Capital Asset Pricing Model and Cost
What is the WACC and why is it important to estimate a firm’s cost of capital? Do you agree with Joanna Cohen’s WACC calculation? Why or why not? Answer: The cost of capital refers to the maximum rate of return a firm must earn on its investment so that the market value of company’s equity shares will not drop. This is a consonance with the overall firm’s objective of wealth maximization. WACC is a calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. All capital sources – common stock, preferred stock, bonds and any other long-term debt – are included in a WACC calculation.
All else equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk. The WACC of a firm is a very important both to the stock market for stock valuation purposes and to the company’s management for capital budgeting purposes. In an analysis of a potential investment by the company, investment projects that have an expected return that is greater than the company’s WACC will generate additional free cash flow and will create positive net present value for stock owners.
Thus, since the WACC is the minimum rate of return required by capital providers, the managers in the company should invest in the projects which generate returns in excess of WACC. We do not agree with Joanna Cohen’s calculation regarding the WACC from 3 aspects: 1) When Joanna Cohen computed the weights or proportions of debt and equity, she used the book value rather than the market value. The book values are historical data, not current ones; on the contrary, the market recalculates the values of each type of capital on a continuous basis, therefore, market values are more appropriate. )
The cost of debt should not be calculated by “taking total interest expense for the year 2001 and dividing it by the company’s average debt balance. These historical data would not reflect Nike’s current or future cost of debt. 3) She mistakenly used the average Beta from year 1996 to 2001. The average Beta could not represent the future systemic risk, and we should find the most recent Beta as Beta estimate in this situation. 2. If you do not agree with Cohen’s analysis, calculate your own WACC for Nike and be prepared to justify your assumptions. Answer: 1)Weights of equity and debt:
In 1997 Nike’s revenues plateaued around $9 billion while net income had fallen from around $800 million to $580 million. Also, from 1997-2000 Nike’s market share in U. S. athletic shoes fell from 48% to 42%. Supply-chain issues and the adverse effect of a strong dollar had negatively affected revenue in recent years. At the June 28, 2001 analyst meeting Nike planned to add both top-line growth and operating performance. One goal was to develop more mispriced ($70-$90) athletic shoes and the other to push its apparel line.
At this meeting a target long-term revenue growth rate between 8%-10% was given and an earnings-growth target above 15%. After reviewing all the analysts’ reports about the June 28th meeting Ford still did not have a clear picture of how to value Nike. Ford then performed her own sensitivity analysis which revealed Nike was undervalued at discount rates below 11. 17%. WHAT IS THE WACC? A firm derives its assets by either raising debt or equity or both. There are costs associated with raising capital and WACC is an average figure used to indicate the cost of financing a company’s asset base.
More formally, the weighted average cost of capital (WACC) is the rate that a company is expected to pay to debt holders and shareholders to finance its assets. Companies raise money from a number of sources so the WACC is the minimum return that a company must earn on existing asset base to satisfy its creditors, owners, and other providers of capital. WACC is calculated taking into account the relative weights of each component of the capital structure which means it is the proportional average of each category of capital inside a firm.
This rate, also called the discount rate, 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 = [Wdebt * Kdebt * (1-t)] + [Wequity * Kequity] + [Wpreferred * Kpreferred] K = component cost of capital W = weight of each component as percent of total capital t = marginal corporate tax rate WHY IS IT IMPORTANT TO ESTIMATE A FIRM’S COST OF CAPITAL? The cost of capital is an important issue from the perspective of management while taking a financial decision.
We can list some basic issues related to the importance of WACC and its interpretation by firms: * The importance of the WACC is in its relation to the evaluation of projects. For a project to be feasible, not just profitable, it must generate a return higher than the cost of raising debt (Kd) and the cost of raising equity (Ke). WACC is affected not only by Re and Rd, but it also varies with capital structure. Since Rd is usually lower than Re, then the higher the debt level, the lower the WACC. This partly explains why firms usually prefer issuing debt first before they raise more equity.
As part of their risk management processes, some companies add a risk factor to the WACC in order to include a risk cushion in their project evaluation. * The cost of capital is also important for the management while taking a decision about capital budgeting. Naturally, the project which gives a higher (satisfactory) return on investment compared to the cost of capital incurred for its financing would be chosen by the management. Cost of capital is the key factor in deciding which project to undertake out of different opportunities. * The cost of capital is significant in designing the firm’s capital structure.
It will direct the management about adopting the most appropriate and economical capital structure for the firm which means the management may try to substitute the various methods of finance to minimize the cost of capital so as to increase the market price and the earning per share. * The cost of capital is also an important factor for taking a decision about the soundest method of financing for the company whenever the company requires additional finance. The management may try to catch the source of finance which bears the minimum cost of capital.
The cost of capital can be used to evaluate the financial performance of the top management by comparing actual profitability’s of the projects and the projected overall cost of capital and an appraisal of the actual cost incurred in raising the required funds. DO WE AGREE WITH JOANNA COHEN’S WACC CALCULATION? WHY OR WHY NOT? We do not completely agree with Joanna Cohen’s calculation of WACC. There are several problems in her calculation; * In Cohen’s calculation, she used the book value for the weights of each capital structure component (debt and equity). Book value of equity should not be used when calculating cost of capital.
Instead she should have calculated the market value of equity. Also, she should have discounted the value of long-term debt that appears on the balance sheet to find the market value of debt (even if the book value of debt is accepted as an estimate of market value). * Also, she should have considered the preferred stock while calculating the weights of the components of capital structure (the redeemable preferred stock is relatively small in Nike’s capital structure so it doesn’t affect the weights). * Another problem with her calculation is about the cost of debt. Cohen used a cost of debt which is even lower than treasury yield.
In common sense, a company, even it might be a large AAA firm, should be risky than US government. Cost of debt should be calculated by finding the yield to maturity on 20-year Nike Inc. debt with current coupon rate paid semi-annually instead of by taking total interest expense for 2001 and dividing it by the company’s average debt balance. USING SINGLE OR MULTIPLE COSTS OF CAPITAL IS APPROPRIATE FOR NIKE INC.? Even Nike Inc. has multiple business segments such as footwear, apparel, sports equipment and some non-Nike-branded products (which accounts for relatively small fraction of revenues), we assumed Nike Inc. o have a single cost of capital since its multiple business segments are not very different and would experience similar risks and betas.
Kimi Ford was the portfolio manager in NorthPoint Group, who was concerned about whether or not to add Nike, Inc. shares into her fund. Since net income and market share had been fallen from 1997, a new strategy was proclaimed by the Nike management team during the meeting held in June, 2001: First, highly priced products are no longer their only target, now they would develop the midpriced segment so that more customers will be able to afford it. Second, another way to boost the revenue is to focus on its apparel line, which they found out to be profitable.
Finally, Nike needs to reduce its costs by exerting more effort on expense control. Company executives were optimistic about the long-term revenue, expecting an 8%~ 10% growths and earnings growth above 15%. Analysts had different opinion about the company prospects; Lehman Brothers suggested a strong buy while UBS and CSFB recommended a hold. Meanwhile, Ford wanted to make her own forecast so she developed a discount cash flow to determine that, at a discount rate of 12%, Nike was overvalued at its current price $42. 09 and undervalued if the discount rate was below 11. 17%.
She asked her assistant, Joanna Cohen, to calculate the company’s cost of capital precisely. On the report, Joanna Cohen used WACC to calculate the cost of capital, where she adopted book values to obtain a proportion of 27% of debt and 73% of equity. For cost of debt, she took total interest expense divided by average debt balance which resulted lower than treasury yields. For cost of equity, she used 20-year Treasury bond as risk-free rate and 5. 9% as market premium. Moreover, she divided each division by revenue, deciding to use one overall WACC. At the end, she came to a conclusion that the cost of capital for Nike, Inc was 8. 4%.