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Nike,Inc.:CostofCapitalCaseBackground:NorthPointLargeCapFundweighingwhethertobuyNike’sstock.NorthPointLargeCapFundweighingwhethertobuyNike’sstock.Nikehasexperiencedsalesgrowthdecline,declinesinprofitsandmarketshare.Nikehasexperiencedsalesgrowthdecline,declinesinprofitsandmarketshare.Nikehasrevealthatitwouldincreaseexposureinmid-pricefootwearandapparellines.Italsocommitstocutdownexpenses.Nikehasrevealthatitwouldincreaseexposureinmid-pricefootwearandapparellines.Italsocommitstocutdownexpenses.ThemarketrespondedmixedsignalstoNike’schanges.KimiFordhasdoneacashflowestimation,andaskherassistant,JoannaCohentoestimatecostofcapital.ThemarketrespondedmixedsignalstoNike’schanges.KimiFordhasdoneacashflowestimation,andaskherassistant,JoannaCohentoestimatecostofcapital.Nike,Inc.:WhatisWACC?andwhyisitimportanttoestimateafirm’scostofcapital?Thecostofcapitalistherateofreturnrequiredbyacapitalproviderinexchangeforforegoinganinvestmentinanotherprojectorbusinesswithsimilarrisk.Thus,itisalsoknownasanopportunitycost.SinceWACCistheminimumreturnrequiredbycapitalproviders,managersshouldinvestonlyinprojectsthatgeneratereturnsinexcessofWACC.WhatisWACC?andwhyisitimportanttoestimateafirm’scostofcapital?TheWACCissetbytheinvestors(ormarkets),notbymanagers.Therefore,wecannotobservethetrueWACC,wecanonlyestimateit.DoyouagreewithJoannaCohen’sWACCestimations?Whyorwhynot?IssuesSinglecostorMultipleCost?SinglecostorMultipleCost?CostofdebtCostofdebtCostofequityCostofequityWeightsofcapitalcomponentsWeightsofcapitalcomponentsSinglecostorMultipleCost?ShouldCohenestimatedifferentcostofcapitalforfootwearandappareldivisions?Iagreewiththeuseofthesinglecostinsteadofmultiplecostsofcapital.ThereasonofestimatingWACCistovaluethecashflowsfortheentirefirm,thatisprovidedbyKimiFord.Plus,thebusinesssegmentsofNikebasicallyhaveaboutthesamerisk;thus,asinglecostissufficientforthisanalysis.CostofdebtTheWACCisusedfordiscountingcashflowsinthefuture,thusallcomponentsofcostmustreflectfirm’sconcurrentorfutureabilitiesinraisingcapital.Cohenmistakenlyusesthehistoricaldatainestimatingthecostofdebt.Shedividedtheinterestexpensesbytheaveragebalanceofdebttoget4.3%ofbeforetaxcostofdebt.ItmaynotreflectNike’scurrentorfuturecostofdebt.Thecostofdebt,ifitisintenttobeforwardinglooking,shouldbeestimatedby1.yieldtomaturityofbond,or2.accordingtocreditrating.ThemoreappropriatecostofdebtcanbecalculatedbyusingdataprovidedinExhibit4.WecancalculatethecurrentyieldtomaturityoftheNike’sbondtorepresentNike’scurrentcostofdebt.PV=95.60PV=95.60N=40N=40Pmt=-3.375Pmt=-3.375FV=-100FV=-100CompI=3.58%(semiannual)7.16%(annual)CompI=3.58%(semiannual)7.16%(annual)Aftertaxcostofdebt=7.16%(1-38%)=4.44%CostofequityJoannaCohenseemstouseCAPMtoestimatecostofequity.Hernumbercomesfromfollowing:10.5%=5.74%+(5.9%)*0.80Herriskfreeratecomesfrom20-yearT-bondrateHerriskfreeratecomesfrom20-yearT-bondrateCohenusesaveragebetafrom1996toJuly2001,0.80.Cohenusesaveragebetafrom1996toJuly2001,0.80.Cohenusesageometricmeanofmarketriskpremium5.9%Cohenusesageometricmeanofmarketriskpremium5.9%Commentsoncostofequity–Therisk-freerateItisnoproblemtouse20-yearT-bondratetorepresentrisk-freerate.ThecostofequityandtheWACCareusedtodiscountcashflowsofverylongrun,thusrateofreturnaT-bondwith20yearsmaturity,5.74%,isthelongestratethatareav...