Nike Case Study Finance

Nike, Inc. Case Study

Cost of capital of the firm

1. Why is it important to estimate a firm’s cost of capital?

2. What does it represent?

3. Is the WACC set by investors or by managers?

What is the Cost of capital?

Cost of capital represents the opportunity cost of using capital for a particular venture as oppose to the alternative investment which has similar systematic risk. (Brigham &Ehrhardt, 2002). The question to be answered: is this the required return necessary to make a capital budgeting project of the company profitable? Cost of capital includes the cost of debt and the cost of equity. Cost of debt includes various bonds, loans and other forms of debt; this measure is useful for giving an idea as to the overall rate being paid by the company to use debt financing. The measure can also give investors an idea as to the riskiness of the company compared to others, because riskier companies generally have a higher cost of debt ("Cost of debt"). Cost of equity includes cost of common stock shares.

1. Estimating a firm’s cost of capital is a very important analysis that helps in determining the overall decision about investing in a project or company. It also helps with predicting and measuring risk that can occur within a company (risk management). Moreover, estimating a firm’s or projects’ cost of capital helps investors to diversify their investment, reduce risk, and maximize profits.

Normally, the investors will choose the project (compare with many other projects), which gives a higher return and lower risk on investment. If a company must decide on an individual project, the company will choose the project which give satisfactory return on investment.  All of the projects which are chosen must get higher return than the costs of capital invested in those projects.

Cost of capital also helps for designing the Corporate Finance Structure. On one hand, firms always follow the changing capital market for getting information and choosing the best way for capital structure of company. On the other hand, managers can use various methods to minimize company’s cost of capital, by changing the market price and the earning per share, it can bring benefits to company.

2. Cost of capital represented by WACC (Weighted Average Cost of Capital). The required return will reflect the risk of the investment and the return of alternatives investments. WACC is the sum of cost of debt (RD) and cost of equity (RE). RE is calculated by using DDM (Dividend Discount Model), Earning Capitalization Model or CAPM (Capital Asset Pricing Model). In many cases, many companies do not pay dividend at the end of the period, it might lead to inaccurate calculating RE that is the reason why using CAPM is more popular than DDM to calculate cost of equity, although using CAPM can have some disadvantages. To find the average cost of capital, we weight individual cost of capital by their proportions in the firm’s capital structure: