Nike In Cost of Capital - Case Study Example

?Nike In: Cost of Capital Investors require knowing the return on their capital in order to make long-term strategic plans in an investment. Cost of capital is the value of expected returns on capital. This rate is calculated by establishing the rate of return on the capital if it was invested in an investment of similar risk. An investment is considered as worth, if its expected returns exceed its cost. Various approaches are used to determine the cost of capital in an organization (DeMello 56). These techniques are used to determine the debt and cost of equity in a company. These rates are required to calculate the cost of its capital in a company. Nike is a global investment and, therefore the cost of its capital has great implications to various stakeholders across the globe. Currently the company has been experience a decrease in the market value for its stock. Capital cost can therefore, be a useful ratio that manager in the company can apply to establish its worth. This paper will therefore, establish the cost of the company’s capital 1. WACC (The weighted cost capital) is the rate at which an investment is expected to meet its debts. WACC is therefore, the value at which a company is ready and able to pay for its capital. This involves the rate at which a company expects to pay its debtors and the rate at which the company is expected to pay dividend to its shareholders. Most companies consider raising capital from various sources such as debtors, sale of stocks and government subsidies. Using these ratios, investors are able to establish the most appropriate source of capital for their company. A company’s cost of capital is useful to a company since it evaluates the worth of an investment. The worth of an investment establishes the expected return on similar capital invested in an alternative investment. Therefore, the rate enables investors to make appropriate investment decisions. The cost of capital is not only required in making investment decisions but it is also used to make management decisions. Management decisions are based on financial implications and expectations of a company. The cost of capital determines financial expatiations of a company through capital and, therefore it is essential in making management decisions. A company’s cost of capital is therefore a useful tool in decision-making process. I do not concur with Joanna Cohen’s value for WACC since it has considerable limitations. Cohen’s calculation also had some errors and hence the company cannot rely on the value to make critical financial decisions. 2. Although Cohen’s calculation of Nike’s WACC was analytical, it has some weakness and hence inappropriate. In her calculations, Cohen weighted the capital structure based on book values. This was inappropriate since the company is a public liability company, and the values of its market capitalization have greater significance than the value of its book equity. Her Cost of debt was also wrongly calculated; Cohen obtained her cost of debt by determining the ratio between interest expense and interest-bearing debt. In some case, interest expenses contain expenses that are not covered or related to the company’s debt. This might have introduced some errors in her final WACC value. Cohen also used 5.9% as her market premium this figure was significantly low. Cohen also obtained a wrong value for her WACC; this is because she weighted all her divisions using revenue instead of cash flow. This factor contributed to the margin between her WACC value and the expected value. Her calculation of weights also did not accommodate the different products that the company produces. This is because her weight did not consider all the footwear that Nike produces. Although the company makes most of its sales from sport shoes, other types of footwear contribute significantly to the sales of the company. WACC = Cost of Equity + Cost of Debt = (We) (Ke) + Wd (Kd) (1-t) Where Wd = loan capitals, We =finance from equity, Kd =bank’s interest rates, and Ke = risk premium, t= tax rates The following are the required ratios for the company according to the case study (DeMello 76). Wd = 10.05%, We = 89.95% Kd = 7.51%, Ke = 10.46, t=38% WACC = (89.95 * 10.46) + (1- 38)* 10.05* 7.51 = 9.4087 +0.4682 =9.8767% This value of WACC is more inclusive than the initial value obtained by Cohen. 3. Cost of equity is the expected rate of return for equity capital in an investment. The ratio measures the expected rate of return, if the given capital was placed in an alternative investment that has similar levels of risks. The dividend discount model, CAPM and Earnings Capitalization ratio are the basic models used to determine the cost of equity. The following are different calculation for Nike’s cost of equity based on the different models. Dividend discount model: Cost of Equity = Dividend Growth Rate + (Next Year's Dividend) / (Current Stock Price) Ke= 0.055 + [0.49*(1+ 0.55)/42.08] = 6.71% Unlike the CAPRM method, the dividend discount model has significant flexibilities. The second advantage of the method is that it lacks significant assumptions. This implies that the resultant value has a high degree of accuracy. Lack of major assumption also makes the method suitable for testing sensitivity on various factors in the company. The main disadvantage of this method is that it is highly sensitive to insignificant variation of variables. The method also lack adequate specifications on its key models and, this affect its results. CAPM method: Cost of equity = Rf –?( Rf –Rm), { Rf = 5.74% (20 year returns for united states treasuries), ? = 0.8) , ?( Rf –Rm) = 5.90% } Ke= 5.74 + 5.90 = 10.46% The main advantage in this model is that it assumes systematic risks; this is because most shareholders have diversified investments or portfolios. The method also corresponds to the derived relationship between systematic risks and expected returns. The main disadvantage of the method is that it emphasizes more on market risk without considering internal risks. Earning Capitalization model: Ke =E1/ Po = 232 / 42.09 = 5.52% This method is not appropriate for use in developing or growing firms and hence it is inappropriate for Nike’s case. This is because the company is still on its developing stages. Work Cited DeMello, Jim. Cases in Finance. New York: McGraw-Hill, 2005. Print. Read More