Meaning and Importance of WACC
WACC is weighted average cost of capital, which represents how the firm’s assets are financed by how much debt or equity. WACC can be viewed as a required rate of return for the firm’s capital provider. A correct estimation for WACC is very important because of these following reasons. First, firm uses WACC as the benchmark to decide which project the firm should invest in. It helps the firm decide about capital budgeting. If the firm underestimates its WACC, it can lead to a misinterpretation. People would understand that all of the projects have a feasibility to succeed and gain returns as they expect which in reality this is not always true. In contrast, if the firm overestimates its WACC, the firm may lose a chance to invest in lucrative projects because they think that the project gives lower returns than its WACC. Moreover, WACC is used to discount the firm free cash flow to calculate the firm value. Analyst estimates the firm’s WACC to value the firm’s stock price and write a report to suggest investors whether they should buy, sell or hold the firm stock. After investors follow the analysts’ recommendation, their actions will signal the market and affect the firm’s stock price. Third, WACC is used to decide about the methods of financing. When the firm needs external funds, the firm has to decide whether it will issue equity or borrow more debt. It’s simple that every firm wants to minimize one’s cost which means that the lower the WACC is, the more benefits the firm gets.
In our ideas, we both agree and disagree with Joanna Cohen’s WACC calculation. We agree with how Joanna Cohen used single cost of capital method even though Nike Inc. has multiple business segments but each segment of Nike Inc. is all related to sports and they are operated under the same marketing plan and same distribution channels which means that Nike’s business segments expose to almost the same risk level. For the part that we disagree is about the way she calculates WACC. The reasons why we disagree are as follow; 1.) Value of Equity
Joanna Cohen used book value to calculate Equity Value, which we think it’s not appropriate because in reality book value doesn’t reflect the firm’s potential but market value does. Market Value of Equity can be calculated by; Market Value of Equity = Stock Price x No. Of Shares Outstanding
= $42.09 x 271.5
According to Cohen’s calculation ($3,494.5), we can see a big difference here. 2.) Value of Debt
Joanna Cohen used book value as an estimate of market value of debt and we think that it’s appropriate since Debt Value doesn’t vary when time changes like Equity. Even if the firm sells bonds at discount rate but in the end the firm records the price at its face value anyway. Market Value of Debt can be calculated by; Market Value of Debt = Current LT portion + Notes Payable + LT Debt
= $5.4 + $855.3 + $435.9
From Joanna Cohen’s calculation, the debt as a proportion of total capital is 27% and 73% for the equity. She used book value to calculate both Debt and Equity Value. But for our calculation, we use Market Value to calculate. It will affect the weight proportion. Weight can be calculated by; Wd = D/(D+E)
= 1,296.6 / (11,427.44 + 1,296.6)
We = E/(D+E)
= 11,427.44 / (11,427.44 + 1,296.6)
4.) Cost of Equity
We use CAPM method to calculate cost of equity.
CAPM = Rf + B(Rp)
* Rf : Current yield on 10-year Treasury Bonds = 5.39%
* Rp: Geometric Mean of Historical Equity Risk Premium (1926-1999) = 5.9% * Beta: Average of Nike Historic Beta (1996-2001) = 0.8
CAPM = 5.39% + [(0.8)(5.9%)] = 10.11%
The reason we chose current yield on 10-year Treasury Bonds is that it will match with the firm’s free cash flow analysis. For Geometric Mean, we use it because the geometric mean yields lower...
Please join StudyMode to read the full document