What is he WACC and why is it so important to estimate a firms cost of capital?
The WACC (weighted average cost of capital) is a percentage figure resulting from a calculation method by which the adequate cost of capital of a firm is expressed. It considers the composition of a company’s funding, be it debt or equity. A corporation whose source of funding is equity by 100 percent will have a WACC equal to the cost of equity. By contrast, a levered company will have to reflect the cost of debt as well. The WACC takes their respective quantitative contributions to the entire amount of funding, serving hence as an allocation base, into account. As there is a direct relationship between the two ...view middle of the document...
If the internal rate of return of a project lies above the WACC it should hence be pursued.
The cost of debt (cd) as used by the WACC refers to the costs a company incures by raising parts of its funds through debt. As debt has a prior position to equity in terms of claiming it is in most cases supposed to be “cheaper” than equity (moreover the debt costs depend on the leverage). The overall market value of debt of a company can be retrieved by adding all debt positions less excess cash and short-term investments (net debt). Expressed as a relative portion of entire assets and multiplied by the cost of debt it yields the contribution to the WACC figure.
By contrast, the cost of equity (ce) is a quantitative result which can be derived from the CAPM e.g. (capital asset pricing model). It suggests that the cost of equity is equal to the sum of the risk-free rate and a risk premium of an average market portfolio adjusted for a company-specific factor beta. This beta reflects the risk associated with the company whereas a beta of 1,0 is equal to the market risk.
The importance of estimating the WACC properly becomes evident when using it for the valuation of a company. There is a direct and strong correlation between the exact cost of capital and the preciseness of resulting figures. Future free cash flows of orders of magnitudes are discounted sometimes. Hence, the resulting present value is subject to enormous sensitivity and an arbitrary rounding off of the second decimal as in the NIKE case is inacceptable and should be desisted from as it results in a wrong overall figure.
2. Do you agree with Joanna’s WACC calculation? Why or why not?
Considering the application of the discounted free cash flow model in order to find out whether Nike’s stock is undervalued, the calculation of the WACC is in general a necessity since it is used to discount the free cash flows. As NIKE is funded by both equity and debt and no information is given about a potential future change in the debt-to-value-ratio we can therefore use the WACC formula, which Joanna correctly applied. Nevertheless there are several misgivings to be expressed.
- Single or Multiple Costs of Capital?
In the authors’ opinion calculating the single overall costs of capital of NIKE is the accurate method. The reason is that in case you calculate multiple costs of capital one would have to derive different WACCs belonging to each sub division and subsidiary. At this place the problem arises that divisions and also many subsidiaries usually did not issue own stocks or bonds as they might not be listed at the stock exchange (e.g. Bauer was a limited company at that time). Therefore you can compute neither a beta, nor a bond’s yield to maturity in order to get out the equity and debt costs of capital. Another reason is that the WACC itself reflects an overall number...