The first step of my work was to evaluate what the Cost of Debt is. Then, I worked on the cost of Equity. Those two percentages represent how much the company pays for financing its capital. By weighed them I will find what Nike’s Weighed Average Cost of Capital is.
Cost of Debt (Kd)
In order to calculate the Cost of Debt I used the future cash flow calculation method. I found what interest Nike’s has to pay to finance its debt. The shoe company finances its debt with bond which follows those characteristics:
|Coupon Rate |6.75% (Paid semi-annually) | |Issued |07/15/1996 | |Maturity |07/15/21 | |Current Price |$95.60 |
Because the bond interests are paid semi-annually I first calculated their semi-annual cost:
|Payment |(6.75%) /2 * 1000 = $33.75 | |Par Value |$1000 | |Present Value |(95.6%) x 1000 = $956 | |Time-to-Maturity |25 x 2= 50 periods |
⇨ Semi-Annual Yield-to-Maturity = 3.56%
Which is equal 7.13% a year. This yield represents the cost of issuing the bonds for the company before taxes. Nike is in the 35% bracket, but the company also pays state taxes. Those varied from 2.5% to 3.5% depending of the years, so I counted them as an average of 3%.
Nike’s Cost of Debt after Taxes
Kd = 7.13 x [1-(35+3)%]
Kd = 4.42%
Cost of Equity (Ke)
The Cost of Equity for a company can be evaluated using different ways. The two main ones are the Capital Asset Pricing Model and the Dividend Capitalization Model. I used the C.A.P.M. because the second model would not be accurate enough. Indeed, this method needsto evaluate the growth rate of the dividend that the company will pay. Nike’s value line forecast is 5.5% between 1998 and 2006. This corresponds to a dividend of 74 cts, whereas over the last 4 years it has only increased from 40 cts to 48 cts between 1997 and 1998. It can be seen as an optimistic forecast. This uncertainty led me to use the C.A.P.M.
According to this Model
Ke = Rf + B (Rf – Rm)
Ke= Cost of Equity
Rf = Risk-free rate
Rm = Expected market return
B = Beta of the security in 2000
• Risk-Free Rate
As risk-free rate I chose 5.74% which is the current yield on the 20 years U.S. Treasuries. It corresponds to the secure investment (guaranteed by the U.S. Government) with the highest yield.
Rf = 5.74%
• Risk Premium
The risk premium is equal to the difference between the risk-free rate and the expected market return. There is different ways to find the risk premium: evaluating it by estimating what the market return will be or using the historical data. I used the historical data because the last years’ market returns were subject to large variations. Indeed between 07/03/00 and 07/02/01, the Standard & Poor’s 500 Index lost 19.49% whereas over the year before (between 07/05/1999 and 07/03/00) it had increased of 5.39%. This makes it hard to estimate the next market return, so I chose to use the geometric mean of the historical risk premium (1026-1999).
According the Ibboston Associates Yearbook, 1999, the historical geometric mean of the risk premium between 1926 and 1999 is 5.90%. I used the geometric mean instead of the arithmetic for its accuracy. The geometric average takes into account the influence of the prior years’ returns on the new...