We do not agree with Joanna Cohen’s WACC calculation because she mistakenly used historical data to estimate the future cost of debt. Joanna calculated the cost of debt by taking the interest expense for 2001 and dividing it by the average debt balance. The cost of debt for Nike is the effective rate that it pays on its current debt, meaning the yield to maturity of bonds should be used to make an estimate instead of the average debt balance. Through the use of past data, the average balance of debt, the 4.3% before-tax cost of debt does not accurately reflect Nike’s current or future cost of debt, and therefore a new WACC should be calculated to discount future cash flows. Additionally, Joanna’s cost of equity calculation should also be revised to recalculate a more accurate WACC. Rather than using the average beta from 1996 to 2001, the most recent beta estimate should be used because it is more relevant to the current cost of equity. Furthermore, the market values, not the book values, of debt and equity, should be used to correctly weight the capital components.
2) Using CAPM:
a. The market free rate is 5.74%, which is the longest US Treasury Yield forecast. We used this rate because WACC is used for long-term projects and therefore, the longest treasury rate should also be used.
b. The market risk premium is the geometric mean of 5.9%. The geometric mean was used, as it is a common measure for measuring the results of a portfolio. The geometric mean uses percentages and it is therefore much more accurate than the standard arithmetic mean.
c. The Beta that was used to gain a return on equity equivalent to 10.5% was 0.8, the average of all the Betas from 1996 to the present. Although this is a good measure to use, in actuality the Beta of 0.69 for the recent year of 2001 is a much better indicator of the return on equity given the present situation
Joanna’s CAPM Re= 10.5% = 5.74 + (.8)(5.9)
Re= 10.5% Rf= 5.74 Rm-Rf= 5.9 B= 0.8...
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