Case Study 4: Nike Inc. - Cost of Capital

Introduction

Kimi Ford, the portfolio manager at NorthPoint Group, was considering investing in some Nike’s shares, which had declined in price significantly. Nike had held an analysts’ meeting to discuss the situation. By doing that, the management team wanted to communicate a strategy for revitalizing the company. However, the analysts’ reactions were mixed. Kimi Ford found the meeting gave her no clear guidance; therefore, she decided to develop her own discounted cash flow forecast to make a clearer conclusion. She therefore asked Joanna Cohen to estimate Nikes cost of capital. Our task is to find whether the memo, produced by Joanna, is correct.

Cost of Capital

The Cost of Capital shows the price of the risk. It is important for both investors and the company itself. In the investor’s point of view, the cost of capital estimation will help to discount a stem of further expected cash flow into expected present value. Then investors can compare this present value with the market price of the company to decide whether this company’s price is under or over-valued. This ultimately gives investors a platform to decide whether this company is a good investment.

On the other hand, the company itself will also benefit from the cost of capital estimation. As Pratt & Grabowski (2010) stated in their book, the cost of capital is the expected rate of return that is required by the company in order to attract funds for investment. Companies see Cost of Capital as the minimum return that investors expect, thus cost of capital is a benchmark that a company should meet when considering investing in a new project.

Weight Average Cost of Capital (WACC )

WACC is a method to estimate the firm’s overall cost of capital. It refers as the rate of return that a firm will pay on average to all its capital providers to raise funds. The formula of WACC shows below:

WACC=r_e (E/(D+E))+ r_d (1-t)(D/(D+E))

The company funds its capital from variable resources such as the common stock, preferred share, debt, convertible debt, warrants and so on. The WACC formula shown is made up by cost of equity and cost of debt. The calculation of WACC benefits both the investors and internal managers. The WACC is often used internally by managers as a hurdle rate for capital investment i.e. the minimum rate of return needed from an investment. The WACC is also used to find the optimal capital structure for a company, and measures the economic feasibility of making an expansion and/or merger decisions.

Cost of equity: there are three methods to calculate the cost of equity; it can be estimated using the Dividend Growth model, CAPM and the Earning Capitalization model. Under the dividend growth model, r_e=(D_1/P_0 )+g where