Cost of Capital-Nike

Introduction

Nike is the world leader in athletic shoes. The company rose quickly from small-time sales at track meets to a major publicly-traded Fortune 500 company. Nike began its history as Blue Ribbon Sports in 1964 at the University of Oregon. The first retail location for the company opened in 1966 in Santa Monica, California. As the relationship between Blue Ribbon Sports and Onitsuka Tiger ended in 1971, the company launched its own line known simply as "Nike". Nike successfully garnered 50 percent of the market share within the United States by 1980, the same year the company went public. In 1984, Nike's sales were in decline. In response, the company hired rookie basketball player Michael Jordan to be the company spokesman. The $2.5 million deal for five years resulted in the creation of one of the most popular lines of shoes ever made.

Kami Ford, a portfolio manager of a large mutual fund management firm, is looking into the viability of investing in the stocks of Nike for the fund that she manages. Ford should base her decision on data On the Company which were disclosed in the 2001 fiscal reports. While Nike management addressed several issues that are causing the decrease in market sales and prices of stocks, management presented its plans to improve and perform better. Third party sources also gave their opinions on whether the stock was a sound investment.

Weighted average cost of capital (WACC)

This report will be focus on Nike's Inc. Cost of Capital and its financial importance for the company and future investors. Generally, the Cost of Capital shows the price of the risk. It is important for both investors and the company itself. In the investor's point of view, the cost of capital estimation will help to discount a stem of further expected cash flow into expected present value. Then investors can compare this present value with the market price of the company to decide whether this company's price is under or over-valued. This ultimately gives investors a platform to decide whether this company is a good investment. On the other hand, the company itself will also benefit from the cost of capital estimation. As Pratt & Grabowski (2010) stated in their book, the cost of capital is the expected rate of return that is required by the company in order to attract funds for investment. Companies see Cost of Capital as the minimum return that investors expect, thus cost of capital is a benchmark that a company should meet when considering investing in a new project. The WACC is a useful tool to measure how a company is financed and what the costs are of its capital. Furthermore WACC sets the minimum level that a company has to earn in order to satisfy creditors and owners (see above), therefore the model can be used as a benchmark figure (a minimum return rate) that a new project has to meet. The expected rate of return when evaluating such new projects has to be higher than the WACC (benchmark) in order to be profitable. WACC is the rate that a company is expected to pay to debtors and creditors. A weighted average of the component cost of debt, preferred stock, and common equity. This is the minimum rate that a company must earn on its assets in order to satisfy the company's shareholders (most importantly, the creditors and the owners). WACC is calculated as a weighted average or composite, of the various types of funds used over time, regardless of the specific financing used in a given year.

Where:

E: MARKET VALUE OF THE FIRM'S EQUITY

D: MARKET VALUE OF THE FIRM'S DEBT

D+E=V: MARKET VALUE OF THE FIRM

E/ (D+E): PERCENTAGE OF FINANCING THAT IS EQUITY

D/ (D+E): PERCENTAGE OF FINANCING THAT IS DEBT

KE: COST OF EQUITY

KD: COST OF DEBT

t: CORPORATE TAX RATE

Management always takes notice of the cost of capital while taking a financial decision. The concept is quite relevant in the following managerial decisions and hence its importance

1. Capital Budgeting Decision.

Cost of capital may be used as the measuring road for adopting an investment proposal. The firm, naturally, will choose the project which gives a satisfactory return on investment which would in no case be less than the cost of capital incurred for its financing. In various methods of capital budgeting, cost of capital is the key factor in deciding the project out of various proposals pending before the management. It measures the financial performance and determines the acceptability of all investment opportunities.

2. Designing the Corporate Financial Structure.

The cost of capital is significant in designing the firm's capital structure. The cost of capital is influenced by the chances in capital structure. A capable financial executive always keeps an eye on capital market fluctuations and tries to achieve the sound and economical capital structure for the firm. He may try to substitute the various methods of finance in an attempt to minimize the cost of capital so as to increase the market price and the earning per share.

3. Deciding about the Method of Financing.

A capable financial executive must have knowledge of the fluctuations in the capital market and should analyze the rate of interest on loans and normal dividend rates in the market from time to time. Whenever company requires additional finance, he may aver a better choice of the source of finance which bears the minimum cost of capital. Although cost of capital is an important factor in such decisions, but equally important are the considerations of relating control and of avoiding risk.

4. Performance of Top Management.

The cost of capital can be used to evaluate the financial performance of the top executives. Evaluation of the financial performance will involve a comparison of actual profitability's of the projects and taken with the projected overall cost of capital and an appraisal of the actual cost incurred in raising the required funds.

5. Other Areas.

The concept of cost of capital