MBA 505 Tabish Syed

Financial Management b00015165

CASE STUDY
NIKE INC.: COST OF CAPITAL

1. What is WACC and why is it so important to estimate a firm’s cost?

The weighted average cost of capital (WACC) is the rate at which the firm is able to raise
investment for future or ongoing projects. The WACC is an average cost because it is a weighted
average of the firm's component costs of capital. This includes the cost of debt to debt holders
and cost of equity (including preferred stock and common stocks) to share holders. WACC is
calculated considering the relative weights of each component of the capital structure- debt and
equity, and is used to see if the investment is worth taking.

Following are the reasons to why it is important to estimate a firm’s cost:-

a. Capital Budgeting Decision: It is important to estimate a firm’s cost of capital to decide

Capital Budgeting Decision. Cost of capital is used to decide whether an investment proposal
should be undertaken or not. A wrong estimation of WACC would lead to selection of a
wrong investment or rejecting a good investment proposal.

b. Method of financing decision: The WACC can be observed constantly to see the market
changes in interest rate on load and dividend rates on stocks to make a better choice of the
source of financing when the firm needs financing. The idea here is to minimize the cost of
capital based on market changes.

c. Firms Performance: This can also be used as a measure to evaluate the performance of the
firm based on comparing the returns that it is getting from a selected project and the cost it is
incurring in raising the finance for this project.

2. Do you agree with the Joanna Cohen’s WACC calculation? Why or why not?
Joanna’s calculated weighted average cost of capital (WACC) as 8.4% using CAPM model
and I do not agree with her WACC calculations and the reasons to that are mentioned below:-

a. Joanna’s calculation uses the book value for both debt and equity. The book value of debt is
as an estimate of market value and the book value of equity should not be used when
calculating cost of capital. The market value of equity should be calculated by multiplying
the stock price of Nike Inc. by the number of shares outstanding.
b. Also, the market value of debt should be used in the calculation of the cost of debt instead of
the book value used by Joanna. She should have discounted the value of long-term debt that
appears on the balance sheet ($ 435.9) at Nike’s current coupon.
c. Hence, this led to incorrect weights for the cost of equity and cost of debt.

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MBA 505 Tabish Syed
Financial Management b00015165

3. If you don’t agree with Joanna’s analysis calculate your own WACC for Nike.

Market Value of Equity = Share Price x No. of shares

= $42.09 x 271.5
= $11427.435
Market Value of Debt = Current LT + Notes Payable + LT Debt (discounted)
= $5.40 + $855.30 + $408.337
= $1,269.037
Total Financing = $11427.435+ $1,269.037
= $12696.472
Weight of Equity, we = $11427.435 / $12696.472
= 90.00%
Weight of Debt, wd = $1,269.037 / $12696.472
= 10.00%

Note: Geometric mean is used to coincide with the choice to use the 20-year yield on U.S.
Treasuries

Market Risk Free Rate = 5.74% (i.e. 20-year yield on U.S. Treasuries)
Beta (β) = 0.80 (Avg. Beta based on historic betas)
Equity Risk Premium = 5.9% (Geometric Mean for Historical Equity Risk
Premium)
Cost of Equity, rs = rRF + (RPM) β
= 5.74 +(5.9) * 0.8
= 10.46%

Current Price of the Bond = $956

Par Value of the Bond = $1000
Coupon Rate = 6.75% (Semi-Annual Bond)
Time of Maturity = 20 Years
Cost of debt, rd = 3.584 x 2
= 7.167%

WACC = we x rs + wd x rd x (1 –t)
= 90% x 10.46% + 10% x 7.167% x (1 – 0.38)
= 0.44% + 9.41%
= 9.85%

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MBA 505 Tabish Syed
Financial Management b00015165

4. Calculate cost of equity using Capital Asset Pricing Model (CAPM), Dividend Discount
Model (DDM), and Earnings Capitalization Model (ECM). What are the advantages and
the disadvantages of each model?

Cost of Equity using CAPM:-

Market Risk Free Rate = 5.74% (i.e. 20-year yield on U.S. Treasuries)
Beta (β) = 0.80 (Avg. Beta based on historic betas)
Equity Risk Premium = 5.9% (Geometric Mean for Historical Equity Risk Premium)
Cost of Equity, rS = rRF + (RPM) β
= 5.74 +(5.9) * 0.8
= 10.46%

Advantages:
a. It uses only systematic risk, reflecting a reality in which most investors have diversified
portfolios from which unsystematic risk has been essentially eliminated.
b. It generates a theoretically-derived relationship between required return and systematic risk
which has been subject to frequent empirical research and testing.
c. It is clearly superior to the WACC in providing discount rates for use in investment appraisal

Disadvantages:
a. It is difficult to estimate betas for many projects.
b. People sometimes focus on market risk and exclude corporate risk, and this may be a mistake

Cost of Equity using DDM:-

Growth, g = 5.5%
Dividend Payment, D0 = $0.48
Share Price, P0 = $42.09
Cost of Equity, rS = (D0(1 + g)/P0) + g
= 6.7%

Advantages:
a. Allow significant flexibility when estimating future dividend streams.
b. Provide useful value approximations even when the inputs are overly simplified
c. Can be reversed so the current stock price can be used to impute market assumptions for
growth and expected return
d. Investors are able to suit their model to their expectations rather than force-fit assumptions
into the model

Disadvantages:
a. Subjective inputs can result in mis-specified models and bad results
b. Over-reliance on a valuation that is at heart an estimate
c. High sensitivity to small changes in input assumptions

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MBA 505 Tabish Syed
Financial Management b00015165

Cost of Equity using ECM:-

Earnings per share, E = $2.32

Share Price, P0 = $42.09
Cost of Equity, rS = E/P0
= 5.52%

Advantages:
a. Very simple to calculate.

Disadvantages:
b. Does not take into consideration the growth of the company.

5. What should Kimi Ford recommend regarding an investment in Nike?

As per Kimi Ford’s forecast, at the current share price of $42.09 Nike is over-valued at a
discount rate of 12% and under-valued at discount rate below 11.2%.

The weighted average cost of capital (WACC) by using CAPM was found out to be 9.85%. This
discount rate is less than the 11.2% which implies that the Nike share is under-valued at $42.09.

Hence, based on this forecast, Nike Inc. should be added to the North Point Large-Cap Fund at
this time because the stock is undervalued. Therefore, at this point in time we recommend a buy
decision for Nike Inc.

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