Nike, Inc.: Cost of Capital
Kimi Ford is a portfolio manager at a large mutual-fund management firm called, NorthPoint Group. Ford is considering the addition of Nike Inc. to the Large-Cap Fund at NorthPoint Group. Nike’s share price has notably declined since the beginning of the year. Her decision whether or not to add Nike to the portfolio should be made by looking at the 2001 fiscal year end 10-K report.
In 1997 Nike’s revenues plateaued around $9 billion while net income had fallen from around $800 million to $580 million. Also, from 1997-2000 Nike’s market share in U.S. ...view middle of the document...
WACC is calculated taking into account the relative weights of each component of the capital structure which means it is the proportional average of each category of capital inside a firm. This rate, also called the discount rate, is used in evaluating whether a project is feasible or not in the net present value (NPV) analysis, or in assessing the value of an asset.
WACC = [Wdebt * Kdebt * (1-t)] + [Wequity * Kequity] + [Wpreferred * Kpreferred]
K = component cost of capital
W = weight of each component as percent of total capital
t = marginal corporate tax rate
WHY IS IT IMPORTANT TO ESTIMATE A FIRM’S COST OF CAPITAL?
The cost of capital is an important issue from the perspective of management while taking a financial decision. We can list some basic issues related to the importance of WACC and its interpretation by firms:
* The importance of the WACC is in its relation to the evaluation of projects. For a project to be feasible, not just profitable, it must generate a return higher than the cost of raising debt (Kd) and the cost of raising equity (Ke). WACC is affected not only by Re and Rd, but it also varies with capital structure. Since Rd is usually lower than Re, then the higher the debt level, the lower the WACC. This partly explains why firms usually prefer issuing debt first before they raise more equity. As part of their risk management processes, some companies add a risk factor to the WACC in order to include a risk cushion in their project evaluation.
* The cost of capital is also important for the management while taking a decision about capital budgeting. Naturally, the project which gives a higher (satisfactory) return on investment compared to the cost of capital incurred for its financing would be chosen by the management. Cost of capital is the key factor in deciding which project to undertake out of different opportunities.
* The cost of capital is significant in designing the firm's capital structure. It will direct the management about adopting the most appropriate and economical capital structure for the firm which means the management may try to substitute the various methods of finance to minimize the cost of capital so as to increase the market price and the earning per share.
* The cost of capital is also an important factor for taking a decision about the soundest method of financing for the company whenever the company requires additional finance. The management may try to catch the source of finance which bears the minimum cost of capital.
* The cost of capital can be used to evaluate the financial performance of the top management by comparing actual profitability’s of the projects and the projected overall cost of capital and an appraisal of the actual cost incurred in raising the required funds.
DO WE AGREE WITH JOANNA COHEN’S WACC CALCULATION? WHY OR WHY NOT?
We do not completely agree with Joanna Cohen’s calculation of WACC. There are several problems in...