What is the WACC and why is it important to estimate a firm’s cost of capital? Do you agree with Joanne Cohen’s WACC calculations? Why or why not? WACC, the weighted average cost of capital, which is the minimum return required by the finance providers for investing in an asset, project or the entire company. It needs to reflect the capital structure used to finance the investment. WACC is also used as the discount rate to appraise new investments for a company.
Using WACC we can calculate the interest a company has to pay on the finances it makes. A firm’s WACC is the overall required return on the firm as a whole and used by the firm to determine the economic condition of the company for near future opportunities. We do not agree with Joanne Cohen’s WACC calculations because of three factors: a) For Cost of Debt, she used the book value of interest expense divided by the average book value of debt, which is wrong. Cost of debt is the actual yield that NIKE is paying on their issued debt (bonds) on the market. ) For Cost of Equity, Joanne is using the yield rate of 20-year treasury bonds, but her projections of cash flows are done for 10 years, so she should be using the 10-year treasury bonds rate. c) For WACC, Joanne calculating the weights of cost and debt using book values, but this is wrong; Joanne should be using the market values of both equity and debt.
However, with the information given in the case she can only determine equity’s market value, because the case is not presenting how much debt has been issued by Nike, to calculate the market value of debt, but doing it this way will give Joanne a better estimate of the real market weights. ) If you do not agree with Cohen’s analysis, calculate your own WACC for Nike and justify your assumptions. After modifying the problems we observed with Joanne’s calculations, we presented the following reviewed results for Nike’s WACC: – Cost of Debt: Calculated with the data provided by the case about Nike’s traded debt (bonds), determining a yield rate of 7. 17%, which is the actual rate of how much is Nike paying in the market for it’s debt. After the tax effect, we have a resulting Cost of Debt of 4. %, slightly higher than the previous calculations done by Joanne (2. 7%) – Cost of Equity: The calculations done with the CAPM model are correct, with the exception that now we are using the risk-free return rate of 10-year treasury bonds in order to be in line with amount of years used to forecast the free cash flows of Nike. – WACC: Market value of equity was calculated by multiplying the current price of Nike’s Stock times the total number of outstanding shares in the market.
An accurate market value of debt cannot be calculated with the information of the case, so we keep using the book values of debt in books which shouldn’t be that difference from it’s market value because Nike’s bonds are being traded with a price of $95. 6. As a result of this new calculations, Nike’s WACC is 9. 53%, higher that the previous WACC calculated by Joanne (8. 35%). Even if the results are similar, the new result is more accurate and calculated entirely with market assumptions without the use of book values. ) Calculate the costs of equity using CAPM and the dividend discount model. What are the advantages and disadvantages of each method? Cost of Equity though CAPM is already calculated on question 2, with a resulting WACC of 9. 53%. Now, the resulting Cost of Equity using the DDM is completely different. The formula tells us that the expected return of a company’s stock is the expected dividend to be paid one period from now divided by the price of the stock today, plus the estimated growth rate.
All of this numbers are given to us in the case, and after the necessary calculations we arrive at a WACC of 6. 42% (approx. 3% less than using the CAPM method). DDM (Discounted Dividend Model): – Advantages: Simple calculation that doesn’t need any complex data, just internal information about stock behavior. Good a quick look at possible future stock price. – Disadvantages: Not accurate, not reliable as a valuation tool because stock valuation can be highly sensible to market changes and DDM does not take any of that into consideration.
CAPM (Capital Asset Pricing Model): – Advantages: The most important advantage of CAPM is that it only takes data from market behavior, only accounting for systematic risk which are the risks associated with the market, making CAPM a accurate tool to determine the actual market value of an asset. – Disadvantages: CAPM it build under several assumptions and estimations, like the estimated return of the market premium rates and free-risk rates, which are really dynamic and sensible to uncountable factors.
This dynamic nature of the market itself can go against the rigid nature of CAPM. 4) What should Kimi Ford recommend regarding an investment in Nike? After all the calculations and analysis done in the previous questions, and even though our reviewed calculations are slightly different than the WACC calculated by Joanne, the recommendation for Kimi is that she should invest in Nike’s stock and make it part of their portfolio, because the stock is undervalued.