Nike Inc.Case - the Weighted Average Cost of Capital (wacc)

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Lombard, Team 3

Amandeep Singh Sodhi

Amrita Jaffar

Manuel Sevilla

Martina Filippi

Pouya Farajpour

Thanun Nirundorn

Introduction

Weighted Average Cost of Capital (WACC) is a method to calculate a company's cost of capital when each category of capital is proportionately weighted. It is one of the most important estimation of Cost of Capital because practically it represents the minimum return that a firm should earn to satisfy the shareholders and everyone providing the capital (creditors, owners, etc.). WACC in fact includes all capital sources, such as bonds, preferred stock, common stock, any long-term debt. To calculate it sometimes could be laborious, especially if the firm has a complex capital structure.

If the beta and the rate of return on equity of the company increase also WACC increases. This cause an increase in the risk and a decrease in valuation. Businesses –included Nike– often use WACC to discount cash flow and determine the Net Present Value. The equation of WACC is:

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Where:

Kd : Cost of debt

Ke : Cost of equity

E : Market value of the firm's equity

D : Market value of the firm's debt

t : Corporate tax rate

The Weighted Average Cost of Capital (WACC)

The WACC changes over time. And this change is caused by external and internal factors. Internal factors that can affect the Weighted Average Cost of Capital are: investor risk aversion, the firm stops risk adjusting the WACC on different projects, the company increases its debt ratio, the firm pays out more of its earnings as dividends. The former two internal factors decrease WACC, the last two increase it.

Some of the external factors instead are: an increase in the corporate tax rate (WACC increase), FED lowers the interest rate (WACC decreases).If the company wants to have a valid tool of analysis, it is really important to rebalance the capital structure to maintain the right market-value debt ratio (at least for the near future). In the reality to rebalance the capital structure is not an easy operation, therefore the firms can assume a steady and gradual adjustment in the long-term. This method doesn't work if the company is facing important changes in the capital structure.

Managers usually use WACC to make investment decisions. They examine it to check if the company has the right inputs and if there are any changes. This tool is useful to show what is the current market risk premium, to control the firm's risk-free rate, to update and utilize in the best way the historical data. Once the managers have calculate the number, they use it to reflect their ability to time their investments and choose projects that maximize firm's expected return. Thanks of WACC they also assess the opportunity cost to make the best investment decision.

When an investment project is being considered, the WACC of that project could depend of multiple things. First, the riskiness of the project is being considered. However, it is not possible to calculate the beta of a project. Therefore, the WACC is estimated mostly by comparing with previous realized projects that have the same level of risk. According to the Capital Asset Pricing Model, investor expect similar return at similar risk levels. Secondly, if the project is big enough and reflect the total activities of a company the cost of capital of said project is efficiently estimated with the WACC.

Methodology for Calculating the WACC

The first mistake of Ms. Cohen is using the book value of equity instead of the market capitalization when calculating the weights in the WACC. It is possible to calculate the market capitalization given that we have the company has 271.5 millions of shares outstanding and the current share price is $42.09. Moreover, the analyst utilizes the book value of debt instead of the market value of debt in her calculations. This number can be calculated given that we already have the current price of the Nike corporate bonds and making the assumption that all of Nike’s long term debt comes from the bonds issued in 1996. This gives that the debt as a portion of capital is 10.05% and the equity accounts for 89.95%:

Cost of Debt

When calculating the cost of debt Cohen obtains her estimate by taking the interest expense in year 2001 and dividing that number by the company’s average debt balance. However, we believe that Nike is a big corporation and for that is safe to assume that the risk of default of a Nike Corporate Bond is small enough to ignore it. Thus, the yield to maturity of the Nike 25-year corporate bond is a good estimate of the debt cost of capital. That number is 7.49% (see Exhibit 1). Consequently, we can adjust to the tax rate of 38% and therefore we have that the tax adjusted cost of debt is 4.64%.