Cost of Capital
Columbus: Team 3
Table of Contents:
Importance of Cost of Capital
Assumptions for Calculation of WACC
Single cost or Multiple cost?
Cost of Debt
Cost of Equity
WACC calculation methodology
Value of Nike
Nike Inc. Background
Large Cap Fund weighing whether to buy Nike’s stock.
has experienced sales growth declines in profits and market share.
has reveal that it would increase exposure in mid-price footwear and apparel lines. It also commits to cut down expenses.
market responded mixed signals to Nike’s changes. Kimi Ford has done a cash flow estimation, and ask her assistant, Joanna Cohen to estimate cost of capital.
What is Cost of Capital & why is it important to estimate a firm’s cost of capital?
The cost of capital is the rate of return required by a capital provider in exchange for foregoing an investment in another project or business with similar risk. Thus, it is also known as opportunity cost.
Need for Cost of Capital:
To decide whether to go ahead with a certain project or not, we need to compare the cost of capital with the return on capital.
When the return on capital is greater than cost of capital we go ahead with the project.
What is WACC ?
The Weighted Average Cost of Capital (WACC) is the rate that company is expected to pay on average to all its security holders to finance its assets.
Since WACC is the minimum return required by capital providers, investment should be done which generate excess of WACC.
An optimal capital structure, which is defined as mix of debt, preferred stock and common equity that maximizes its stock price.
The WACC is set by markets not managers. Therefore, we cannot observe the true WACC, we can only estimate it.
We have used to WACC to calculate the Net present
Value (NPV) and the future Cash flows.
Single cost or Multiple cost?
Nike case, the use of the single cost instead of multiple costs of capital is correct assumption. The reason behind is : different products are sold through the same marketing and distribution channels and are often marketed in other collections of similar designs.
Hence, the business segments of Nike basically have about the same risk; thus, a single cost is sufficient for this analysis. Plus, the reason of estimating WACC is to value the cash flows for the entire firm, that is provided by Kimi Ford.
Cost Of Equity
Definition & Need:
In Financial theory, the return that stockholder’s require for a company.
A firm’s cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk.
We Calculated the Cost of Equity using three models:CAPM Model
Gordon Model (Dividend Discount Model)
Earnings Capitalization Ratio Model
Method 1 :Calculate the cost of equity using CAPM.
Ke = Krf + (KM – Krf) x Beta
Beta: Average beta is 0.80; beta in 2001 is 0.69
Krf or Risk free rate: U.S Treasury 10-year 5.39%, 20-year Krf=
we prefer to use 20-year Krf (risk free rate) as that is less risky.
(KM - Krf) Risk market premium: According to Joana Cohen analysis, she took geometric mean 5.90% as risk premium instead of arithmetic mean because geometric mean is better to measure long-term period valuation.
Joanna Cohen calculated: Ke= 5.74% + 5.90% x 0.80 = 10.46%
Cohen uses 0.80 of average beta from 1996 to July 2001 instead of 0.69. But, our team believes that 0.69 will be better choice because of it more representative to the future systematic risk.
What are the advantages and disadvantages? Advantages
It considers only systematic risk, reflecting a reality in which most investors have diversified portfolios from which unsystematic risk has been essentially eliminated. It is