- The WACC of Nike and the importance of estimating a firms cost of capital
The weighted Average Cost of Capital (WACC) is a calculation of a company’s capital cost whereby each class of capital is proportionally determined or weighed. Different capital sources such as preferred stock, common stock, long-term debts, and bonds are incorporated in the computation of the weighted average cost of capital. The WACC of a company rises as the return rate on equity and the beta increases. An increase in WACC signifies decline in valuation and a bigger risk. From a broader perspective, a firm’s resources or assets are funded by either an equity or a debt .The weighted average cost of capital is the average of expenses of these financial sources, of which each source is weighted by its particular use in a given situation. A company can thus determine how much interest it is required to pay per every dollar financed.
The weighted average cost of capital reflects the overall necessary return on the company in total and often utilized by a firms board of directors to establish the economic and financial feasibility of expansion prospects and chances as well as mergers. It is actually the appropriate rate of discount to utilize for cash flows with a level of risk congruent that of the whole firm. Figures derived from the calculation of the WACC are applied during capital budgeting as ‘hurdle rate’ in benchmarking various projects. The weighted average cost of capital has become a vital tool in modern business during making investment decisions for maximum profitability. By understanding, the concepts of the WACC a company’s management can chose a capital makeup that will offer the highest returns for the company’s share holders relative to the apparent risk of the firm.
- Justification of WACC
I do not agree with the Joanna Cohen’s WACC. In using this method, she makes many mistakes. Joanna Cohen is wrong to use the short-term debt and notes payable in the calculation of long –term debt. The role of the Weighted Average Cost of Capital is to reflect the firm’s ability to raise capital both at present and in future. The statistics she uses do not really reflect or show the firm’s future perspectives. To get a clear future perspective, she was supposed to only use the long-term debt in calculating WACC.
She also uses the wrong rate in calculating the WACC .She uses 38%, which is incorrect. She should have used 36% which is the most recent tax rate paid by Nike. The most recent tax rate would have given a quite realistic and clear picture of the company’s cost of capital.
Joanne Cohen makes another mistake to use the 20-year bond rate, which is 5.74 % as the risk free rate. She should have used the short term(12 months or less) Risk free rate which in our case is 3.59%.This incorrect risk free rate will significantly give a wrong impression of the WACC.
In her method, she uses the wrong beta. She applied the average of Nike’s historical betas, which amounts to 0.8 instead of the most recent year to date beta of 0.69, which was the most recently calculated.
She uses the incorrect equity .In her calculation she determined the equity by including all the equity of the shareholders. To get a more precise weighted average cost of capital (WACC), she should have used the current market equity value in her calculations
- Cost of equity
Estimated EPS = $2.32
Current stock price = $42.09
Cost of equity = estimated EPS/current stock price
= $2.32 / $42.09 = 0.0552
Re = 5.52%
b) Cost of Equity using Dividend Discount Model:
Given the following: P0 = $42.09, Div1 = .48, g = 5.50%
DDM Calculation: r = Div1/P0 + g = 0.48/42.09 + .055 = .0114 + .055 = .0664
Re = 6.64%
5.52 percent is the expected return by the stockholders from the Nike Corporation. Since the return is significantly low, the compensation that is demanded by the market in exchanges of acquiring assets and bearing the risk of ownership is sustainable for the company. This indicates that the Nike Co. is exposed to less risks since the lower late of return the less risk the company. This is logical because the investors of the company will not have a tendency of demanding remunerations on the risk that they are expecting to experience.
On the side of the lender, 5.52 % indicate the return the investors earn from investing in Nike Company is relatively low. The investors would prefer return on capital of around 10 percent which the firm could not attain since it will increase the chances of risks in the firm. Therefore, the return of Nike Co. leaves the company better off and leaves the investors or lenders slightly worse off. However, the return on the equity is sustainable.
- What should Kimi Ford recommend regarding an investment in NIKE?
Since the brands that were not produced by Nike constituted only 4.5 percent of the company’s total revenue and sales, computing multiple costs of capital would not be more effective. Instead, an effective analysis should be carried on when a single cost of capital is applied. Therefore, the cost of capital is calculated using the after tax WACC method. This will be an effective method for a company to determine how it can raise money. After calculating the cost of capital using the after Tax WACC, the company return on capital amounted to 6.23%.
Nike’s WACC of 6.23 percent indicates how much the company ha to pay in each dollar it invests in raising funds. It represents the average cost of the sources of financing the company and each is weighted according to its use in particular condition. This figure indicates that the company is therefore, not risky to invest. Consequently, the WACC indicates that the discounting rate of the firm is sustainable and present to the investors.
Therefore, in my point of view, I would recommend Ms. Kimi Ford to invest her funds in Nike, Inc. this is because, the minimum rate of return at which the company produces to the investors is reasonable. The company’s return is relatively higher than the WACC. Hence, the company is safe from shedding value. This is a clear indication that the investors are favored in investing in the firm. At WACC of 6.23 percent the investor will hence earn a sustainable discount rate. The Nike, Inc. is estimated to be hold less risks at discount rates that are below 11.17 percent. In conclusion, it is advisable that the investor should definitely invest her money in the company.