Nike Case

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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?

WACC is the weighted average cost of capital. It can be calculated as:

WACC = (Weight of funding source 1) x (Cost of funding source 1) + … + (Weight of funding source n) x (Cost of funding source n)

Usually this will be simply:

WACC = (Percentage of debt) x (Cost of debt) + (Percentage of equity) x (Cost of equity)

It is important to estimate a firm’s cost of capital for the appraisal of new projects; a project should only be undertaken if the return from it is greater than that of the capital required to fund it unless there are other compelling (strategic) reasons.

A firm should also be aware of it’s own cost of capital and try to minimise this.

We do not agree with Joann’s WACC calculation:

▪ Her funding source weightings are wrong

▪ There is an argument that all debt (including accounts payable etc) or net debt and a blended return on this should be used

▪ The debt figure will only ever be an estimate as the balance sheet is one day in the year

▪ Her analysis assumes Nike debt is trading at par – it is not

▪ Equity should be based on market value, not book value

▪ Hence total will be based on market cap., not balance sheet

▪ Her debt cost is wrong

▪ She should use the current or projected cost rather than a historic one

▪ i.e. use a Bloomberg terminal (other terminals are available) to research yields on debt of the same credit rating as Nike

▪ It is unlikely Nike has a cost of debt lower than T bills

▪ Raising debt in a foreign currency (Jap Yen) either carries an associated hedging cost or exposes the borrower to FX risk, hence the coupon rate on the notes is not the actual cost of the debt

▪ Her assumed tax rate is probably wrong, if a firm is paying anywhere near the statutory tax rate they are not doing their job properly. We would expect their actual tax rate to be much lower, even though the case does not show this

▪ Her equity cost is only an estimate and she has not used all of the tools available to her

▪ The CAPM only provides an estimate. Her inputs are based on assumptions:

▪ We do not know whether 20 year T bills are the most appropriate measure of the risk free rate. If NorthPoint is planning a 20 year investment they might be but we need more information. Any proxy for the RFR will only ever be an estimate

▪ The market risk premium is even harder to estimate. Although the geometric mean is the better measure she has used numbers based very old data. Markets may well have changed since 1926 and hence a more recent or even anticipated premium should be used

▪ Nike’s Beta appears to be on a downward trend so an average might not be the best estimate. A forward looking Beta based on the outlook and expectations for the business would be better

▪ Because equity markets are forward looking (12 to 18 months) the current Beta is probably the best estimate

▪ Nike has been very volatile compared to the S&P 500 so the historic Betas smooth reality

▪ By only considering the CAPM she ignores other methods for calculating the cost of equity and potentially makes a mistake

▪ A better approach would be to calculate the cost of equity using all available methods then make an estimate based on a larger range of data

If you do not agree with Cohen’s analysis, calculate your own WACC for Nike and justify your assumptions

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Assumptions:

▪ Market value of debt

▪ Better reflection of actual value of source of funds

▪ We want to be forward looking, par is a historic number

▪ Running yield on bonds rather than YTM

▪ Quicker and easier to...
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