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1. What is the WACC and why is it important to estimate a firms cost of capital?

Do you agree
with Joanna Cohens WACC calculation? Why or why not?

1.1 The definition of WACC


Weighted average cost of capital(WACC), is a weighted-computational method of analyzing the cost
of capital based on the whole capital structure of a firm. The result of WACC is the rate a firm use to
monitor the application of the current assets because it represents the return the firm MUST get. For
example this rate could be used as the discount rate of evaluating an investment, and maintaining the
price of firms stock.

1.2 Analysis of Johanna Cohens calculation


We analyzed the process of Johanna Cohens calculation, and found some flaws we believe caused
computational mistakes.

i. When using the WACC method, the book value of bond is available as the market value since
bonds are not quite active in the market, but the book value of equity isnt. Instead of Johannas using
equitys book value, we should multiply the current price of Nikes stock price by the numbers of
shares outstanding.

ii. When calculating the YTM of the firms bond, Johanna only used the interest expense of the year
divided by the average debt balance, which fully ignored the discounted cash flow of the cost of debt.

2. If you do not agree with Cohens analysis, calculate your own WACC for Nike and be
prepared to justify your assumptions.

Combining the analysis above, we now give our own WACC calculation as following:

2.1 The value of debt(based on EXIHIBIT 3).


Since the book value of debt may represent the market value, we merely need to sum up the values
of Long-term debt, Notes payable, and the Current portion of long-term debt:
435.9+855.3+5.4=$1,296.6 m

2.2 The cost of debt (based on EXIHIBIT 4):


PV: -95.6 ; FV: 100 ; n: 40 ; Pmt: 6.75/2= 3.375 (as it pays semiannually)
So, we get the YTM is i*2=3.58*2=7.16%

2.3 The value of equity (based on EXIHIBIT 1&4):


Price of stock * numbers of shares outstanding= 42.09*273.3=$11,503.2m

2.4 The cost of equity (based on EXIHIBIT 4):


E(Ri) = Rf +E(Rm) - Rf* i

Because the government bond yield is 5.74%, Geometrical historical risk premium is 5.90%, and the
average historical of Nike is 0.80, then we get:
E(Ri)= 5.74%+5.90%* 0.8=10.46%

2.5 Weights of each security (based on 2.1&2.3)


Weight of debt=1,296.6/(1,296.6+11,503.2)=10.13%
Weight of equity=11427.44/(1,296.6+11,503.2)=89.87%

2.6 Cost of capital by WACC method (based above):


Cost of capital = Weight of debt * Cost of debt * (1 Tax rate) + Weight of equity
* Cost of equity = 10.13% * 7.16%* (1-0.38) + 89.87% * 10.46% = 9.85%

3. Calculate the costs of equity using CAPM, the dividend discount model, and the earnings
capitalization ratio. What are the advantages and disadvantages of each method?

i. Calculation:
According to 2.4, we have already got the result of CAPM, which is 10.46%.

ii. Advantages
First, because CAPM is a theory based on the whole market, it obviously includes the effects
between the market as the integrity and each individual stock. Second, with the counterbalance
among each stock in the entire market, CAPM only needs the consideration of systematic risk, which
much simplifies the calculation. Third, CAPM also bypasses the specific values of future cash flow
because the equation is actually the relation between systematic risk and return rate, which is also
another simplification of calculating. Fourth, merely depending on the systematic risk, CAPM could
offer the investors a reliable discounting rate to assess the value of a certain investment.

iii. Disadvantages:

First, involving the counterbalance among the entire market, CAPM acquiesces an effective, active
and healthy market environment. Second, comparing the consideration of market risk, CAPM may
omit the subtle risk differences among each single firm. Third, the crucial systematic risk, the beta
coefficient, is obviously hard to calculate.

3.2 Calculating the costs of equity by DDM, and its advantages & disadvantages

i. Calculation (based on EXIHIBIT 4):


Based on the dividend discount model, P0 = D0 * (1+g) / (k g), then we get the return rate (the cost
of equity) k = D0 * (1+g) / P0 + g = 0.48 * (1 + 0.055) / 42.09 + 0.055 = 6.7%

ii. Advantages
First, DDM fully considers the time value of consistent cash flow of an investment. Second, it is pretty
easy to get the necessary historical data. Third DDM is flexible enough for the adjustment of any
future situation. Fourth, once the growth pattern is confirmed, it is very straightforward to get the
discount rate of assessing an investment.

iii. Disadvantages
First, without enough consideration of risk cost, DDM may underestimate the equity cost. Second, all
of the data is based on historical record, so the result is not reliable considering of the future
situations. Third, with the predetermined growth rate, it is obviously practical for the stock investors to
estimate the possible profit, but may mislead the stock issuing firm from a better budgeting decision to
a comparatively unsubstantial investment.

3.3 Calculating the costs of equity by the earnings capitalization ratio, and its advantages &
disadvantages

i. Calculation (based on EXIHIBIT 1&4)


According to the earnings capitalization model, we have cost of equity = E1 / P0 = 2.16 / 42.09 =
5.13%

ii. Advantages
First, its very easy to calculate and understand. Second, its easy to get the necessary accounting
data

iii. Disadvantages

Without any consideration of the risk and the growth of the firm, it doesnt reflect the true value of an
investment or the cost of the budgeting at all.

4. What should Kimi Ford recommend regarding an investment in Nike?


According to EXIHIBIT 2, the markets forecasting sensitivity of equity value of Nike is 11.17%. But
based on our own analysis by WACC, we believe the discount rate of Nike is around 9.85%. That
means the market underestimated the value of Nike. So we recommend the Northpoint to purchase
the stock of Nike.

Source: http://wenku.baidu.com/view/913e3542c850ad02de8041a2.html