In a Word document, please respond briefly and concisely to the following questi
ID: 2806403 • Letter: I
Question
In a Word document, please respond briefly and concisely to the following questions:
Nike Inc., Cost of Captial Case Study 15
What is WACC and why is it important to estimate a firm’s cost of capital?
Is the WACC set by managers or investors?
What mistakes did Joanna Cohen make in her analysis?
Which of the three methods she discusses in her memo – CAPM, DDM, or ECM -- is best for calculating the cost of equity? Why?
Based on a more accurate WACC, what should Kimi Ford recommend regarding an investment in Nike? (Hint: see below and complete the template first.)
Explanation / Answer
What is WACC and why is it important to estimate a firm’s cost of capital?
WACC or weighted average cost of capital is the average cost of capital for a company that uses several different forms of capital like debt, equity etc for funding.
The weighted average cost of capital (WACC)is the rate that a company is expected to pay on average to all its security holders to finance its assets.
• The WACC is the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere.
• Companies raise money from a number of sources: common equity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities, executive stock options, governmental subsidies, and so on. Different securities, which represent different sources of finance, are expected to generate different returns. The WACC is calculated taking into account the relative weights of each component of the capital structure.
It is important to estimate a firm’s cost of capital as Management always takes notice of the cost of capital while taking a financial decision. The concept is quite relevant in the following managerial decisions and hence its importance:
• (1) Capital Budgeting Decision.
• (2) Designing the Corporate Financial Structure.
• (3) Deciding about the Method of Financing.
• (4) Performance of Top Management.
• (5) Other Areas.
Is the WACC set by managers or investors?
WACC is set by investors and not managers. Therefore we can only estimate WACC. Wacc is set by investors when they calculate and find out the decisions about invest or reject into a company/ project. Managers just listen the market reply and react by estimate their options in invest in a project or restructure their company, give it all for board of management (investors) who have the final decisions. Beside that, it also help managers can adjusted share prices, market value of the firm for firm’s benefit.
What mistakes did Joanna Cohen make in her analysis?
she made a mistake for estimating the firm’s cost of debt when taking historical data for calculation, because in terms of academic theory, the WACC is the required return on investments by the firm in the future, so all components of the WACC, of which is the cost of debt that must reflect the future interest rate the firm has obligations to pay upon its new borrowing.
* Cost of capital based on market value not book value
Cohen is wrong to use book values as the basis for debt and equity weights; the market values should be used instead. The reasoning of using market weights to estimate WACC is that itis how much it will cause the firm to raise capital today.
Which of the three methods she discusses in her memo – CAPM, DDM, or ECM -- is best for calculating the cost of equity? Why?
CAPM is best for calculating cost of equity,
DDM : The assumption made with this model is that the company pays a substantial dividend, but Nike Inc. does not. Therefore, we rejected this model because it does not reflect the true cost of capital. Because Nike did not pay any dividend for share holders since after June 30, 2001, so thismodel (DDM) can not be used for calculating KE in this case because it does not reflect the truecost of capital.
ECM : Capitalization refers to the return on investment that is expected by an investor. Capitalizationmethods for valuing a business are based upon return on the new owner's investment.The problem with this model is that it does not take into consideration the growth of the company, itis appropriate for no-growth firms. Therefore we chose to reject this calculation.
CAPM : CAPM has the advantage of simplicity and can be applied in practice. However, like manyother models, CAPM inevitable limitations and criticism. Maybe the attraction of CAPM issimplicity and easy to apply, but may be CAPM too simple to apply, it lead to reflect not reallytrue happen, it is normally just a model.
CAPM is a useful device for understanding the risk return relationship in spite of its limitations. It provides a logical and quantitative approach for estimating risk. It is better than many alternative subjective methods of determining risk and risk premium. One major problem is that many times the risk of an asset is not captured by beta alone.
Based on a more accurate WACC, what should Kimi Ford recommend regarding an investment in Nike?
Kimi Ford should recommend to buy Nike Inc.,shares at this time because the stock is undervalued and because it had growth potential that would be beneficial to the fund.
Overall, Nike’s shares are very potential. In details, Kimi Ford also should consider before buy Nike’s shares depend on some of reasons. First of all, as we know that “January Effect” not really happen every year, but it can be happen anytime, at that time, almost every shares become better by investors feeling and habit. If Kimi Ford buy Nike’s share in this moment, he should be careful because he might spend much more time than normal market prices. Secondly, Nike’s shares long-term always is wonderful investment, but short-time buying also should be careful because of the changing fast of industry, the changing of Nike, the changing of trend in footwear industry and so on. Beside that, Kimi Ford also don’t forget monitor its activities very closely. If North-Point Large-Cap Fund want to invest in Nike’s shares in short-term, they should buy Nike’s shares at the end of the year, while others not really pay attention to much in market and sell it in the first month of next year. In January, when people have a little overestimate, North-Point Large-Cap Fund can sell for achieve their profit.