Cost of Capital Essay
Cost of Capital
1. WACC is used for discounting cash flows in the future, thus all the modules of cost must reflect firm’s future abilities in raising capital. Cohen made the mistake of using the historical data in estimating the cost of debt yet the share price has changed considerably over time. The market value of equity should be used instead of book value. 2. Cohen calculates the cost of debt by taking total interest expense for the year 2001 and dividing it by the company’s average debt balance.
This is an estimate of the true cost of debt, but is inaccurate and may not reflect Nike’s current or future cost of debt. 3. Cohen obtained the corporate tax rate of 38% which is used to calculate the adjusted cost of debt by adding state taxes of 3% to the U. S. statutory tax rate 35%. In WACC calculation, marginal tax rate should be used as a corporate tax rate for the future estimate. We can use Yield to Maturity (YTM) on 20-year Nike Inc. Bond issued in1996 of 6. 75% Cost of Equity The 20-year old U. S.
treasury used by Cohen for a short-term investment of NorthPoint for the short-term 3 months to 1 year yields is more suitable. Given the risk-free rate (Rf) of 5. 74%, the market risk premium (Rm-Rf) of 5. 90% and beta value of 0. 80, we can calculate the cost of equity using the CAPM as follows: Cost of equity = Rf + ? *(Rm-Rf) = 5. 75%+0. 80(5. 90%) = 10. 46% Weighted Average Cost of Capital (WACC) We calculate the WACC of Nike Inc. using the weights and costs of debt and equity using the following formula WACC = Wd Kd(1-T) + We Ke.
= 10. 05% x 7. 5 %( 1-38%) + 10. 46% x 89. 95% = 0. 4682% + 9. 4083% = 9. 8765% The weighted average cost of capital for Nike Inc. is approximately 10% percent. Recommendation Given the stock price at WACC of approx. 10% ,stock price should be greater than $50. 92, which is higher than current stock price $42. 09. This shows that the current stock of Nike is undervalued and is discounted rate of 11. 17%. Cohen’s WACC of 8. 4% of the stock was undervalued compared to 10%. Therefore Kim Ford should invest in the Nike for her mutual fund.