Calculating Wacc

Topics: Capital asset pricing model, Interest, Weighted average cost of capital Pages: 8 (2495 words) Published: March 20, 2011
1. Cohen calculated Nike’s weighted average cost of capital (WACC) to be 8.3%. I find error in this calculation as a result of the following points of disagreement: a) Weighting of Capital Structure: Use of book values of capital rather than the market values b) Cost of Debt Calculation: Incorrect method for calculating debt c) Tax Rate: Use of a tax rate derived from the summation of state and statutory taxes instead of the firm's marginal tax rate

2. Revised Calculation of WACC:
WACC reflects the weighted average cost of the various sources of invested capital: WACC = Kd (1 – t) Wd + Ke We + Kp Wp Where:
Kd (Wd), Ke (We) and Kp (Wp) are the costs (weights) associated, respectively, with the firm’s interest bearing debt, common equity and preferred stock. Classification of redeemable preference shares as either debt or equity varies between different regions based upon the different standards they adopt. Given Nike is a U.S. firm, American standards will be followed. Thus, redeemable preference shares have been assumed debt components. WACC is therefore simplified to:

WACC = Kd (1 - t) Wd + Ke We
a) Cost of Debt (Kd):
To calculate Nike's Kd, Cohen simply divides total interest expense for the year by the average debt balance. Concern over this method lies in the possibility that the interest expense line, incorporates expenses not directly related to the company’s debt. A more appropriate measure for the cost of debt should include the current market yield on Nike's publicly traded debt. In recalculating WACC, YTM on Nike's current bonds is used as a proxy to estimate Kd. This method is justified via the satisfaction of two conditions: a) the firm has issued debt in the past and b) the bonds issued were publicly traded. Having met these criteria, it is assumed that the rate paid by Nike on its current bonds, is an accurate measure of the firm's current credit risk as represented in the market. Thus, (refer to Appendix 2a. for calculations). -------------------------------------------------

Nike’s annual Kd before taxes = 7.13%
To calculate the true Kd however, it is important to consider, after tax Kd. This is because interest expense is tax deductible and thus creates a saving for the firm. Therefore, the net cost of the debt is in fact, the interest paid less the tax savings, resulting from the tax deductible interest payment. Thus, after-tax cost of debt = Kd (1 - corporate tax rate). As a result of calculations being assumed in perpetuity, the marginal tax rate is used. This rate generally refers to the "federal income tax that is levied onto the additional dollar earned" and is commonly approximated to be 40%. b) Cost of Equity (Ke):

Ke can be evaluated using a number of different methods e.g. Capital Asset Pricing Model (CAPM), the Dividend Discount Model (DDM) and the Earnings Capitalization Model (ECM). In calculating WACC, the most difficult component to estimate is Ke. Unlike debt, Ke cannot be observed in the market. The standard approach used to estimate Ke is the CAPM which is also the method use in our analysis as well as Cohen’s. i. CAPM: Kei

The CAPM states that the opportunity cost of equity (Ke) is equal to the risk-free rate (Rf) plus the multiple of the market risk premium (Rm-Rf) and the company’s systematic risk (β).

Ke =Rf + β (Rf – Rm)

Risk-free rate (Rf):
The risk-free interest rate is the theoretical rate of return of an investment with zero risk, including default risk. While such an asset exists only in theory, one commonly uses government bonds in representation as their likelihood of default is extremely low. In addition to default risk, the Rf should also have no associated reinvestment risk. To avoid reinvestment risk it is important to match up the duration of cash flows to the duration of the bonds used to determine the Rf. Since Nike is a USD investment, the risk-free rate used in the analysis was...
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