The weighted average cost of capital (WACC) is an important indicator helping managers or specialists analyze the firm’s current state. It can be determined as the cost of all individual sources of capital, including common stock, preferred stock, and other types of debt. Usually, it consists of the equity the shareholders invest in the brand or the debt used by the lenders. The importance of WACC comes from several factors. First, it is an indicator of the company’s wealth and its current status. Second, the WACC of the firm is used in the stock market for the valuation process. It can also help to plan the capital budgeting process for the top managers. Using this indicator, the shareholders or lenders acquire the opportunity to determine the return generated if deciding to invest in a certain organization.
At the same time, it is critical to remember that WACC is established by the investors, not the top management of the unit. This factor influences their decision-making process and choices of new opportunities for investing. The accurate WACC shows the return which can be expected and can be viewed as the factor either proving the necessity to continue cooperation or end it. In such a way, the given factor plays a critical role in the work of any company as it indicates its attractiveness for potential partners and investors.
Speaking about the case, it is possible to state that Johana made several crucial mistakes when calculating the WACC. First of all, the weights of debt and equity were determined using the book value, not the market one. The fact is that book values are historical data that will not change and will be irrelevant. The current data for estimating the debt cost should be used to show the funds needed to raise the firm’s capital. Another mistake is that the historical data used by Cohen does not demonstrate Nike’s current cost of debt. Instead, she should have calculated the yield to maturity (YTM) using the 20-year debt as the basis and the coupon rate paid every half year. Finally, Cohen mistakenly used the average beta 0,80 (1991 2001); however, it does not represent the future risk, meaning that the most recent beta should be used.
To acquire an improved vision of current Nike’s performance and continue the discussion of the case, it is vital to calculate the cost of equity and the cost of debt. To determine the cost of debt, it is vital to calculate the YTM of Nike’s bonds to acquire the relevant number:
Current price (Po)= $95.60, Issued date= 07/15/96.
Maturity date= 07/15/21, Coupon Rate=6.75%
Payment (PMT)= PAR value = $100, a 25-year bond (year 1996 – year 2021)
N= (25-5). x 2= 40 paid semiannually.
Using the financial calculator, we acquire; r=3.58% Semiannual. Rd= 3.58% x 2= 7.16%.
The cost of debt is 7.16%.
The cost of equity is calculated using the 20-year treasury bond rate, which is 5,74%. The long-term rate is the better choice as it represents a more accurate number. In such a way, Rf = 5,74%. The market risk premium is found using the historical equity risk premium. Considering the current geometric mean (5,9%), it is possible to determine that the risk premium is 5,90%. The beta is the most recent one, which is 0.69.
In such a way:
Re=Rf +B * (Market Risk Premium)= 5.74%+0.69 (5.90%)= 9.811%.
It means the cost of equity is 9,81%.
Finally, to correct the mistakes made by Johana Cohen in her calculations, it is possible to acquire a new and relevant WACC. First, it is necessary to get the weights of equity and debt.
Market value of equity = (Current Share Price x Current Shares Outstanding)= $42.09 x 271.5 million=$11,427.44 million.
Because of the lack of information about the market value of debt, the book value is employed:
Market Value of Debt= Current portion of long-term debt + Notes Payable + Long-Term Debt= $5.4 m + $855.3 m + $435.9 m= $1,296.6 million
Therefore, Wd= 100% – 89.81 % = 10.19%
The tax rate remains the same, as it was acquired by adding the US statutory tax rate to the state taxes. In such a way, the tax rate is 35%+3%=38%
Weighted Average Cost of Capital (WACC)= Wd x Rd x (1-T) + We x Re=10.19% x 7.16% x (1-38%) + 89.81% x9.811%= 9.264%.
In such a way, the correct WACC=9.26%.
Using the WACC regarding the presented table (Figure 1), specific recommendations can be offered. It is necessary to buy Nike’s shares because of the opportunities associated with their growth at the moment. At the discount rate of 11.17%, the share price is $42.09. Because the relevant WACC is 9.26%, which is below 11.17%, it can be predicted that the equity value should fall, meaning that Nike’s shares can be bought. The stock is undervalued now, meaning it has a significant growth potential that can help investors generate income and acquire extra funds. Additionally, the existing growth rate is lower than the estimated one meaning there is a good opportunity to become an investor.
Figure 1. Nike case