Nike Case Solution - Wacc for Nike

NIKE CASE STUDY (Cost of capital) This paper mainly deals with corporate acquisition events during 1970-1989 authors are try 1. What is the WACC and why is it important to estimate a firm’s cost of capital? [2 to 3 sentences max.] WACC is the Weighted average cost of firm capital and is used to determine cost of capital that is raised from lender and shareholder in the form of debt and equity respectively. It is important to estimate a firm of cost of capital because it helps investors to evaluate firm’s capability to providing return on their investment into a firm. 2. Calculate your own WACC for Nike. Note the following requirements: a. Calculate the Cost of Debt based on the information provided in the case. [Fill in the highlighted Excel cells; explain your calculation briefly To calculate the cost of debt first need to pull out some given financial values in the Exhibit 4 of the Nike case. FV= 100, PV=95.06, PMT = 3.375( 6.75/2), N=40 Excel Formula: =Rate(nper,pmt,pv,{fv],[type],[guess]) Hence the rate given by above excel formula, is 3.58%. (Calculation shown in the excel) and multiply by 2 to get annual rate 7.167% Tax rate 38% After tax cost of debt is 7.167*(1-0.38)= 4.44% Manual calculation for cost of debt estimate can be seen from the following formula: 95.60 = 3.375*([1-(1+r/2)^(-40)/(r/2)]+[100/(1+r/2)^40]) Solving we get r as 7.167% When you are calculating the Cost of Equity, do it under three different scenarios: i. CAPM [Fill in Excel file] ii. Dividend Discount Model [Fill in Excel file] iii. Earnings Capitalization method [Fill in Excel file] CAPM model Cost of Equity = risk free rate + beta(Equity risk premium) Cost of Equity = 5.74 +0.69(5.90) = 9.81% geometric mean for equity risk premium is better estimate for long life valuation and arithmetic is better estimation for one-year expected return so we selected geometric mean for Nike 20-year valuation. More accurate beta would be current beta because it reflects current systematic risk. Dividend Discount Model P0 = D0(1+g)/(k-g) K = D0(1+g)/P0 + g K = 0.48(1.055)/42.06 + 0.055 K = 6.7% Earning Capitalization Model K= E1/P0 K = 2.32/42.06 = 5.51% Consensus Estimate Earning For 2002 = 2.32 / current price of Nike Stock on July 5,2001 = 42.09 both inputs values are given in the Exhibit 4 c. Summarize what the WACC would be in 3 different scenarios: using the Cost of Debt and three different Cost of Equity percentages. First Scenario(CAPM) Market value of equity = current share price*no. of shares = 42.09*273.3 million = $11,503 million. Book value of debt will be used as market value of debt is not provided. Thus, total of debt and equity = 11503+1296.60. Weight of equity = 11503/(11503+1296.60) = 89.87%. Weight of debt = 1-89.87% = 10.13% My estimate of WACC under First Scenario WACC = Re*E/(E+D) + Rd*(1-t)*D/(D+E) = 89.87%*9.81% + 10.13%*4.44% = 9.27% In the second and third scenario all calculation for WACC is same as above except cost of equity. Due to different estimate of cost of equity through different model, my WACC estimate is also change to 6.47% under DDM scenario and 5.40% under Earning cap Scenario. All three scenarios’ calculations for WACC are shown in the attached excel file 3. Highlight/note any differences versus Joanna Cohen’s calculation. 1. For cost of debt Calculation I calculated cost of debt by considering current yield on publicly traded Nike debt as shown above 2a whereas Cohen calculate cost of debt by considering historic data of Nike debt and dividing total interest expenses for the year 2001 by average Nike debt balance. 2.For Cost of Equity Calculations To calculate the cost of equity under CAPM model, Cohen used three values. The first value 20-year Treasury bond current yield as risk-free rate 5.74% Second value historical equity premium (5.9%). The final value she used was Nike’s average beta from 1996 to 2001 as the beta (0.8). This gave a CAPM value of 10.5%. All of these are acceptable except for the beta. Instead of taking the average of the past few years, it is more accurate to use the most recent beta. By replacing her beta value of 0.8 with the current beta of 0.69, my CAPM value is 9.81%. 3. For WACC Weights Calculation. In Cohen’s calculations for the weights of equity, she used the book value of equity that is presented in the balance sheet to calculate the weights. Instead, she should have used the current market value Cohen Weights estimate Debt weight = 27% Equity weight =73% vs My Weight estimate Debt weight = 10.13% Equity weight =73% 4. Which of your three WACC calculations (based on the 3 different Costs of Equity) do you think makes the most sense and why? I think that the CAPM model for WACC calculations makes the most sense because CAPM model considers the systematic risk which other model does not consider in their calculation of cost of equity. CAPM model is also simple and can be used to drive ranges of possible results which develop the confidence for calculated cost of equity. When using the CAPM approach in the Nike, the cost of capital shows that Nike stock is undervalued and should be a buy and good investment for Northpoint Group. By plugging the above calculated weights and CAPM cost of equity into the excel sheet (shown in Appendix A) the WACC discount rate is 9.27%, . Many companies do not pay dividend at all and many other do not pay at the end of the period. It might lead to inaccurate calculating cost of equity and DDM has high sensitivity to small changes in input assumption. The main assumptions made with DDM model is that the company pays large dividend, but Nike does not. Therefore, CAPM model is more popular than DDM. The CAPM is also prefer over ECM because it does not consider Future growth of the company in its calculations.