In this report we focus on Nike's Inc. Cost of Capital and its financial importance for the company and future investors. The management of Nike Inc. addresses issues both on top-line growth and operating performance. The company's cost of capital is a critical element in such decisions and it is important to estimate precisely the weighted average cost of capital (WACC).
In our analysis, we examine why WACC is important in decision making and we show how WACC for Nike Inc. is calculated correctly. Also, we calculate the company's cost of equity using three different models: the Capital Asset Pricing Model (CAPM), the Dividend Discount Model (DDM) and the Earnings ...view middle of the document...
The YTM is a good estimate for the cost of debt if a company had issued debt in the past and the bonds are publicly traded just as in Nike's case. Our calculations for Nike's yield to maturity based on the given data showed that Kd= 7.16%.c1 (See Appendix for detailed calculations)
The second variable that should be noted is T or the tax rate. In her calculations, Joanna Cohen added the 3% state taxes to the 35% statutory tax where in WACC calculation the marginal rate should be used. The marginal tax rate generally refers to the "federal income tax that is levied onto the additional dollar earned" and usually is about 40%.
The weights of the costs, Wd and We, are very important in calculating WACC as they show the company's capital structure. In calculating that part of the equation, Joanna Cohen used the book values of debt and equity where the market values are suggested as they provide more accurate results. As book and market values of debt and equity may differ a lot, market values of debt and equity give a closer estimation of the capital structure2. We calculate the enterprise value (P0*#shares outstanding = $11,427.4357m). For debt, the book value gives a close estimation for the current value, whereas the same doesn't hold for the value of equity. Thus, debt is equal to $1,296.6m (current portion of L-T debt + notes payable + L-T debt). In finding the weights, the previous explanation shows that equity is 88.65% whereas debt is 11.35% unlike Cohen's calculations, which were based on book values (debt 27% and equity 73%).
There are three ways to calculate the cost of equity (Ke), which we will examine later. In our calculations of WACC we use the Capital Asset Pricing Model (CAPM), as it is considered to be the most complete model for estimating the cost of equity.
CAPM Equation is: Ke=Krf+ β(Km-Krf)c2,
where Ke is the cost of equity, β is beta that measures the tendency of a stock to move up and down with the market, Km is the required return of the market, Krf is the risk free rate and (Km - Krf) is equal to the market risk premium.
For the Krf (risk free rate), we used the current yield on 10yr bond (5.39) U.S. treasuries, instead of the 20yr, as the 10yr matches the duration of cash flows for the Nike's investment project (Exhibit 2) and because it is relatively less exposed to unexpected changes in inflation and the liquidity premium when compared to the longer 20 yr bond3. For the market risk premium, Km - Krf, we used the arithmetic mean (7.5%). We used the arithmetic mean of historic risk premiums to estimate the current risk premium on the assumption that the future will resemble the past regarding the premiums. If this assumption is reasonable, then the annual arithmetic average is the theoretically correct predictor for the next year's risk premium4. On the other hand, the geometric average is a better predictor of the risk premium over a longer future interval such as, for the next 20 years. For...