Question 1: How, if at all, would you change Cohen’s equity cost of capital calculation? Why? In this case, Cohen calculated the equity cost of capital by using CAPM: rE = rf +βi ( E[rmkt]-rf ) 10.5% = 5.74% + 0.80 * (5.9%) * Risk free rate: The rf should be kept consistent with the time horizon of the investment. Since Cohen did her estimate in 2001 and Nike’s bond will expire in 2021, it is reasonable to use the 20-year T-bond rate, 5.74% as the risk free rate. * Risk premium: Arithmetic mean is often used for one-year period valuation, while geometric mean is better for long-term period estimated expected returns.
In practice, the risk-free rate is often a short-term Treasury rate. We found that a 90-Day Treasury bill is most often used. By combining our analysis above, we compute the WACC calculation as following: 1. The value of debt (based on Exhibit 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,
2. If you do not agree with Cohen’s analysis, calculate your own WACC for Nike and be prepared to justify your assumptions. * * I calculated the cost of debt differently by calculating the yield to maturity then taking the tax out of that. * For cost of equity I agreed with how she calculated it with using the geometric mean instead of the arithmetic mean, the risk free rate using the 20 year treasury rate, and an average beta * The weights of equity and debt I calculated differently. For equity I took the number of shares outstanding times the stock price to get 11503.2 million.
Her assistant Cohen did her own analysis and calculated WACC to be 8.4%. What Joanna Cohen did wrong? While calculating WACC, Cohen used book value of both debt and equity. While book value of debt is an acceptable measure, market value should be used to determine the cost of equity. Her calculations gave a WACC of 8.4%.
I did not have information as to whether or not they could get more Japanese debt so cheaply, and the fact that their cost of debt under Joanna is less than the risk free rate does not make any sense. I took Nike’s current bond information on the market (N=50, PV=-956, PMT=67.5/2, FV=1000) you get an I/Y of 3.56*2=7.13%. That is the cost to issue new debt for Nike based on current market conditions. Should be 40 periods; -2 For the cost of equity Joanna did a better job. A mutual fund trying to get returns off of value based, large cap stocks will probably hold the stock for quite some time.
CCI would be taking a somewhat high risk by issuing additional stock due to the uncertainty about the offering price. Having a low P/E ratio with respect to the rest of the market, and the replacement cost of the firm being greater than its book value (argument 3), there is a good chance that the current stock price and the proposed offering Although long-term debt is a better financing choice a few of the drawbacks are pointed out. Debt holders claim profit before equity holders, so the chance that profits may be lower than expected, increases risk to equity may reduce or impede stock value. However, in extreme financial situations such as a recession period, CCI would still be able to increase its cash during a recession period with all debt capital structure. Also, there is a remaining 12.5 million that would have to be paid at the expiration of the bonds, but that could be paid off by issuing new bonds or additional equity at that time.
* Risk premium: using the geometric mean from 1926 to 1999 might be problematic, since the risk premium of recent decades is obviously lower than earlier (stated in the lecture). So we think a range of 3% to 5% is more reasonable. * Cost of Debt: Joanna’s calculation is based on the items on the income statement. However, when calculating cost of debt, we should consider the opportunity cost rather than the accounting cost. We should perceive the opportunity cost as the return investors will expect to earn somewhere else when accepting similar risk.
1. Cost of Capital Pratt and Grabowski (2010) defined cost of capital is the expected rate of return required by the managers in order to seeking additional funds for a particular investment. It measures the total costs to finance an investment through a combination of debt and equity taking into account different financial risks. There are several reasons why estimating the cost of capital is vital for the management of the company. First of all, cost of capital forces managers to reconsider the capital structure in order to discover the better approach to raise finances.
Everything being equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC means a decrease in valuation and a higher risk. A firms WACC 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 create positive NPV for stockholders. Since the WACC is the minimum rate of return required, the managers in the company should invest in the projects that generate returns in excess of the WACC. WACC is set by the investors (or markets), not by managers.
This would also help improve the company’s inventory turnover ratio from 4.7 to the industry average of 6.1. The firm’s debt ratio anticipation of 44.17% is better than the market average and will allow the company to pay down its debt quicker than competitors and have more cash on hand. The extra cash on hand provides more liquidity and is attractive to potential investors. However, these numbers are based on high projections. If such numbers are not reached the company is considered underperforming and makes an unattractive appeal to investors.