Nike Inc.: Cost of Capital

CASE 14: NIKE, INC.: COST OF CAPITAL

What is WACC and why it is important to estimate a firm's cost of capital? Do you agree with Joanna Cohan's WACC calculation? What is WACC and why it is important? Do you agree with Joanna Cohan's WACC calculation?

WACC (Weighted average cost of capital) is the minimum return that a company must earn on existing asset base on satisfy its creditors, owners and other providers of capital

WACC is important to estimate a firm's cost of capital because:

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

WACC is the minimum return required by capital providers, so that managers should invest only in projects that generate returns in excess of WACC

WACC is set by the investors, not by managers.

We cannot observe the true WACC, we can only estimate it.

We do not agree with Joanna Cohan's WACC calculation because she used much information irrelevant to apply in the WACC. And we introduce our method for Nike's WACC in the following part.

Calculate WACC for Nike.

The formula below is used to calculate the Weighted Average Cost of Capital (WACC):

WACC = Debt/(Debt + Equity) x after Tax Cost of Debt + Equity/(Debt + Equity) x Cost of Equity

We are going to find each component of the WACC formula.

Determining the proportion of each source of capital:

We use market value for weighting Nike's equity.

Market value of equity = current share price x share outstanding (data in Exhibit 2)

= $42.09 x 271.5 million shares = 11,427.44 million $

Due to lack of information, we use book value of debt that is 1,296.6 million $ to calculate weight.

Thus, weight for equity is (11,427.44 )/(11,427.44 + 1,296.6 ) = 89.81% and weight for debt is 10.19%

Determining the Cost of debt

We determine cost of debt by finding Yield to maturity of Nike bonds whose information given in Exhibit 4.

Using Excel to calculate YTM: =Rate(nper,pmt,pv,fv)

Nper: 20*2

Pmt: -6.75/2

PV: 95.6

Fv: -100

The result is 3.584% (semiannual)

Yield to maturity or cost of debt is 3.584% x 2 = 7.17%

After tax cost of debt is 7.17% x (1 - 38%) = 4.44%

We use a tax rate of 38% as Ms. Cohen did.

Determining the Cost of Equity

Like Ms. Cohen, we also use Capital Asset Pricing Model to estimate the cost of equity.

r_e= r_f+ β(r_m-r_f)

Risk free rate (r_f): It is common to use the return on short-term T-bill as the risk free rate. Since this investment is long-term decision, we prefer to choose long-term T-bond as our risk free rate. Thus, 20-year T-bond with the rate 5.74% is the best rate available.

Beta (β): the average beta over the period from 1996-mid2001 is not very precise to represent Nike's future beta. Therefore, we choose the most recent beta, 0.69, in mid 2001 to calculate.

Risk premium(r_m-r_f): it is more accurate to use geometric mean as risk premium than arithmetic mean  Nike's risk premium is 5.90%.

Cost of equity r_e =