What Is the Wacc and Why Is It Important to Estimate a Firm’s Cost of Capital? Do You Agree with Joanna Cohen’s Wacc Calculation?

1. What is the WACC and why is it important to estimate a firm’s cost of capital? Do you agree with Joanna Cohen’s WACC calculation? Why or why not?

The WACC is the weighted average cost of capital that denotes the opportunity cost of using capital for a particular investment as oppose to the alternative investment which has similar systematic risk. This is the required return necessary to make a capital budgeting project of the company. It includes the cost of debt and the cost of equity.

It is important in order to determine the acceptability of investment opportunities. Normally, the investors will choose the project (compared with many other projects), which gives a higher return and lower risk on investment. All of the projects which are chosen, must be get higher return than the costs of capital invested in those projects.

In addition, cost of capital helps managers to decide the method of financing. Understanding about financial situations, the rate of interest on loans and dividend rates in the market, are needed conditions for financial managers, which will help them to better balance the sources of finance and minimize the cost of capital.

Even though Joanna was right to use a single cost of capital (similar risks factors and Nike’s segments revenue contributions), we do not agree with Joanna’s WACC calculation because she estimated the firm’s cost of debt based on historical data, which does not reflect current neither future cost of debt. Regarding cost of equity, even though she used the CAPM method an use the right numbers for risk free rate and risk premium, she took the average of Nike’s betas (1996-2001) instead of taking the most recent beta rate, which is more representative for future volatility. In addition, she was wrong to use book values as the basis for debt and equity weights; market values should be used instead. The reasoning of using market weights to estimate WACC is that it is how much it will cause the firm to raise capital today.

1. If you do not agree with Cohen’s analysis, calculate your own WACC for Nike and be prepared to justify your assumptions.

Cost of debt calculation:

Cost of debt should be calculated by using data provided in Exhibit 4. We are calculating the current yield to maturity ( r ) of the Nike’s bond to represent Nike’s current cost of debt:

• Current Bond Price = 95.6
• Face value = 100
• Annual coupon rate =  = 0.03375  → Coupon = 100 × 0.03375=3.375[pic 1]
• Bond issued in 07/15/96, its maturity is 07/15/21 => 25-year bond (or the bond was issued 5 years ago, because now is year 2001). As result, we have n=2×(25-5)=40 (paid semiannually)

Using bond’s value formula:

r= 7.16%

So:

→ Cost of debt (after tax) is: 7.16% x (1-38%) = 4.44% 

Cost of equity calculation:

We are estimating the cost of equity using CAPM.

RE = RRF + (RM) x Beta

RRF= 5.74%

We took U.S Treasury 20-year current yield as RRF (exhibit 4, long-term government bonds).

RM= 5.9%

We took geometric mean as risk premium (exhibit 4) because it is used for long-term period valuation.

Beta= 0.69

We took a beta that is most representative to future beta (exhibit 4, most recent beta at 06 June 2001).

So:

RE = RRF + (RM) x Beta

RE = 5.74% + (5.9%) x 0.69

RE = 9.811%

Equity and debt weights calculation:

Market value of equity = Current Share Price x Current Shares Outstanding

                                      = $42.09 x 271.5 = $11,427.43 

Thus, Market value weight for equity is = 11,427.43 / (11,427.43+1,296.6)

                                                         = 89.81%

*1,296.6 is the total debt of 2001 (current portion of long-term debt + notes payable +   long-term debt).

So, the weight for debt is 10.19%

WACC calculation:

WACC = wd x rd + we x re

WACC = (10.19% x 4.44%) + (89.81% x 9.811%)

WACC = 0.45% + 8.81%

WACC = 9.26%

1. Calculate the costs of equity using CAPM and the dividend discount model. What are the advantages and disadvantages of each method?

Cost of equity using CAPM: (Details of components are in answer 2)

RE = RRF + (RM) x Beta

RE = 5.74% + (5.9%) x 0.69

RE = 9.811%

Advantages and disadvantages:

CAPM has the advantage of simplicity and can be applied in practice. It is a useful model for understanding the risk return relationship and provides a logical and quantitative approach for estimating risk. It is better than other alternative subjective methods of determining risk and risk premium. One major problem is that many times the risk of an asset is not captured by beta alone, which do not remain stable over time.