Cost of Capital
Cost of capital is the opportunity cost of making a specific investment. Big investments require huge capital in order to operate smoothly. A company’s financial sources may include debts, common stock, or preferred stock. The cost of acquiring these finances is know as cost of capital. Cost of capital incurred by a given investment may include cost of equity, cost of debt, or cost of preferred stock. The cost of capital represents the minimum rate of return an investment must make in order to be profitable.
Importance of estimating the co st of capital
The estimation of cost of capital is very vital in financial decision making. Given numerous competing investment opportunities, investors prefer investments opportunities with higher returns. Cost of capital is important to investors since it represents the minimum rate of return an investment must make to be worthwhile. An investor expects the rate of return of an investment to be at least the cost of capital. Therefore, investors can also use cost of capital as a discount rate in the calculation of the fair value of a given investment’s cash flows. Cost of capital is thus important to investors in designing capital structure, capital budgeting decisions, comparative study of sources of financing, evaluation of financial performance, determining of investment’s expected income and inherent risk, and financing and dividend decision making.
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The cost of capital set by investors or managers
The cost of capital is determined by the investors (or the market) and not managers. Cost of capital represents investor’s degree of perceived risk. Whenever investors are to chose between two investment opportunities with equal risk, they will prefer the investment opportunity with higher return.
Assessments
Is it appropriate to use a single cost of capital for all Nike’s businesses? Explain.
Yes. It is appropriate to use single cost of capital for all Nike’s businesses. The main purpose of estimating cost of capital is to determine the fair value of the Nike’s cash flows. Most revenues earned by Nike are from Nike’s multiple segments. The risk faced by the Nike Company is the same hence using a single cost of capital is appropriate. The only difference in the risk might arise from the sales of non-Nike branded products, but these products contribute a tiny part of Nike’s revenue. Moreover, the state of management of all these segments including distribution channel, marketing project, and customers services is the same. Therefore, it is necessary to use a single cost of capital.
How does Joanna Cohen calculate the weights for debt and equity? Do you agree with these calculations?
Weight on Equity and Weight on Debt
Cohen used book value in calculation of weight on equity and weight on debt which does not reflect the current Nike’s cost of equity.
She should have calculated the market value weight of equity using market value as follows;
Market value of equity = current share price * average shares outstanding
= 42.09 * 27300000
= 11,503,000,000
The market value weight for equity = = 0.899
Weight for debt = 1- 0.899 = 0.101
Calculation of Cost of debt
In calculating the cost on capital, Joanna Cohen used the book value instead of the market value. This is inappropriate since calculation using book value does not reflect the current market situation nor the current cost of debt. The appropriate calculation of cost of debt should been based on calculating yield to maturity of the bond.
Current bond price = 95.6, face value =100, coupon rate = =0.03375, Coupon paid= 0.03375 * 100 =3.375, total periods of payment = 20 *2 = 40
The equation of value of bond is given by;
Using trial and error method in equation of value of bonds, the yield to maturity =0.716 =cost of debt.
Weight on debt = R d (1-T) = 0.176 (1-0.38) = 0.444
Calculation of cost of equity
Cohen calculated cost of equity using CAPM model which is suitable in this case. However, she made a mistake by calculating cost of equity using book value instead of market value. She averaged betas instead of using the recent one.
CAPM Model formula: R e = R f + β (R m -R f ) Where R f is the risk-free rate of return, β is beta, and R m is risk adjusted rate of return.
R f =0.0574 β =0.69 (R m - R f ) =0.059,
R e = 0.0574 + 0.059*0.60
= 0.09811 or 9.811%
Calculating cost of equity (R e ) using Dividend Discount Model (DDM)
Cost of equity (R e ) = + g where D 0 is the current dividend, g is the rate of dividend growth, P 0 is the current share price. D 0 =0.48, g=0.055, P 0 =42.09
R e = + 0.055
= 0.670
It is not appropriate to use Dividend Discounting Model in calculating cost of equity. This is because there was no dividend payment by Nike since after June 30, 2001. Therefore, calculating cost of equity using DDM does not reflect true cost of capital.
Nike’s Weighted Average Cost of Capital (WACC)
WACC = R e * + R d (1-T) *
= 0.11*0.444 + 0.981*0.899
= 0.0045 + 0.0882
=0.927 or 9.27%
I would recommend an investment in Nike’s stock. The discount rate of 12% which Kimi Ford used in share price is higher as compared to cost of capital of 9.27%. This means the rate of return of Nike is greater as compared to its cost of capital. Therefore, it is advisable to invest in Nike’s stock.
