In our analysis, weexamine 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 Capitalization Model (EPS/ Price), we analyze their advantages and disadvantages and finally we conclude whether or not aninvestment in Nike is recommended.
Our analysis suggests that Nike Inc.'s common stock should be added to the North Point Group's Mutual Fund Portfolio.
I. The Weighted Average Cost of Capital and its Importance for Nike Inc.
The Weighted Average Cost of Capital (WACC) is the average of the costs of a company's sources of financing-debt and equity, each of which is weighted by itsrespective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every marginal dollar it finances. A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. Also, WACC is the appropriatediscount rate to use in stock valuation.
II. Calculation of Nike's WACC
The calculating methodology for Nike's Inc. WACC seems to be inconsistent with the principles1 that should be followed when estimating this measure. These are our points of disagreement with the calculations in Exhibit 5:
- Calculation of the cost of debt by taking the total interest expense for the year 2001 dividing it by thecompany's average debt balance, which is not appropriate for the WACC estimation
- Use as tax rate the sum of state and statutory taxes instead of the firm's marginal tax rate
- Use of the Book Value of equity rather than the market value which is suggested as it gives more precise results
- Calculation of the cost of equity using long time period for risk free rate and risk premium
In orderto make our justifications more comprehensive we need the formula for estimating WACC:
WACC= Wd*Kd(1-T) + We*Ke
First, we reexamine the cost of debt (Kd) which in this case is the yield to maturity (YTM) on the bonds. 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'syield 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 leviedonto 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 andequity 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...