Submitted by: MAMATHA MOHAN

Cost of capital is a term used in the field of financial investment to refer to the cost of a company’s fund. Cost of capital of any investment is the rate of return the suppliers of capital would expect to receive if the capital were invested elsewhere in an investment of comparable risk. Its used to evaluate new projects of a company as it’s the minimum return that the investors expect for providing capital to the company. It mainly sets a benchmark at which the new project has to meet.

Weighted Average Cost of Capital is the rate that a company is expected to pay on average to all its security holders to finance its assets. In short, WACC is the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners and other providers of capital or they will invest elsewhere. WACC is set by investors and not by managers as it’s the minimum return required by capital providers to determine the economic feasibility of expository opportunities and mergers. As for Managers should invest only in projects that generate returns in excess of WACC.

WACC is estimated to value the cash flows for the entire firm.

In this case analysis, single cost is sufficient because the business segments of Nike i.e. foot wears and apparels, have about the same risk.

The WACC is used for discounting cash flows in the future, thus all components of cost must reflect firm’s concurrent or future abilities in raising capital. Cohen mistakenly uses the historical data in estimating the cost of debt and not the present. When the cost of debt is calculated, interest expenses by the average balance of debt to get 4.3% of before tax is taken instead of after tax hence it may not reflect Nike’s current or future cost of debt.

By estimating yield to maturity of the Nike’s bond to represent Nike’s current cost of debt

YTM = ( C+(f – p)/ n)/ 0.6p + 0.4p Given: PV = 95.60 N = (2001 to 2021 = 20 yrs) 20*2 =40 C = 6.75/2 =3.375 FV = 100 Therefore, YTM = 3.58(semi annually), 3.58*2 = 7.16 (annually)

After tax cost of debt = 7.16%(1-38%) = 4.44%

Cost of equity:

Joanna Cohen used CAPM method because it is most superior method.

rE = Rf + E [E(RM) – Rf ] =5.74%+(5.9%)*0.69)=9.811%
Cohen uses average beta from 1996 to July 2001, 0.80. Cohen uses a geometric mean of market risk premium 5.9%

Cost of equity using E/P approach
Diluted EPS (E)= 2.16  Market price (P)= 42.09

E/P =2.16/42.09= 0.051319 = 5.13
 

Discrepancies E/P is lower than Rf= 5.74%
Dividend Discount Model
D1 = D0(1+g) Given: D0= 0.48 ; g= 5.9
Therefore, D1= 0.48(1+5.9) = 0.48(6.9) = 3.312 Given: P0= 42.09 Therefore, R=(D1/P0)+g = (3.312/42.09)+5.9 = 0.0786+5.9 = 6.07 Hence there is a discrepancy.

The discounted cash flow analysis showed that at the discount rate of 12%, Nike was overvalued at a share price of $42.09 This shows that Nike is undervalued at the discount rate equal to WACC, which makes a Nike good investment, which is proven below.

Market Value Of Equity (MVE) Given: Market share =42.09, Average shares=273.3 MVE = MS*AS = 11503.197

Market Value Of Debt (MVD) Given: Current proportion of LTD =5.4, Notes Payable= 855.3 , Long term Debt=435.9

Adding the above, MVD=1296.6

The market value weight for equity is = 11,503 / (11,503+1,291) = 89.9%

The market value weight for debt is= 1,291/(11,503+1,291)= 10.1%.
After tax cost of debt = 7.16%(1-38%) = 4.44%

Given: Beta = 0.69 Rf = 5.74 G = 5.9 CAPM = 9.81

WACC= 9.81*0.899+4.44*0.101 = 9.27
At 9.27% WACC the present value of equity is 58.13% which is more than 42.09. This means that the value is undervalued so we recommend the investors to buy.

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