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CASE ANALYSIS

Importance of Cost of Capital

The concept of cost of capital is used in finance decisions.

Acceptance or rejection of an investment project depends on the cost that the company has to pay for financing it. Good financial management calls for selection of such projects, which are expected to earn returns, which are higher than the cost of capital. It is therefore, important for the finance manager to calculate the cost of capital, which the company has to pay and compare it with the rate of return, which the project is expected to earn. In capital expenditure decisions, finance managers go on accepting projects arranged in descending order of rate of return. The manager stops at the point where the cost of capital equals to the rate of return offered by the project. That is, the finance manager finds out the break-even point of the project. Accepting any project beyond the break-even point will cause financial loss for the company. The cost of capital is a guideline for determining the optimum capital structure of a company.

Weighted Average Cost of Capital The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital. A company's assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances. A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company…...

...NIKE, INC. COST OF CAPITAL Context: Estimating Cost of Equity with different methods. Compute WACC Nike’s current price per share= $ 42.09 Question: Is it undervalued or overvalued to make buy /sell decision? Forecasts for Cash flows, Dividend growth, EPS estimates for NIKE are given. Interest rate #’s, Betas, Book values on debt and equity are given. Also historical performance #s are given. At 12% WACC Nike is overvalued and hence sell decision; At 11.17% correct valuation; WACC below 11.17% , undervaluation and hence buy decision. Exhibit 2 : The bottom table shows the sensitivity of share price to discount rate. The issue is which discount rate (WACC) to use to make the decision. Lower the discount rate, higher the estimate of stock price. How do you estimate WACC? Weights of Debt and Equity Cost of Debt and Cost of Equity Overall Assessment of the firm: Exhibit 1 Uneven growth rate in revenue, operating income and net income from negative to low positive. All profit margin #s are relatively stable. Market share has declined. Company’ plans: (1) New Products in shoes and Athletic Apparel; (2) Expense Control Revenue growth target= 8-10% Earnings growth target=15% Both are substantially higher than the recent performance. Methodologies for Valuing a Firm 1. Estimating Cash flows per share; Take a good look at Exhibit 2. Exhibit 2 has information for ten years. Question: Why is terminal value given at the end of year 10...

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...1. What is the WACC and why is it important to estimate a firm’s cost of capital? Do you agree with Joanna Cohen’s WACC calculation? Why or why not? Answer: The cost of capital refers to the maximum rate of return a firm must earn on its investment so that the market value of company's equity shares will not drop. This is a consonance with the overall firm's objective of wealth maximization. WACC is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation. All else equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk. The WACC of a firm is a very important both to the stock market for stock valuation purposes and to the company's management for capital budgeting purposes. In an analysis of a potential investment by the company, investment projects that have an expected return that is greater than the company's WACC will generate additional free cash flow and will create positive net present value for stock owners. Thus, since the WACC is the minimum rate of return required by capital providers, the managers in the company should invest in the projects which generate returns in excess of WACC. We do not agree with Joanna Cohen’s calculation regarding the WACC from 3 aspects: 1) When Joanna......

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...Executive summary In this report we focus on Nike's Inc. Cost of Capital and its financial importance for the company and future investors. The management of Nike Inc. addresses issues both on top-line growth and operating performance. The company's cost of capital is a critical element in such decisions and it is important to estimate precisely the weighted average cost of capital (WACC). In our analysis, we examine why WACC is important in decision making and we show how WACC for Nike Inc. is calculated correctly. Also, we calculate the company's cost of equity using three different models: the Capital Asset Pricing Model (CAPM), the Dividend Discount Model (DDM) and the Earnings Capitalization Model (EPS/ Price), we analyze their advantages and disadvantages and finally we conclude whether or not an investment in Nike is recommended. Our analysis suggests that Nike Inc.'s common stock should be added to the North Point Group's Mutual Fund Portfolio. I. The Weighted Average Cost of Capital and its Importance for Nike Inc. The Weighted Average Cost of Capital (WACC) is the average of the costs of a company's sources of financing-debt and equity, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every marginal dollar it finances. A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company......

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...problem Nike has new investment endeavors revamp its recent drops in net income and market share. Wall Street analyst reactions to the endeavors are mixed, with some recommending Nike as a “Strong Buy” and others recommending a “Hold.” In case 13, Nike Inc.: Cost of Capital, I am acting as a portfolio manager to estimate Nike’s cost of capital to determine whether the stock is overvalued or undervalued. II. Alternative Solutions • Dividend Growth Model (DGM) see appendix for calculations • Capital Asset Pricing Model (CAPM) see appendix for calculations • Weighted Average Cost of Capital (WACC) see appendix for calculations III. Analysis of the Alternatives • Dividend Growth Model (DGM) The Dividend growth model is a simple and easy to understand model used to estimate a company’s cost of capital. The method works because RE the return that the stockholders require to the stock, so it can be interpreted as the firms cost of equity capital. In able to use this method I used Value Line’s Forecast of Dividend Growth from ’98-00 to ’04-’06 of 5.50% for Nike as my growth (g) ( see Exhibit 4). I was able to forgo the calculation of D1 because Nike had paid a constant dividend of .48 for the past 3 years (Exhibit 5). Although the method is simple in its approach, DGM does not account explicitly for risk. There is no adjustment for the riskiness of the investment. • Capital Asset Pricing Model (CAPM) The CAPM is widely used to determine a company’s cost of equity...

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...NIKE, INC.: COST OF CAPITAL The cost of capital represents the minimum return required by providers of finance for investing in an asset, it may be a project, a business or strategic unit or an entire company. It needs to represent the capital structure used to finance the investment and therefore likely to include cost of equity and debt. The cost of capital also represents a “hurdle rate” that a company’s projects must exceed in order to increase shareholders wealth and is used as a discount rate in net present value (NPV) investment appraisal techniques. Projects that generate a positive NPV at the cost of capital are accepted since they earn more than the investors required rate of return. Projects which generate a negative NPV are rejected as they earn less than their target rate of return. The cost of capital therefore plays a vital role in corporate finance, establishing a link between investment decisions and finance decisions i.e what companies should be spending their money on and how this should be funded. The weighted average cost of capital (WACC) represents the overall cost of capital for a firm, incorporating the cost of debt, equity and preference share capital, weighted according to the proportion of each source of finance within the business. In arriving at the WACC for a firm, the models used to calculate the cost of each source of finance assume that the required rate of return is a function of the shareholders’ expectations of future......

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...UV0010 NIKE, INC.: COST OF CAPITAL On July 5, 2001, Kimi Ford, a portfolio manager at NorthPoint Group, a mutual-fund management firm, pored over analysts’ write-ups of Nike, Inc., the athletic-shoe manufacturer. Nike’s share price had declined significantly from the beginning of the year. Ford was considering buying some shares for the fund she managed, the NorthPoint Large-Cap Fund, which invested mostly in Fortune 500 companies, with an emphasis on value investing. Its top holdings included ExxonMobil, General Motors, McDonald’s, 3M, and other large-cap, generally old-economy stocks. While the stock market had declined over the last 18 months, the NorthPoint Large-Cap Fund had performed extremely well. In 2000, the fund earned a return of 20.7%, even as the S&P 500 fell 10.1%. At the end of June 2001, the fund’s year-to-date returns stood at 6.4% versus −7.3% for the S&P 500. Only a week earlier, on June 28, 2001, Nike had held an analysts’ meeting to disclose its fiscal-year 2001 results.1 The meeting, however, had another purpose: Nike management wanted to communicate a strategy for revitalizing the company. Since 1997, its revenues had plateaued at around $9 billion, while net income had fallen from almost $800 million to $580 million (see Exhibit 1). Nike’s market share in U.S. athletic shoes had fallen from 48%, in 1997, to 42% in 2000.2 In addition, recent supply-chain issues and the adverse effect of a strong dollar had negatively affected revenue. At the meeting...

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...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 portions, debt and equity, in order to calculate a proper overall price, they must be multiplied with their respective single prices. What is crucial in the calculation process is that one must not omit the tax shield effect caused by debt. Which is, due to fiscal regulations, that all interest expenses which occur in the financing process are tax deductible and, hence, reduce the overall result. This circumstance is mathematically reflected by inserting the term (1-tc). Tc here stands for the corporate tax rate, which, as in the NIKE case, needs adjustment for any taxes imposed by particular states. So if a company faces 38% corporate tax rate the remaining part of 62% count as an expense. Again, as there is a direct relationship to the proportion of the debt and its cost, the higher the tax rate the higher the...

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...Calculation of cost of debt by using IRR method : Formula : B0=I*t=1n11+rd t +M*11+2dn=I*PVIFA r d,n+M*PVIFrd,n B0=Value of the bond at time zero I= annual interest paid in dollars n=number of years to maturity m=par value in dollars rd=required return on bond B0=$956 Coupon Rate =13.5% I= coupon payment=13.5%*1000 = 135 Year to maturity =n=25 years Par value =1000 A trial –and – error technique: At the first consider rd=7.58%equal to method one and B0=$956 I= coupon payment=$135 1)The first try: 956=135*t=1251(1+7.58%)t +1000*(1(1+7.58%)25) 956= 135*(PVIFArd,n) +1000*(PVIFArd,n) From table A-4 and A -2 (Appendix A) r=7.58%, n=25 PVIFArd,n=11.164 1000*(1(1+7.58%)25)=1000*0.161=161 135*11.164=1507.1 956≠1507.1+22.3 2)Another try rd=0.10 956=135*t=1251(1+10%)t +1000*(1(1+10%)25) PVIFArd,,n=9.077 135*9.077=1225.4 1000(1(1+10%)25)=0.092 PVIFrd,n=0.092 ,1000*0.092=92 956 ≠ 1225.4 +92 3)An other try: rd:=12% PVIFArdn=7.843 PVIFrdn=0.059 135×7.843=1058.9 1000×0.059=59 956≠1058.9+59 4) An other try: rd=%14 PVIFArdn=6.873 PVIFrdn=0.038 135×6.873=927.9 1000×0.038=38 927.9+38=965.9 956≠965.9 5)An other try: rd=%14.2 PVIFArdn=6.791 PVIFrdn=0.036 135×6.791=916.8 1000×0.036=36 916.8+36=952.6 956≠952.8 6)An other try: rd=%14.15 PVIFArdn=6.810 PVIFrdn=0.037 135×6.81=919.3 1000×0.037=37 919.3+37 = 956.3 959=956.3 rd=%14.15= cost of debt=correct answer...

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...POST-GRADUATE STUDENT RESEARCH PROJECT Estimating the Cost of Capital of CNX Nifty Prepared by Bhaswar Sarkar Student of PGDM Program of 2011-2013 Xavier Institute of Management, Bhubaneswar Supervised by Dr. Shridhar Kumar Dash Professor, Accounting and Finance Xavier Institute of Management, Bhubaneswar March 2013 Estimating the Cost of Capital of CNX Nifty Prepared by Bhaswar Sarkar1 Abstract This paper calculates the cost of capital of the CNX Nifty 50 Stock Index. It explores the possibility of establishing a new benchmark, the cost of capital of stock index, in the context of capital markets. The weighted average cost of capital (WaCC) of the Nifty 50 Stock Index is computed. The WaCC computed can form a new benchmark against which companies can compare their own cost of capital. Usually, companies raise a combination of debt and equity to finance their business. A new company can use this benchmark as a reference to choose the perfect combination of debt and equity to reduce its overall weighted average cost of capital. The methodology computes the cost of capital for the index by including each of the fifty companies of the Nifty index. An aggregate cost of capital is then calculated for all the companies, leading to a new benchmark called the cost of capital of the Nifty 50 stocks. 1 The author is currently a post-graduate student of business management (Batch 2011-2013) at Xavier Institute of Management, Bhubaneswar. The......

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...Nike Cost of Capital I. Single of Multiple Costs of Capital Since Nike has multiple business segments it is appropriate to question whether to use single or multiple costs of capital for the analysis. Kimi’s assistant Joanna went ahead and chose to use one cost of capital for Nike. We agree with her decision because Nike’s different segments are all generally sports related and are susceptible to the same market risks. For example, Nike’s footwear and apparel lines, which make up a combined 92% of their revenue, are segments that complement each other and are sold through the same marketing and distribution channels. Non-Nike products made up only 4.5% of Nike’s revenue including the Cole Haan brand, a company that sells casual dress and footwear products. Since the Cole Haan is the only business segment that took on different risks than the others and since it makes up such a tiny fraction of the revenues, its impact on the decision is insignificant so one cost of capital should be used for the whole company. II. Methodology for Calculating Cost of Capital Joanna is correct to use the WACC method for computing the costs of capital. However, her estimation of the proportion of debt to equity is incorrect because she uses book values from the past instead of using the current market values. The reason why we must use the current market value of debt and equity is so that the estimate of Nike’s present day WACC is as accurate as possible. Using book values, even though it...

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...MANAGEMENT ADVISORY SERVICES COST OF CAPITAL THEORY 1. All of the following statements are correct except: a. The matching of asset and liability maturities is considered desirable because this strategy minimizes interest rate risk. b. Default risk refers to the inability of the firm to pay off its maturing obligations. c. The matching of assets and liability maturities lowers default risk. d. An increase in the payables deferral period will lead to a reduction in the need to non-spontaneous funding. 2. Which of the following would increase risk? a. Increase the level of working capital. b. Change the composition of working capital to include more liquid assets. c. Increase the amount of short-term borrowing. d. Increase the amount of equity financing. 3. A firm’s financial risk is a function of how it manages and maintains its debt. Which one of the following sets of ratios characterizes the firm with the greatest amount of financial risk? A. High debt-to-equity ratio, high interest coverage ratio, stable return on equity. B. Low debt-to-equity ratio, low interest coverage ratio, volatile return on equity. C. High debt-to-equity ratio, low interest coverage ratio, volatile return on equity. D. Low debt-to-equity ratio, high interest coverage ratio, stable return on equity. 4. Which of the following classes of securities are listed in order from lowest risk/opportunity for return to highest risk/opportunity......

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...average cost of capital, WACC, is the rate of return required by investors. The WACC calculates the different risks associated with the individual components of the capital structure. The individual components within the WACC are preferred stock, common stock, and after-tax debt. The WACC is very important because it tells the investors if the return they are receiving is equal to the return they require depending on the risk associated with the investment. The WACC is the company’s overall rate of return and cost of capital. After much calculations, we believe Joanna Cohen’s analysis is incorrect. The reason being, when she calculated the WACC she used the book value instead of market values for the weights of debt and equity. When calculating the long term debt, Joanna should have discounted the debt that appears on the balance sheet. When calculating the risk free rate in her capital asset pricing model, Joanna used the 20 year U.S. treasury yield of 5.74% and a geometric mean of 5.90%. We chose to use the one-year U.S. treasury yield 3.59% and the arithmetic mean of 7.50%. As discussed in class, you should always try to use the current yield under a year. Cohen averaged all of the betas from 1996 until 2000 and used 0.80 as her beta. In our calculations we used the most current beta available, 0.83. Our results varied by almost 1% since we used a different beta. Cohen showed a WACC of 8.3% and we calculated a WACC of 9.27%. When calculating the weighted cost of......

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...Case Study: Nike, Inc.: Cost of Capital BUSFIN 4214 Written By: Joe Nau Nau.33@osu.edu Section: 32347 Cost of Capital NorthPoint Group’s strategy consists of identifying and investing in undervalued public companies. Joanna Cohen, an assistant to a portfolio manager at NorthPoint, is asked to help evaluate whether Nike Inc. is undervalued. Analysis by the portfolio manager shows that when Nike’s cash flows are discounted at 12% their shares are overpriced, however, when discounted at rates below 11.17% the firm is undervalued. Cohen is tasked to further analyze Nike’s cost of capital to accurately estimate what rate their cash flows should be discounted back at. Joanna Cohen’s WACC Calculations Cohen decides to use a single cost of capital rather than multiple costs of capital. This is accurate as Nike operates primarily in the same business segments and each segment assumes similar risks. To find Nike’s Weighted Average Cost of Capital (WACC), she must first find the capital structure of the firm. Cohen incorrectly uses the book value of equity, rather than the market value. Additionally, she uses the book value of debt, however this is acceptable because the market values are not provided in the case. With Nike’s capital structure in hand, Cohen begins calculate the cost of capital for debt and equity. To calculate the cost of debt, Cohen uses historical interest expenses as a proxy, however this is not a forward looking estimation and using the materials......

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...US E RE VI PR EW O P ON E R LY T Y ± N OF OT C E NG FO A R GE SA LE LEA OR R N CL ING AS SR O Northern Forest Products OM Case 90 Cost of Capital Directed FO R Northern Forest Products (NFP) was established in the 1800s to log timber in the Great North Woods. In response to changing conditions, the company underwent radical changes in the way it operates and currently it is a large multidivisional corporation. The major focus of the company remains managing over one million acres of timber production and overseeing the manufacture of consumer paper products from pulp derived from its land holdings. Over the years the company has diversiﬁed into several other related businesses, such as a moderately sized mill that produces paneling and wood flooring. This operation has developed a consistent outlet for all of its output and therefore is stable. The company is also involved in real estate as a result of developing some of the prime lake front properties from its forestlands for residential and private recreational use. Successful property development during the 1970s resulted in expanded real estate holdings. However, residential development was particularly hard hit during a recent economic downturn, and the company struggles in this area. NFP is aware of the increasing international demand for wood products and is concerned about recent environmental pressures concerning logging. The company believes that diversiﬁcation......

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... Ford considered buying shares of Nike, Inc., the well-known athletic shoe manufacturer. It would be prudent of Ford to base her assessment on Nike’s financial reports for 2001. Around the same time, Nike held an analysts’ meeting to disclose those financial results. They also addressed ways to revitalize the company, since share price was beginning to decline and revenues had plateaued at around $9 billion. Although Nike projected a rosy future, many analysts had mixed reactions to the projections. Ford was right to come up with her own forecast, seeing as the reactions ranged from too aggressive to growth opportunities. In order to completely analyze Nike and its possible place in the NorthPoint Large-Cap Fund, Ford needs to know Nike’s cost of capital. One of the most useful ways to measure the cost of capital is the weighted average cost of capital (WACC). Theoretically, the optimal capital structure in the mix of types of financing that produces the lowest WACC. WACC is calculated by multiplying the cost of each type of financing a company uses, be it debt or the many types of equity, by their respective weights. It is the rate of return that a company needs to earn in order to satisfy the returns they have to pay out to debtholders and stockholders. The respective weight of each type of financing is determined by their percentage of total capital. The WACC is extremely relevant to a company’s capital budgeting team and other capital finance department members. WACC......

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