Group 2 Members : Devendra Rane, Vivekkumar Nema, Chandrashekhar Joshi, G. Ajithkumar, Prakash Shetty Case Background:
* NorthPoint Large Cap Fund weighing whether to buy Nike’s stock. * Nike has experienced sales growth decline, declines in profits and market share. * Nike has revealed that it would increase exposure in mid-price footwear and apparel lines. It also commits to cut down expenses. * Kimi Ford’s initial assessment at a discount rate of 12% showed Nike as overvalued at $42.09. However it should undervalued at discount rates below 11.2% * The market responded mixed signals to Nike’s changes. Kimi Ford has done cash flow estimation, and asks her assistant, Joanna Cohen to estimate cost of capital. WACC Methodology:
* The weighted average cost of capital (WACC) is the rate (expressed as a percentage, like interest) that accompany is expected to pay to debt holders (cost of debt) and shareholders (cost of equity) to finance its assets. * It is the minimum return that a company must earn on existing asset base to satisfy its creditors, owners, and other providers of capital. * The cost of capital is the rate of return required by a capital provider in exchange for foregoing an investment in another project or business with similar risk. Thus, it is also known as an opportunity cost. * Since WACC is the minimum return required by capital providers, managers should invest only in projects that generate returns in excess of WACC. * The WACC is set by the investors (or markets), not by managers. Therefore, we cannot observe the true WACC, we can only estimate it.
WACC formula: WACC = (E/V). Ke + (D/V). Kd . (1-T)
* V = D + E = Total Capital
* D: Amount of Debt
* E: Equity
* Kd: Cost of Debt
* Ke: Equity
* T: Tax rate
Do you agree with Joanna Cohen’s WACC estimations? Why or why not? Cohen calculated a weighted average cost of capital (WACC) of 8.4% by using the capital asset pricing model (CAPM) for Nike Inc. and we do not agree with her figure fully. The issues and the reasons to that are postulated as follows: * Single Cost or Multiple cost consideration – for footwear and other divisions (like apparel) We agree with the use of the single cost instead of multiple costs of capital. The reason of estimating WACC is to value the cash flows for the entire firm, which is provided by Kimi Ford. Plus, the business segments of Nike basically have about the same risk; thus, a single cost is sufficient for this analysis.
* Weights of capital components
* Cohen is wrong to use book values as the basis for debt and equity weights; the market values should be used in calculating weights. * The reasoning of using market weights to estimate WACC is that it is how much it will cause the firm to raise capital today. That cost is approximated by the market value of capital, not by the book value of capital. * Market value of equity: $42.09*273.3 Mn Shares = $ 11,503 Mn. This figure is much different than the book value of equity that Joanna Cohen used ($3,494.50 Mn). * Due to the lack of information of the market value of debt, book value of debt, 1,291 mn, is used to calculate weights as per Joanna Cohen calculation * Thus, the market value weight for equity is E/V = 11,503 / (11,503+1,291) = 89.9%; the weight for debt is D/V = 1,291/ (11,503+1,291) = 10.1%.
* Cost of Debt:
* The WACC is used for discounting cash flows in the future, thus all components of cost must reflect firm’s concurrent or future abilities in raising capital. * Cohen mistakenly uses the historical data in estimating the cost of debt. She divided the interest expenses by the average balance of debt to get 4.3% of before tax cost of debt. It may not reflect Nike’s current or future cost of debt. * The cost of debt, if it is intent to be forwarding looking, should be estimated by 1. Yield to maturity of bond,...