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The Weighted Average Cost of Capital (WACC) is a crucial metric that represents the overall required rate of return on a firm's investments. It is a key factor in determining the feasibility of potential investments for a firm, as it takes into account the cost of both equity and debt capital.
However, upon reviewing Joanna Cohen's WACC calculation, it is evident that there are several inaccuracies in her approach. For instance, Joanna incorrectly determined the value of equity by simply using the number stated on the balance sheet, instead of multiplying the current stock price by the number of outstanding shares.
The correct calculation should have been $42.09 x 271.5M = ,427.435M.
Similarly, the value of debt should have been calculated by multiplying the price of publicly traded bonds by the amount of debt outstanding, resulting in 95.60% x $1296.6M = $1,239.550M. The total sum of debt and equity should have been $12,666.985M.
Consequently, the weight of equity is 0.902 and the weight of debt is 0.098. To determine the cost of debt, the yield to maturity of the debt must be calculated.
By using a financial calculator with the parameters (N=30, PV=-$95.60, PMT=$3.375, FV=$100), the YTM is determined to be 7.24%.
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This figure represents the cost of debt. On the other hand, the cost of equity can be calculated using the Capital Asset Pricing Model (CAPM). While Joanna correctly used the 20-year yield on U.S. treasuries as the risk-free rate and 5.90% as the risk premium, she should have used the most recent year's beta instead of averaging multiple years.
The accurate calculation should be 5.74% + 0.83(5.90%) = 10.64%, representing the cost of equity.
By applying a 38% tax rate, the WACC can be calculated as WACC = 90.2%(10.64%) + 9.80%(7.24%)(1-38%) = 10.03%.
Alternatively, the cost of equity can also be determined using the Dividend Discount Model, which involves summing the dividend yield and the dividend growth rate. In this case, it would be ($0.48/$42.09) + 5.50% = 6.64%. Another method, the earnings capitalization ratio, calculates the cost of equity by dividing the projected earnings per share by the current market price of the stock, resulting in $2.32/$42.09 = 5.51%.
Each method of calculating the cost of equity has its own advantages and disadvantages. The CAPM is relatively easy to compute, but it assumes perfect asset valuation, which may not always hold true in reality. On the other hand, the dividend discount model allows investors to value stocks based on the dividends they pay and is also easy to calculate. However, for companies that do not pay dividends, alternative methods would need to be employed.
In light of Kimi Ford's analysis, it is concluded that at discount rates below 11.17%, Nike's stock would be undervalued. With Nike's cost of capital rate standing at 10.03%, Kimi Ford should consider investing in the company.
Analyzing the Weighted Average Cost of Capital (WACC) for Nike. (2016, Dec 29). Retrieved from https://studymoose.com/nike-inc-cost-of-capital-essay
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