing a discount rate of 12%; however, a quick sensitivity analysis showed that Nike was undervalued at a discount rate below 11. 17%. Ford then asked her assistant, Joanna Cohen, to estimate Nike’s cost of capital, which, per Cohen’s analysis, came to 8. 4%. Background The cost of capital is the minimum return that a company should make on an investment or the minimum return necessary for investors to cover their cost.
More Essay Examples on
Two main factors of the cost of capital are the cost of debt and the cost of equity. The capital used for funding a business should earn returns for the investors who risk their capital. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital – the risk-adjusted return on capital must be higher than the cost of capital. The Weighted Average Cost of Capital (“WACC”) is the rate a company will pay to finance all of their assets.
Depending on the capital structure of a firm, a proportionate weighted percentage will be applied towards the financing of debt, equity, and preferred stock. Because the WACC is calculated using weighted averages for debt and equity, it is a good measurement of the cost to the company for financing its operations. It is probably the best estimate of the discount rate needed to be profitable on projects and serves as an adequate proxy for a required return. Companies typically use the WACC to determine the viability of expansion opportunities and other projects.
Again, it is a good proxy to use for the discount rate of future cash flows. Based upon its use, managers and investors both set the WACC. Corporations use the WACC to make capital investment decisions, while investors use it to make portfolio investment decisions. Businesses or projects that are able to earn returns greater than the cost of capital add value for investors. Conversely, those that produce returns less than the cost of capital may still be profitable but hurt the value of the investor. “Best Practices in Estimating Cost of Capital: Survey and Synthesis”
The purpose of this article is to present evidence on how a handful of the world’s financially sophisticated companies, top financial advisors and leading textbooks estimate capital costs or to answer the question “How do companies really estimate their cost of capital? ” The way they went about conducting this survey was through telephone interviews with a series of open-ended questions. The “best practice” to the survey conductors wasn’t necessarily the one that was used most; rather they tried to focus on the gaps between theory and application. Interviewees and research resources were obtained via multiple publications.
The surveyors first found the top 50 companies in financial management through a research report. From those 50, they cut out 18 headquartered outside of the U. S. , and 4 declined to be interviewed, leaving a sample set of 27 companies. They then went on to find some of the top financial advisors using a “league table” of merger and acquisition advisers and drew 10 of the most active advisers. Finally, they picked the top 4 best selling text and trade books from a list of the graduate level books in corporate finance. This paper first discusses the Weighted-Average Cost of Capital.
In order to diminish the opportunity cost to investors by investing in capital, the company must earn in excess of its cost of capital. A standard means of expressing a company’s cost of capital is the weighted average of the cost of individual sources of capital employed. WACC = (Wdebt(1-t)Kdebt)+(WpreferredKpreferred)+(WequityKequity) where K=component cost of capital W=weight of each component as percent of total capital t = marginal corporate tax rate There are several observations to consider when estimating a company’s WACC for example, all capital costs as well as the weights should be current and not historical.
Also the cost of debt should be after corporate tax and not before. As we will see in the survey findings, this equation, combined with these observations can be helpful; however, there are still some difficult choices that would have to be made and the most troublesome component being the cost of equity capital. The survey findings first show multiple similarities. The discounted cash flow is the dominant investment-evaluation technique and the WACC is the dominant discount rate used in the discounted cash flow analysis. Weights are based on market not book value mixes of debt and equity.
The after-tax cost of debt is predominantly based on marginal pretax costs, and marginal or statutory tax rates. The CAPM is the dominant model for estimating the cost of equity, which in and of itself seems to be a bit confusing The capital asset pricing model incites some disagreements on its application. According to the CAPM the cost of equity for a company relies on three components, these are the risk free rate of return, the Beta estimates, and the market risk premium. These three pieces of the CAPM each cause more confusion. When thinking about the risk free rate one must decide whether or not they will use a long or short term rate.
The difference between realized returns on the 90 day T-bill and the ten year T-bond has averaged 150 basis points which can make a difference on the cost of equity and the WACC. Even though the short term risk free rate is more consistent with the CAPM the long term bond more closely reflect the default holding period returns available on long lived investments and this more closely reflects the types of investments made by companies. It’s because of this reason that the survey shows that 70% of the surveyed corporations and financial advisers would rather the long term Treasury bond.
However, the text books showed heavy favor towards the short term T-Bill. The Beta is the second consideration of the CAPM that ignites some debate. Forward looking Betas are unobservable so the debate is what kind of method to use in getting these Betas. There are a few compromises in obtaining the Beta. One of these is increasing the number of time periods you’re looking into for the historical date in which you run the risk of including stale data. Another problem is shortening the time periods increases your chances of factoring in unwanted random noise.
The third issue is deciding which index to actually use as you may get different information from each. Over half the surveyed corporation decided to use published sources for their Beta estimates. These Beta providers use various proxies for the market portfolio. The equity Market Risk Premium is the third observation of the CAPM and is the one that prompted the greatest variety of responses from the surveyed. Finance theory states that the equity market risk premium should equal the excess return expected by investors on the market portfolio relative to riskless assets.
The debate lies between the use of arithmetic vs. geometric average historical equity returns and in their choice of realized returns on T-Bills vs. T-bonds to proxy for the return on riskless assets. The results were that the text books that were studied favored (71%) the use of the arithmetic mean return over T-bills as the best surrogate for the equity market risk premium. Only 50% of financial advisers use the arithmetic mean and 37% of corporate respondents use a premium of 5-6%. So as we can see the results vary wildly when it comes to the Market Risk Premium.
Another question is whether or not make adjustments to the discount rates or do firms use a discount rate appropriate to the risks of the flows being valued in questions on types of investment, terminal values, synergies, and multidivisional companies. These findings, like the answers to the Market Risk Premium were very different. All financial adviser firms used different discount rates for the the different components of multidivisional firms, where 26% of companies always adjust the cost of capital to reflect the risk of individual investment opportunities. When asked about risk djustments for prospective mergers, two separate companies responded that they’d rather make adjustments to cash flows than the discount rate. Why? The adjusted discount rates are more likely to be used when objective financial market benchmarks for rate adjustments can be obtained, but when this information is not available, that’s when making adjustments to other aspects or focus shifts to things like cash flow. From all the studies, the surveyors find that the following is best practice in the estimation of WACC. Weights should be based on market-value mixes of debt and equity.
The after tax cost of debt should be estimated from marginal pretax costs, combined with marginal or statutory tax rates. The CAPM is currently the preferred model for estimating the cost of equity. Betas should be taken from published sources from trusted Beta providers, if the publishers don’t agree, than a good estimate of Beta should be made. Risk free rate should match the tenor of the cash flow being valued, for mergers and acquisitions the long term (10 yr) T-bond is appropriate. The best practice for the equity market risk premium is to use a premium of 6% or lower, some texts and advisers might use a higher figure.
The changes in the WACC should correspond to changes in market conditions. Finally, the WACC should be risk adjusted to reflect the differences between the different businesses in a corporation. The studies show that the best practices are consistent with finance theory, however the issues don’t lie in theory but rather in application. This variance in application can cause some differences in the estimated cost of capital. The most frustrating topics are finding a Beta, since the best practice is obtaining these Betas from publishers, different publishers with different Betas will obviously cause differences in capital cost estimates.
The adjusted discount rate is the other topic that’s causing a problem because of lack of good market proxies. It’s still an imperfect science. The basis points can be anywhere from 100-150 off of the actual number and in the researcher’s last two sentences you get a hint of what they’re getting at. If the numbers aren’t precise, don’t panic, these are just best practices not perfect practices, after all “a blunt ax is better than nothing. ” WACC Calculation The result of our WACC calculation is 11. 44%.
We calculated our WACC by first aggregating all of the necessary inputs from the case study and corresponding exhibits. The results can be seen in Exhibit A, listed under “Inputs. ” Once we had the required data we then calculated the weights of the components of Nike’s WACC. Since Nike has only debt and equity financing, the company’s weighted average cost of capital is calculated using only equity and debt to weight the equation – no preferred stock. The current market value and current number of outstanding shares were used to determine the weight assigned to the equity.
We then used the book value of the debt to determine the weight assigned to the cost of Nike’s debt financing. The results of our calculations can be seen in Exhibit A, listed under “Calculating the Weights of Equity and Debt. ” Although market values are considerably better than book values to estimate the weight of a company’s debt, we needed to have information regarding the number of Nike’s bonds outstanding to accurately determine the weight of the debt. Since this is not readily available, or shown in the case, we deferred to using book values to determine the weight of the debt.
Next, we calculated the cost of Nike’s debt. The cost of debt was estimated by using the data given in Exhibit 4 to calculate the Yield-to-Maturity (“YTM”) on the company’s current debt offerings. Although Nike’s publicly traded debt was originally issued on July 17, 1996, this case is assumed to take place in July of 2001. As such, we subtracted the five years which have elapsed since the debt was issued to come to a current term for the debt of twenty (20) years. This term was then doubled and the coupon rated divided by two because the issue pays semi-annual coupons.
Using the formula for yield-to-maturity we calculated a rate of 7. 17% which we used as the cost of Nike’s debt in the WACC calculation. Due to the inherit assumptions in the calculation, one of the most sensitive areas of determining the WACC is estimating the cost of equity. Multiple models, such as the Capital Asset Pricing Model (“CAPM”), the Dividend Growth Rate Model, or an average of the results of these models can be used to estimate the cost of equity. The CAPM is very sensitive to the rates used, particularly the rate used to estimate the Risk Free Rate.
We decided to use the twenty-year treasury security rates, because it is the rate most consistent with the life of the asset being value (in this case, the company’s twenty year debt). The choice of the market risk premium to use can also vary, and we decided to use the arithmetic mean, rather than geometric, because arithmetic is better for performing short term calculations and is more accurate in forward looking projections. Lastly, in calculating the WACC we chose to use an adjusted beta which creates a forward looking estimate that attempts to adjust for the instability inherent in determining beta.
The formula used for adjusting beta is the same calculation that Bloomberg uses (Nincic) in calculating their adjusted betas and was originally developed by Marshall Blume and published in the Journal of Finance (Blume). The calculation of our adjusted beta is included in Appendix A, listed under “Calculating the Cost of Equity and Debt. ” Making these assumptions and using these inputs in the CAPM model resulted in a cost of equity of 12. 24%. We also computed the cost of equity using the Dividend Growth Model.
Our cost of equity under this approach calculated by using the last annual dividend made of $0. 48 divided by the current stock price of $42. 09 added to the Value Line forecast of dividend growth of 5. 50%. Despite the historical figures being somewhat consistent, we chose to use analyst’s forecasts to be consistent in our forward looking approach as both the analyst forecast and the WACC are forward looking. Under the dividend growth model we calculated a cost of equity of 6. 64% which can be seen in Appendix A, listed under “Calculating the Cost of Equity and Debt. We then took an average of the two methods and determined the cost of equity to be 9. 44%. Although an average of the two methods can be used, review of “Best Practices in Estimating the Cost of Capital” revealed that the majority of both corporations and financial analysts use the CAPM when estimating the cost of equity. Based upon the results of this survey and our own research and understanding of the capital asset pricing model, we concur with the survey results and used the CAPM as our cost of equity in the WACC model, rather than the average of the CAPM and dividend growth model.
We now have all the necessary components to calculate Nike’s weighted average cost of capital. The results from the procedures above were input into the WACC equation and as stated above, Nike’s weighted average cost of capital was determined to be 11. 44% Differences In the process of calculation the WACC, we noticed quite a few areas where we used a different methodology than Joanna Cohen.. The first difference was with the weights. Because we calculated the cost of equity to be higher than Joanna ($11,427 vs. ,495), it was weighted much higher (90% vs. 73%) than in her calculation. This ended up having a large impact on our WACC. The next area of difference was the cost of debt. Using the Yield to Maturity on Nike’s corporate bonds, we calculated a pre-tax cost of debt of 7. 17%. Joanna calculated the same cost of debt at 4. 3% using a method not considered “best practice. ” Lastly, our cost of equity was much higher than Joanna’s for two reasons. Instead of using the arithmetic mean to arrive at the Equity Risk Premium, she used the geometric mean.
The arithmetic mean is considered better for shorter time horizons and is also considered “best practice. ” Our betas were also slightly different. Using an adjusted beta which is used by Bloomberg we arrived at a slightly higher number than Joanna (. 87 vs . 80) did using a simple average.. Recommendation Using the WACC as a discount rate, Kimi Ford should not recommend the investment, being that the stock price is overvalued at 42. 09, with the WACC being 11. 44%, when compared to the equity value.
Nike, Inc Cost of Capital Essay
NorthPoint Large Cap Fund was considering whether to buy Nike’s stock or not - Nike, Inc Cost of Capital Essay introduction. Nike was experiencing declines in sales growth, declines in profits and market share. However, Nike decided it would increase exposure in mid-price footwear and apparel lines, and it also commits to cut down expenses. The market responded with mixed signals to Nike’s changes. Kimi Ford, the portfolio manager at NorthPoint, did a cash flow estimation, and ask her assistant, Joanna Cohen to estimate the cost of capital. The cost of capital is the rate of return required by a capital provider in exchange for foregoing an investment in another project or business with similar risk. Thus, it is also known as an opportunity cost. Since WACC is the minimum return required by capital providers, managers should invest only in projects that generate returns in excess of WACC. There are four main issues: a) If Cohen should estimate different costs of capital for the footwear and apparel divisions or use a single one instead. I agree with the use of the single cost of capital. It is sufficient for this analysis, since Nike’s business segments have very similar risks. b) Calculating the Cost of Capital WACC: Cohen is wrong using the book values for debt and equity weights; the Market values are the ones that should be used when calculating weights.
The reason for using the Market value is that it is how much it will cost the firm to raise capital today. That cost is approximated by the market value of capital, not by the book value of capital. For market value of equity, $42.09×271.5 shares = 11,427.4 Since we are not given the market value of debt, we use the book value of debt, 1,296.6 Therefore, the market value weight for equity is 11,427.4/(11,427.3+1,296.6) = 89.8%; the weight for debt is 10.2%. c) Cost of Debt: The WACC is used for discounting future cash flows; therefore, all components of cost must reflect the firm’s current or future abilities in raising capital. Cohen uses the historical data when she estimating the cost of debt. She divided the interest expenses by the average balance of debt to get 4.3% cost of debt. The cost of debt could be estimated using the Yield to Maturity of a bond. We can calculate the YTM of the Nike’s bond: Coupon Rate= 6.75%
More Essay Examples on Economics Rubric
N=40 (20 semi-annual)
YTM = 3.58% (semiannual) 7.16% (annual)
After tax cost of debt = 7.16%(1-38%) = 4.44%
d) Cost of Equity: Cohen used CAPM to estimate cost of equity. Her number comes from: 5.74% +(5.9%) x 0.80=10.5% Her risk free rate of 5.7% comes from 20-year T-bond rate, average beta from 1996 to July 2001, (0.80), and a Risk premium of 5.9% I do not agree that Cohen uses average beta from 1996 to July 2001 to measure systematic risk, because we need to find a beta that is most representative to future beta. That is why a most recent beta would be more relevant. So I suggest using Beta 0.69. Therefore, the new cost of equity would be:
5.74% + (5.9%) x 0.69 = 9.81%
-Putting it all together:
My calculation of the WACC is:
0.0444 x 0.102 + 0.0981 x 0.898 = 9.26%
This new Cost of Capital/WACC will change the terminal value of FCF 2011. 1,572.7 x (1+0.03)/0.0926-0.03= 25,876.7 The new FCF will now be 27,449.4 NPV is now: $17,109.14
New Price= 17,109.14 – 1296.6 + 304 = 16,116.54 / 271.5 = $59.36 which is more than the current market price of $42.09, meaning it is undervalued. Therefore, the recommendation is to BUY!