Kimi Ford is a portfolio manager at NorthPoint Group, a mutual-fund management firm. She is evaluating Nike, Inc. (“Nike”) to potentially buy shares of their stock for the fund she manages, the NorthPoint Large-Cap Fund. This fund mostly invests in Fortune 500 companies, with an emphasis on value investing. This Fund has performed well over the last 18 months despite the decline in the stock market. Ford has done a significant amount of research through analysts’ reports, which had mixed reviews. She found no clear guidance from the analysts and decided to develop her own discounted cash flow forecast to come to a conclusion. Her forecast showed that Nike was overvalued at its current share price causing a discount rate of 12%; however, a quick sensitivity analysis showed that Nike was undervalued at a discount rate below 11.17%. Ford then asked her assistant, Joanna Cohen, to estimate Nike’s cost of capital, which, per Cohen’s analysis, came to 8.4%.
The cost of capital is the minimum return that a company should make on an investment or the minimum return necessary for investors to cover their cost. Two main factors of the cost of capital are the cost of debt and the cost of equity. The capital used for funding a business should earn returns for the investors who risk their capital. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital – the risk-adjusted return on capital must be higher than the cost of capital. The Weighted Average Cost of Capital (“WACC”) is the rate a company will pay to finance all of their assets. Depending on the capital structure of a firm, a proportionate weighted percentage will be applied towards the financing of debt, equity, and preferred stock. Because the WACC is calculated using weighted averages for debt and equity, it is a good measurement of the cost to the company for financing its operations. It is probably the best estimate of the discount rate needed to be profitable on projects and serves as an adequate proxy for a required return. Companies typically use the WACC to determine the viability of expansion opportunities and other projects. Again, it is a good proxy to use for the discount rate of future cash flows. Based upon its use, managers and investors both set the WACC. Corporations use the WACC to make capital investment decisions, while investors use it to make portfolio investment decisions. Businesses or projects that are able to earn returns greater than the cost of capital add value for investors. Conversely, those that produce returns less than the cost of capital may still be profitable but hurt the value of the investor.
“Best Practices in Estimating Cost of Capital: Survey and Synthesis”
The purpose of this article is to present evidence on how a handful of the world’s financially sophisticated companies, top financial advisors and leading textbooks estimate capital costs or to answer the question “How do companies really estimate their cost of capital?” The way they went about conducting this survey was through telephone interviews with a series of open-ended questions. The “best practice” to the survey conductors wasn’t necessarily the one that was used most; rather they tried to focus on the gaps between theory and application. Interviewees and research resources were obtained via multiple publications. The surveyors first found the top 50 companies in financial management through a research report. From those 50, they cut out 18 headquartered outside of the U.S., and 4 declined to be interviewed, leaving a sample set of 27 companies. They then went on to find some of the top financial advisors using a “league table” of merger and acquisition advisers and drew 10 of the most active advisers. Finally, they picked the top 4 best selling text and trade books from a list of the graduate level books...