Nike, INC: Cost of capital
1. What is the WACC and why is it important to estimate a firm’s cost of capital? Do you agree with Joanna Cohen’s WACC calculation? Why or why not?
Definition of WACC (Weighted Average Cost of Capital):
WACC is basically the average of the cost of finance (debt and equity). Since a company’s assets can be financed by debt or equity, WACC can show the averages of the costs involved in the sources of financing. These costs are then weighted by the users of the information as required in a specific situation. This shows how much both debt holders expect to pay in interest and how much return the shareholder can expect to receive, for each dollar of financing (Investopedia, ND).
The calculation of the cost of capital is one of the important elements that decide the enterprise value. The value of the enterprise can significantly change when the percentage of cost of capital changes in the business model, with the cost of capital representing the expected return for shareholders.
We disagree with Joanna’s WACC calculation for following reasons: The calculations of WACC and DCF can be effected as they are subjective by her human judgment. Even though there are no right answers to make these decisions, our team disagrees with some of the assumptions Joanna Cohen made.
i. ‘Ratio of debt financing’ and ‘Ratio of equity financing’
It has to be applied the market value because current shareholders’ expected return has to be reflected. Both ratios should be calculated not by using ‘Book Value’ but ‘Market Value’.
ii. Cost of Debt
Cost of Debt can be calculated with the current yield publicly traded in the market, because we are projecting the future cash flows. Joanna calculated this by using historical data. However cost of debt should be calculated using current YTM of debt.
iii. Cost of Equity
Joanna calculated cost of debt by using following CAPM formula: