1. Please define Weighted Average Cost of Capital (WACC). Write down the WACC formula, and discuss its components.
WACC (Weighted Average Cost of Capital) is a market weighted average, at target leverage, of the cost of after tax debt and equity. It is a critical input for evaluating investment decision, and typically the discount rate for NPV calculation. And it serves as the benchmark for operating performance, relative to the opportunity cost of capital employed to create value.
Algebraically, it is given by
WACC = [E/(E + D)] *re + [D/(E + D )]*rd * (1-t)
Where WACC= Weighted Average Cost of Capital
re = cost of equity
rd = cost of debt
E = market value of equity
D = Market value of debt
t = tax rate
2. Calculate cost of equity using the Capital Asset Pricing Model (CAPM). Given are the values:
Rf = 5.74%
β = 0.8
Rm – rf = 5.9%
Required to calculate the cost of equity re; using CAPM.
It follows that from our formula
Re = rf + β (Rm –rf)
= 5.74% + 0.8 (5.9%)
We decided to use the 20 year treasury risk free rate value of 5.74% because it is a conservative value for such a period of time; and having covered such a span of time compensates for volatility. The average beta (β) of Nike firm from 1996-date which is 0.80 appears to be the best for such an analysis, so we adopt it as well.
3. We have discussed in class the dividend discount model (DDM)as an alternative method to calculate cost of equity:
Re = (D1/P0) + g
Re = Cost of equity
D1 = Expected dividends
P0 = Current share price
g = Expected dividend growth rate
Calculate cost of equity using the dividend Discount Model (DDM). Compare your estimate using the dividend discount model to your estimate from the CAPM. Which estimate makes more sense to you?
Re=D1/P0 + g
=D0(1 + g)/P0 + g
= 0.48*(1 + 5.5%)/42.09 + 5.5%
We believe the...