Wanting to add Nike’s share to her portfolio, Kimi Ford asked her new assistant, Joanna Cohen, to estimate Nike’s cost of capital. Cohen, later, came up with the cost of capital of 8.4% that was contradicted to Ford’s cost of capital of 12%.
This report points out flaws of Cohen’s assumption and recalculates the WACC to obtain the most accurate cost of capital. In the cost of equity calculation, we will use CAPM, the dividend discount model (DDM), and the earnings capitalization model (ECM) to see the different in each and suggest the most suitable one.
To sum it up, Ford is suggested to add Nike’s shares to its portfolio.
According to the Cohen’s exhibits, there are 2 main flaws in her calculation of cost of capital and they are:
1. It’s correct that she used WACC since the company is funded with both debt and equity. However, the proportion that she weighted is incorrect because she used the book value of equity to calculate. She should have used market value of equity to obtain the value of equity.
2. Cohen’s cost of debt is ridiculously low, 4.3%. That is even lower than the Treasury bill. The way she calculated was also strange (Divide interest expense by company’s average debt balance). She stated that a portion of funding was raised through Japanese yen note, which offer lower rates. However, funding internationally, we need to take in account the FX risk that Cohen didn’t.
Recalculation of Weighting
Instead of using book value to calculate the equity value, I will the market value of Nike’s equity.
According to figures in the case, Nike’s share price on July 5, 2001, is $42.09 while the average shares outstanding in 2001 is 271.5 million shares. Together, the equity value is $11,427.435 million.
$42.09 x 271.5million = $11,427.435million
With the same value of debt, $1,296.6 million, the new weight becomes 90% in equity and 10% in debt (Please see Exhibit).
Recalculation of Cost of Debt