1. WACC is the average cost of financing a company’s assets, either through debt or equity. A firm’s WACC is the overall required return on the firm as a whole. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm.
2. We agree with I., choosing a single cost of capital. She made a cogent argument and we think the analysis would be much more complex otherwise. We aren’t trying to evaluate a project in a specific department but instead value the company’s shares. We just need a single cost of capital.
We agree with II. The figures are from the most current year and debt comes from current portion of long-term debt, notes payable, and long-term debt.
We disagree with III. We care about debt that Nike will have to pay in the future, not in the past. The correct way to calculate debt is to look at Nike’s bonds. Currently, Nike’s bonds trade for $95.60 with a semiannual 6.75% coupon and mature in almost exactly 20 years. This yields an annual rate of 7.17%, as opposed to 4.3%. We can still use a 38% federal + state tax rate, and thus our final cost of debt is 4.45%.
Similarly, using the book value of equity to calculate the equity/debt mix would be incorrect, because the book value is backwards looking, whereas market value takes into account today’s opportunity cost of issuing equity. Thus we used current share price multiplied by the number of shares outstanding to calculate equity outstanding.
We disagree with IV. Using the CAPM is a good choice, but using the current yield on 20-year Treasury bonds is not. Because the cost of capital will be used to discount relatively long-term cash flows, it is appropriate to use a relatively long-term risk-free rate, but we should use a more common type of bond to for valuation purposes, such as the yield on a 10-year Treasury bond. Indeed, a survey of highly regarded companies shows two-thirds of them use the rate on 10-year Treasury bonds, and the 5.39%10-year Treasury is appropriate here.
The arithmetic average often is used as an estimate of next year’s risk premium; this is most appropriate if investor risk aversion had actually been constant during the sample period. On the other hand, the geometric average would be most appropriate to estimate the longer-term risk premium, say, for the next 20 years. Thus we will keep the geometric average of 5.90% that she used.
For the beta, we can run a regression, with NKE returns on the Y axis and S&P returns on the X axis. This will yield a slope coefficient of .915, which is the beta for Nike. Take a look:
book value (in millions), as of May 31, 2001
current portion of long-term debt
debt, as % of total capital
current yield on publicly traded Nike debt
1 period = 6 months
maturity (in periods)
bond yield rate, per period
bond yield rate, annual
tax rate (T)
after-tax component of cost of debt
preferred stock, as % of total capital
current share price
total outstanding shares
common equity, as % of total capital
10-yr T-bill yield
geometric mean of historical equity risk premiums (1926 – 1999)
cost of common equity
current stock price (P [sub 0])
as of July 5, 2001
dividend growth rate
from ’09-’00 to ’04-’06
D [sub 1]
expected dividend in 2001
required rate of return
cost of common equity
WACC, using CAPM
3. The cost of equity using the CAPM model can be found above, as can the cost of equity using the dividend discount model. The advantages for CAPM include the fact that it takes into account a company’s level of risk relative to the stock market as a whole. CAPM touches upon the relationship between risk and return, which is how investors make decisions within the market. Disadvantage for CAPM: The components to the CAPM depend on government debt (US treasuries) and the corresponding interesting rates for these change on a daily basis. Some companies also have complex sources of finance and capital and this may be obfuscated in the CAPM model.
An advantage for the dividend discount model includes the fact that it is a simple way to value companies that constantly grow their dividend payments, as there exists many companies in the economy that do this. A disadvantage for the dividend discount model includes the fact that it assumes companies issue dividends with constant growth. This assumption may not hold for rapidly growing companies or, for that matter, companies that don’t pay dividends at all.
4. Kimi should recommend that her company buy Nike shares. The current market price for Nike is lower than our estimate, as shown below: