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Weighted Average Cost of Capital ....................................................................................... 2 Importance of calculating cost of capital .............................................................................. 2 Flaws in Johanna¶s calculation of WACC ............................................................................ 3 Our calculation of WACC .................................................................................................... 4 CAPM and DDM ................................................................................................................. 5 Recommendations................................................................................................................ 6 7

Appendix

Myers and Allen in the book Principles of Corporate Finance (11Edition. or combination of these to finance any project.). The WACC of a firm refers to how much. Weighted Average Cost of Capital Weighted Average Cost of Capital (WACC) is the required rate of return for the company that is calculated considering all forms of financing source it uses. 2 .Bonds (Debt financing).215. on average. WACC is the overall return that a company must earn from its assets and business operation (net income) so as to maintain its current stock price. Cost of debt is the after tax cost of debt. Also it is easier to add or subtract from the company¶s cost of capital than to evaluate each projects capital from the start. Loans. Thus. Preferred Stock or Equity. it costs the firm to raise money. A company¶s capital structure might be a mix of . company¶s cost of capital becomes the right discount rate. WACC can also be used as discount rate to estimate the firm¶s value. For these types of projects. Importance of calculating cost of capital Authors Brealey. assuming the capital structure and interest rate remains the same within the given time frame. Preferred Stock. To interpret WACC from a finance manager¶s perspective or an investor¶s perspective. pp. describe there are few reasons for finding the cost of capital. WD = Debt/Total Capital WPS = Preferred Stock/Total Capital WCE= Common Stock/Total Capital Note: 1. WACC = WD * Cost of Debt + WPS * Cost of Preferred Stock + WCE * Cost of Equity Where. 2. Company uses only Debt. as shown below: Mostly projects can be treated as average risk that is neither more nor less risky than the average of company¶s other assets. WACC is the firm¶s cost of capital that we get by weighing each source of capital proportionately. and Common Equity and the rates of return (or the cost of financing) for each of them is different. in a given capital structure. 2.1. The company¶s cost of capital becomes a useful starting point for setting discount rates for unusually risky or safe projects.

y Value of equity should not be taken as Book Value She has used the Book Value of equity which does not give the real picture of the current value of the firm¶s total capital. But there isn¶t superior method as such. Adopting a methodology to calculate a company¶s cost of equity depends upon the financial scenario of each company. Flaws in Johanna¶s calculation of WACC There are some serious flaws in Johanna¶s calculation of WACC. Also the reliability of the data to calculate CAPM or DDM or ECR determines the selection of methodology. So taking the Book value of equity calculates wrong weight for both debt and equity. a financial manager can recommend changes in capital structure to better accommodate with the market changes and reduce the cost for the company. This is does not give the real required rate of return for the debt. Cost of capital (under WACC) is affected with a change in capital structure. computed at the company¶s cost of capital is well above zero. We suggest she should have used the Yield to Maturity rate for the long term debt that has been issued by Nike Inc. y No method to calculate cost of capital is superior from one another Johanna uses CAMP method to calculate cost of equity since she believes that CAPM is the superior method to calculate a company¶s cost of equity.The authors also mention that many large companies use the company¶s cost of capital not just as a bench mark but also as all purpose discount rate for every project proposal. We found some major mistakes in her underlying assumptions and ways to calculate the input for WACC. risk adjustment shifts from the discount rate to project cash flows. cost of capital helps the management of a firm to decide appropriate capital structure. y Rate of return for Debt is not properly calculated She has calculated the required rate of return for Nike Inc. One benefit gained from this is when firms force the use of a single company cost of capital. Use of market price for the company¶s equity should suggest a more precise result for the weight given to each factor of capital structure. 3 . As measuring risk objectively is difficult and financial managers do not waste time in arguments over them. Furthermore. With careful analysis of the cost of capital. 3.¶s debt by taking total interest expenses for 2001 FY and divided it by the firm¶s average debt balance. The benefit here is while evaluation is going on the top management may request ultra conservative cash flows from high risk projects. So they might reject undertaking such types of projects unless NPV.

Our rational for use of Geometric Mean are as follows: 4 . we have taken the CAPM approach.74%. with these values for the cost of debt and the weight for debt in the capital structure. We have taken Yield to Maturity rate for the Long term bonds issued by Nike Inc as the required rate of return for debt. we have taken Geometric Mean of Historic Equity Risk Premiums. The YTM rate with 6.45 % To get the firm¶s cost of capital. Since Nike does not provide substantial dividends to its stock holders DDM would not yield appropriate required rate of return for the equity invested. Also. Total Debt is calculated by adding the current book value of Notes Payable. 4. The financial theory underlying DDM is ± value of the stock is worth all the future cash flows (dividends) generated by the company¶s operation discounted under a rate of return. it cannot be used to estimate the precise future cash flows for the shareholders.75% coupon rate semi annually is 7.165%. Since Nike does not provide significant amount of dividend. Current portion of Long term Debt and Long Term Debt. For the Risk Premium.6 million. We agree with Johanna and her assumption to get the tax rate 38%. which is equal to $ 1296.81%. in our case CAPM would be the better option to calculate cost of equity rather than DDM.However.5 million). Now. For Risk Free rate (RF).44% and weight of Equity is 89. we get the weighted after tax cost of debt is 0. The Total capital is calculated to be $ 12724. So the total value of Equity is $11427. Therefore the weight given to debt is 4. which is not an appropriate approach.04 million. This time frame would be consistent to the Time to maturity for the Long term debt issued by Nike Inc. We took the market value approach to calculate the total equity. if we can see that the average of tax rate for the past 7 years ± from 1995 to 2001 was 38%. which is 5. we have taken the 20 year yield rate on US Treasuries. using the CAPM methodology to be 9. Our calculation of WACC We have calculated the WACC for Nike Inc.44 (Current price of stock is $42. Johanna had taken the book value to calculate the total equity.846% (Refer to the Appendix) We believe that there is no need of multiple cost of capital for Nike because the multiple business segments in which it operates are not much different and the risks and betas for all segments would be similar.09 and current number of outstanding stock is 271.

However. But since Nike is looking forward to achieve the success they had previously held. using CAPM is 9. Weighted Cost of equity for Nike Inc. the average historical beta would better reflect the company¶s performance in market. and provides clearer picture of risks for the company/investors who have used diversified portfolio and thus have decreased the specific risks for the company in question.8. Geometric mean is a better option to estimate a longer life valuation for rate of return where as Arithmetic mean is useful for one year estimated expected return. CAPM and DDM Cost of Equity using CAPM = 10. we have taken the Average of Historical Beta. Furthermore. return. The Year to Date Beta only gives the current market scenario of the company¶s business practices. 0. It is a simple model for valuing equity and works well when growth rate is fixed and the dividend paid is according to earnings and growth. In the analyst meeting. 5. Also. DDM is defined in term of ordinary variables with known relationships among the variables. And an undervalued stock would not yield to its estimated real value within a short span of time. and investor behaviors.46% Cost of Equity using DDM = 5.39%. like one year. declared its strategy of revitalizing the company and regaining the market share. However. the single period in the CAPM would really mean ten years.y NorthPoint Group emphasize on value investing. So appropriate returns would be defined by Geometric mean. Nike Inc.5114% (Refer to the Appendix) CAPM approach is that it takes into consideration a company¶s market risk as the most relevant risk to stockholder. therefore to determine the effect of new business or project of company on stock price. Moreover.. CAPM considers the only systematic risks. there are no direct adjustments for risk in this approach. With all these assumptions and the related values for input. CAPM is based on historical data onto the future with estimation we use. y For Beta value. it¶s difficult to predict a proper growth rate in economic fluctuation. 5 . CAPM is based on simplifying market. DDM requires enormous amount of speculation in trying to forecast future dividends. They purchase the stock of companies that is perceived to be undervalued and expect to get greater return in the future. When we use the risk premium to estimate the cost of equity to discount a cash flow in ten years (as Johanna has done in Exhibit 2). It means the model is only as good as the assumptions are accurate. Furthermore.

6 . Also. Recommendations According to sensitivity analysis (Exhibit 2) devised by Kimi Ford.17%.In sum. stocks of Nike are undervalued if the discount rate is less than 11. Thus. while comparing CAPM and DDM. the company has the potential to yield abnormal profits.09. we recommend Kimi Ford to µBuy¶ the stock of Nike Inc. the stock price is undervalued by almost $13 dollars. it¶s technically comparing how reliable beta and growth rate are.¶s performance against S&P 500 index.03) and Debt to Equity Ratio (0. is 9. if we look at some of the ratios for the company like Current ratio (2. In addition to that. 6. if we look at the past trends of Nike Inc. the company is in a good position to realize the goals set by the management. in her investment portfolio because the stock price is currently undervalued. With this information. With the change in the company strategy ± to focus more on mid-priced segment.846%. Managers have to make a decision based on how accurate they estimate beta and growth rate under different situations.51). We have found that the discount rate for Nike Inc. and to capitalize on the new leadership in the apparel segment ± it is highly probable that the company might incur greater returns in the future. we recommend that Kimi should include Nike Inc. And since the stock of Nike is currently traded in $42.

Appendix WACC using CAPM for calculating Cost of equity WACC = WD * Cost of Debt + WCE * Cost of Equity = 0.04 = 0.5 millions * $42.8981*10.3+$435.44% + 0.9 (in millions) = $ 1296.44% + 0.5114% = 5.1019 7 .6 millions Total Capital = Total Debt + Total Equity = $ 1296. WD = 1296.846% Where.4+$855. Total Debt = $5.44 millions Total debt is calculated by adding Current portion of Long term debt. which is a wrong approach.6/12724.6 + $11427.46% = 9. Notes Payable and Long Term Debt from the balance sheet. We have taken the market value of the stock and the total value of equity is: Total Equity =Number of Outstanding shares*Current price per share = 271.0 = $ 11427.44 = $ 12724.1019*4. WD = weight for debt WCE = weight for common equity WACC using DDM for calculating Cost of equity WACC = WD * Cost of Debt + WCE * Cost of Equity = 0.04 millions Therefore.1019*4.8981*5.964% Johanna has taken the book value for total equity.

5% semiannually Years to Maturity = 20 Years (2021 ± 2001) Current Price = $95.50% = 5.04 = 0.48/42.WCE = 11427.8 Risk Premium (RP) = 5.74% Beta ( ) = 0.44/12724.60 Therefore.09) + 5.8981 Cost of Debt = YTM*(1-Tax rate) = 7.5114% Note: Dividend provided in the current year (DO) = 0.62) Tax rate = 38 % Cost of Equity with CAPM method = RF + = 5. Face value of the bond = $100 Rate = 6.8(5.90% (RP) Cost of Equity with DDM method = (DO/Current Stock Price) + g = (0.90) = 10.165*(1-.50% [Value line forecast for Dividend Growth from 98-00 to 0406] 8 .165% (for current price to be $95.48 Dividend growth rate (g) = 5. YTM = 7.44% Notes: For YTM.74 + 0.46% Note: Risk Free rate (RF) = 5.38) = 4.

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