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45-822 - Corporate Finance

Nike Cost of Capital Case

45-822 Corporate Finance Mini 2 2017


Tepper School of Business
Carnegie Mellon University
Brent Glover
Admin

:: Form a group of 45 that will remain fixed through the course

:: Have one member email me with the group members and a


rank ordering of your case preferences
:: See the List of Cases page on Canvas

:: Group case allocations will be posted on Canvas

:: No class on Thursday Dec 7

:: Next time: Blaine Kitchenware case

:: Materials, videos on Canvas

Nike Cost of Capital Case Discussion 2


Why WACC?

I Why do we care about estimating a firms cost of capital?

I What does the WACC represent?

I Who determines a firms WACC?

I What can we use it for?

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What is WACC?

D E
rWACC = (1 )rD + rE
D +E D +E

I What do rD and rE represent here?


I Why are we multiplying rD by (1 )?
I Didnt we already count taxes in the FCF calculation?

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Joannas Single Cost of Capital

Joanna decides to compute a single cost of capital for the


company.
I I asked myself whether Nikes business segments had
different enough risks from each other to warrant different
costs of capital.
I Since I believe they face the same risk factors, I decided to
compute only one cost of capital for the whole company.

Do you agree with Joannas decision? Single or multiple costs of


capital?

What sort of applications can we use this single rWACC for?

In what applications would it be inappropriate?

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Joannas WACC

Were there any problems with how Joanna computed the WACC?
D E
rWACC = (1 )rD + rE
D +E D +E

Three inputs to discuss:


D
I Leverage ratio: D+E
I Required return on debt: rD
I Required return on equity: rE

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Inputs: Leverage Ratio, D and E weights

I How does Joanna construct debt and equity weights?

I How should these be constructed?

Debt:

Equity

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Inputs: rD

What does rD represent?

Do we have data to measure this?

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Inputs: rE

What does rE represent?

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Estimating rE using CAPM

rE using CAPM:
rE = rf + E E(rm rf )

:: rf : which rate to use?

:: E : what does Joanna use? What assumptions is she making?

:: Market risk premium E(rm rf ): What should this represent?

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Estimating rE using Dividend Discount Model

d1
rEDDM = +g
P0

:: Where is this coming from?

:: Equity holders are claimants to the perpetual stream of


dividends. What would you pay for Nikes equity?

:: The PV of the stream of future dividends. If we assume


current price reflects this and make an assumption about the
future growth rate of dividends, we can back out rE :
d1
P0 = DDM
rE g

:: What are we assuming here?


:: Anything wrong with the value we get for rEDDM ?
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rE using DDM

Using Exhibit 4, DDM gives rE =?:

Is the rE we get here sensible?

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Unlevering and WACC Recap

Nike Cost of Capital Case Discussion 13


Levered Firm

Think of the levered firm as the sum of an identical unlevered firm,


plus the value of the tax shields on debt:

Debt
VU
=

Equity
PV (Tax Shields)


X FCFt
+ PV(Interest Tax Shields) = Debt + Equity
t=1
(1 + rU )t
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Valuing Tax Shields


X FCFt
VL = + PV(Interest Tax Shields)
(1 + rU )t
t=1

When interest is tax deductible, the firm is paying less cash flow in
taxes to the government
:: More left for the security holders: debt and equity

Ignored these tax shields when calculating FCF, we value them


explicitly here:
X E (ITSt )
PV (ITS) =
t
(1 + rTS )t

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Unlevering

I When we estimate a using a companys stock returns,


which are we measuring?

I Often, we want to compute r , . How do we do this?


I Estimate values for D/V , rD , and rE

I Then unlever the equity cost of capital or equity beta to


obtain r or

I Simplest unlevering formula: assume unlevered return is equal


to return on assets (opportunity cost of capital)

D E
r rA = rD + rE
V V

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Unlevering

I Unlevering E or rE to get or r requires assumptions


about the risk of the tax shields

I Riskiness of TS depends on firms D/V rebalancing

I Different assumptions result in different unlevering formulas


I And different formulas relating WACC r to unlevered cost of
capital r

I The differences in these unlevering formulas are quantitatively


small unless leverage is very high
I Important to understand why different formulas appear
I In practice, can look up the appropriate formula to apply

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Unlevered vs. Average

The firms assets include the tax shields, which are low risk.
D E
rA = rD + rE = (1 w )r + wrTS
V V
and,
D E
A = D + E = (1 w ) + w TS
V V
where
PV(TS)
w= .
V

r , answer: What would the firms cost of capital, or beta, be


if it were unlevered?

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Unlevering Betas

D E
A = D + E = (1 w ) + w TS
V V
where
PV(TS)
w= .
V
Analyst can:
I Estimate E and D from returns on the firms securities, or
similar financial assets.
I Using debt-to-value ratio can then calculate A

To estimate the unlevered , and use it to estimate the all-equity


cost of capital, r , need to make assumptions about risk of the tax
shields.

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Continuous Rebalancing (rTS = r )

With continuous rebalancing of capital structure firm maintains a


constant debt-value ratio.
I w constant through time
I TS = because the tax shields change with the firms value.
I In this case
PV (TS) VU
A = TS + =
VL VL
I This justifies naively unlevering the beta: = A .

(Note this ignores bankruptcy costs):

VL = VU + PV (TS) = D + E

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D
a. Estimating the proportion of debt D+E

I Use market (not book) values


I Use net debt (Debt - Cash)

I Market value of equity: #shares share price


I Want market value of debt, but often hard to calculate. Can
use book debt as a proxy if the value was recorded when:
i) interest rates were similar to today, and
ii) the firms credit rating was similar.
I Otherwise, take current rD and discount the remaining
expected debt payments with it

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How do we decide what is debt or not?

I Cash: All necessary cash is an operating asset. All excess


cash reduces the net debt measure
I Accounts Payable: If an integral part of doing business,
should be counted as a negative operating asset and offset
against accounts receivable (in WC).
If main purpose is financial, then its (often very expensive)
debt.
I Other Liabilities: borrowing from the pension fund, hybrid
securities,. . . They are debt if
i. they are senior to equity, and
ii. non-payment leads to bankruptcy.

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b. Estimating rD

One can measure the cost of debt by:

1. Observing the price of outstanding bonds


- Often the promised yield is used as the cost of debt

2. Observing the credit rating


- Use the average yield corresponding to the credit rating

3. Making your own rating


- Use financial ratios to infer a rating and/or a credit spread

:: Recall: yield on a risky (defaultable) bond is not the same as


the expected return. But for low default probability/high
recovery rate (investment grade bonds) the yield is close to rD
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Estimating rE

CAPM for firm i:

rE ,i = rf + E ,i E(rm rf )

:: Run the regression to estimate E ,i :

ri,t rf ,t = i + i (rm,t rf ,t ) + i,t

:: ri,t return on stock i for period t


:: rf ,t risk-free return for period t
:: rm,t risk-free return for period t
:: i : intercept (=0 according to the CAPM)
:: i : equity beta for stock i

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Back to Snap

Nike is an older, mature firm, compared to Snap. Relative to Snap,


does that mean Nike should have:

:: a lower cost of capital?

:: a more precisely estimated cost of capital?

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Estimating Snaps cost of capital

1. Pick comparables
2. Estimate comparable E s
3. Unlever E s
4. Average across these
5. Lever up to company of interest (Snap) capital structure
6. Compute WACC

:: Twitter
:: E=10.29, D = 1.69, Cash = 3.78

:: Facebook
:: E= 402.7, D= 0, Cash = 29.45

:: Return data on Canvas

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estimates

TWTR -.021 1.34
(0.027) (0.859)

FB .023 0.75
(0.017) (0.548)

:: Which s are these?

:: Whats the we want? (Whats the thats comparable to


Snap?)

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