Nike Cost of Capital

INTRODUCTION

Background:

Kimi Ford, a portfolio manager of a large mutual fund management firm, is looking into the viability of investing in the stocks of Nike for the fund that she manages. Ford should base her decision on data on the company which were disclosed in the 2001 fiscal reports. While Nike management addressed several issues that are causing the decrease in market sales and prices of stocks, management presented its plans to improve and perform better. Third party sources also gave their opinions on whether the stock was a sound investment.

The weighted average cost of capital (WACC) is the rate (expressed as a percentage, like interest) that a company is expected to pay to debt holders (cost of debt) and shareholders (cost of equity) to finance its assets. It is the minimum return that a company must earn on existing asset base to satisfy its creditors, owners, and other providers of capital. Companies raise money from a number of sources: common equity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants, and options, pension liabilities, executive stock options, governmental subsidies, and so on. Different securities are expected to generate different returns. WACC is calculated taking into account the relative weights of each component of the capital structure- debt and equity, and is used to see if the investment is worthwhile to undertake.

Management always takes notice of the cost of capital while taking a financial decision. The concept is quite relevant in the following managerial decisions and hence its importance:

(1) Capital Budgeting Decision. Cost of capital may be used as the measuring road for adopting an investment proposal. The firm, naturally, will choose the project which gives a satisfactory return on investment which would in no case be less than the cost of capital incurred for its financing.