Nike Inc - Weighted Average Cost of Capital (wacc)

INTRODUCTION

Background:

Kimi 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.

The weighted average cost of capital (WACC) is the rate (expressed as a percentage, like interest) that a company is expected to pay to debt holders (cost of debt) and shareholders (cost of equity) to finance its assets. It is the minimum return that a company must earn on existing asset base to satisfy its creditors, owners, and other providers of capital. Companies raise money from a number of sources: common equity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants, and options, pension liabilities, executive stock options, governmental subsidies, and so on. Different securities are expected to generate different returns. WACC is calculated taking into account the relative weights of each component of the capital structure- debt and equity, and is used to see if the investment is worthwhile to undertake.

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 is also important in many others areas of decision making, such as dividend decisions, working capital policy etc.

WACC CALCULATION:

II. Cost of Capital Calculations: Nike Inc

Cohen calculated a weighted average cost of capital (WACC) of 8.3 percent by using the capital asset pricing model (CAPM) for Nike Inc. And we do not agree with her figure, and the reasons to that are postulated as follows:

I. Value of equity

The problem with Cohen's calculations is that she used the book value for both debt and equity. While the book value of debt is accepted as an estimate of market value, book value of equity should not be used when calculating cost of capital. The market value of equity is found by multiplying the stock price of Nike Inc. by the number of shares outstanding.

Market Value of Equity(E) Calculation:

E = Stock Price X Number of Shares Outstanding

= $42.09 X 271.5

= $11,427.44

This figure is much different than the book value of equity that Joanna Cohen used ($3,494.50).

II. Value of Debt

Market value of debt should be used in the calculation of the cost of debt contrary to a book value used by Cohen. She should have discounted the value of long-term debt that appears on the balance sheet. The market value of debt is found by adding the current portion of long-term debt, notes payable, and long-term debt discounted at Nike's current coupon.

Market Value of Debt

D = Current LT + Notes Payable + LT Debt (discounted)

= $5.40 + $855.30 + $416.72

= $1,277.42

Using these figures, we can now find the market value of Nike Inc., and the company's capital structure.

III. Weightings

The weights of debt and equity are calculated using the market values of debt and equity as follows:

Weight of Debt(WD) Weight of Equity(WE)

WD

= D .

D+E

= $1,277.42

$12,704.86

= 10.05% WE