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?
WACC means the weighted average cost of capital. WACC is based on the respective weights of the firm’s financing sources, equity and debt at the respective return rates. A firm’s capital comes from two main ways, equity and debt, and WACC takes both into consideration. This means WACC includes all stock, bonds, long-term debt, and all capital sources in its calculated formula. So WACC is an appropriate discount rate to evaluate a firm’s cost of capital, and to help investors to make investment decisions. WACC is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers.
We disagree with JC’s WACC calculation. The reasons are as below.
- Error in value of debt
JC included the short term debt. For capital cost structure, it requires long term debt, because short term debt is considered as part of working capital.
- Error in value of equity
JC used the book value of $3,494.50. We should use market value (current stock), which is more accurate.
- Error in CAPM Calculations
JC considered 20-year US Treasury bonds as risk free, which is not consistent with the company’s cash flow duration for a projection of 10 years.
2. If you do not agree with Cohen’s analysis, calculate your own WACC for Nike and be prepared to justify your assumptions.
-Kd: cost of debt is equal to the YTM of NIKE’s 25-year bond, which is 7.1674%
| |Given data |Converted data for HP12 input|Calculation result | |Coupon rate/payment |Semiannual rate of 6.75% |6.75%, /2=3.375% ($3.375) |i=3.5837% | | | | |YTM = i * 2 | | | | |= 3.5837 * 2 | | | | |= 7.1674% | | | | | | |Year to maturity |20year |20*2=40 | | | |(from 2001 to 2021) | | | |PV |$95.6 |-95.6 | | |FV |$100 |100 | |
-Ke: cost of equity , 10.1% (see calculation of 4-1)
-Debt: use the long term debt
*Long term debt=$435.9
-Equity: use market value. Stock Price x Number of shares outstanding = $42.09 x 271.5= $11,427.435
-So: Wd(Debt weight)=435.9/(435.9+11427.435)= 3.6743%
-T: tax rate is the...