Nike Case 14
CASE 14
NIKE, INC.: COST OF CAPITAL
Cost of capital denotes the opportunity cost of using capital for a particular investment as oppose to the alternative investment which has similar systematic risk. It is extremely important since it is used in evaluating whether a project is feasible or not in the net present value (NPV) analysis, or in assessing the value of an asset.
WACC (weighted average cost of capital) is the proportional average of each category of capital inside a firm (common shares, preferred shares, bonds and any other long-term debt).
WACC is also called required return. The term required return tends to reflect an investor’s point of view, while cost of capital is the same return only from the firm’s point of view. WACC is the rate of return required by the capital provider in exchange for giving up the opportunity of investment in another project or business with similar risk. Therefore, WACC is set by investors, not by managers. It cannot be observed it can only be estimated.
I do not entirely agree with Joanna Cohen’s WACC calculation. I believe she made the following mistakes: 1. She is wrong to use book values in debt and equity weights calculations. WACC is market driven. It is the expected rate of return that the market requires to commit capital to an investment. Therefore, the base against which the WACC is measured is market value, not book value. 2. In calculations of the cost of debt she used historical data. She divided the interest expense by the average debt balance. The purpose of WACC is to reflect company’s current and future ability to raise capital. Data used in the case will not reflect future perspectives. Cost of debt should be estimated by yield to maturity of bond. 3. In calculations of the cost of equity the average of betas from 1996 to present is being used. This method of beta estimation seems to be too retrospective. Theory calls for a forward-looking beta. However since it is unobservable
NIKE, INC.: COST OF CAPITAL
Cost of capital denotes the opportunity cost of using capital for a particular investment as oppose to the alternative investment which has similar systematic risk. It is extremely important since it is used in evaluating whether a project is feasible or not in the net present value (NPV) analysis, or in assessing the value of an asset.
WACC (weighted average cost of capital) is the proportional average of each category of capital inside a firm (common shares, preferred shares, bonds and any other long-term debt).
WACC is also called required return. The term required return tends to reflect an investor’s point of view, while cost of capital is the same return only from the firm’s point of view. WACC is the rate of return required by the capital provider in exchange for giving up the opportunity of investment in another project or business with similar risk. Therefore, WACC is set by investors, not by managers. It cannot be observed it can only be estimated.
I do not entirely agree with Joanna Cohen’s WACC calculation. I believe she made the following mistakes: 1. She is wrong to use book values in debt and equity weights calculations. WACC is market driven. It is the expected rate of return that the market requires to commit capital to an investment. Therefore, the base against which the WACC is measured is market value, not book value. 2. In calculations of the cost of debt she used historical data. She divided the interest expense by the average debt balance. The purpose of WACC is to reflect company’s current and future ability to raise capital. Data used in the case will not reflect future perspectives. Cost of debt should be estimated by yield to maturity of bond. 3. In calculations of the cost of equity the average of betas from 1996 to present is being used. This method of beta estimation seems to be too retrospective. Theory calls for a forward-looking beta. However since it is unobservable