cost of debt

Topics: Arithmetic mean, Capital asset pricing model, Interest Pages: 3 (732 words) Published: October 17, 2013
Cost of Debt and Cost of Equity:
Cost of Debt is the interest rate and the Cost of Equity is the expected rate of return demanded by investors in the firm’s common stock. The issue at hand is finding the correct costs of debt and equity in order to find an accurate calculation of WACC. Cohen used the 20-year yield on U.S. Treasuries as the risk free rate, which we found to be the correct figure given that Nike Inc. debt was valued over 25 years. Because there is no other given yield that is comparable to a 25-year valuation period, our risk free rate used in calculations is 5.74 percent .Just as important as choosing a risk free rate is choosing the appropriate market risk premium. There are two historical equity risk premiums given for a time period from 1926 to 1999: Geometric mean and arithmetic mean. The geometric mean is a better estimate for longer life valuation while the arithmetic mean is better for a one-year estimated expected return. Therefore, we chose to use the geometric mean to coincide with the choice to use the 20-year yield on U.S. Treasuries, which is 5.9 percent. Next, we had to decide on a beta to use for Nike Inc. for use in the CAPM approach. The logical choice was to use the average (0.80) to account for the large fluctuations seen in Nike’s historic betas. We felt that the YTD beta was a reflection of current business practices, but the goal of Nike Inc. was to look forward and gain back market share and increase revenues. Consequently, we felt the average beta reflected the historical business practices of Nike Inc. better .From here, we calculated the cost of debt and equity. Cost of debt was calculated by finding the yield to maturity on 20-year Nike Inc. debt with a 6.75% coupon semi-annually. We assumed Nike Inc. to have a single cost of capital since its multiple business segments (shoes, apparel, sports equipment, etc.) are not very different and would experience similar risks and betas.

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