The cost of capital is a term in finance used in reference to the total of a firms fund. The funds include both equity and debt capital. In a nutshell, the cost of capital is as an evaluation yardstick for new projects by investors. The cost of capital of a form or investment should be lower than the anticipated returns that an investor earn’s from a venture. This is when the project is feasible and worth investing capital. To arrive at the cost of capital, it is crucial to add up both cost of equity and debt financing must be added up. It can also be termed as the cost of foregone alternative. This means that it is the equivalent of returns that a business would have otherwise accrued had it ventured into a different project of similar risk.
Cost of debt as a component of cost of capital is a term primarily used to refer to the interest accrued to investors as a return for the capital invested. It is, therefore, the compensation that the investors get as an amount in remuneration for lending financial capital to the business. Cost of equity, on the other hand, is rewarded to holders of a firm’s stock for taking up the risks of the business. In contrast to the cost of debt, cost of equity is not as easy to determine since it varies in direct proportion to the type and level of risks perceived to be associated with the business. Once the two costs have been determined independently, then a mix of the two will result in the Weighted average cost of capital (WACC).
Nike Inc. Cost of capital
Nike Inc was facing substantial financial slumps in the US market during the Yester years. There were matters of significant concern on the stagnating revenues of the company that for a long time since 1997 had remained at nine billion US dollars. The income of the sports gear corporation had also declined notably by over two hundred million US dollars. The troubles of Nike Inc also doubled beyond financial instability as research showed that it was losing out fast on the market share it controlled in the US. The significant market share loss was estimated to be at 6% between the periods of 1997 and the year 2000. The firm’s management embarked on a series of strategies to resuscitate the financial position of the company while maintaining its long term growth plans.
Kimi Ford was in the process of evaluating the financial position of Nike Inc in anticipation of acquisition of some of its stock by her North Point group firm. The research carried out by this portfolio manager, produced different opinions on the value of Nike’s shares at different discounting rates. To shed light on a well advised situation, a financial analyst Joanna Cohen was enlisted to determine by estimate the Weighted Average Cost of Capital of the firm.
The results of this study produced a Weighted Average Cost of Capital about 8.3%. Cohen used the Capital Asset Pricing Model (CAPM) method in her calculation. Of note is the fact that the book values of equity and debt are essential when valuing an organization’s net worth. Ordinarily, it is advisable to use the market values rather than the book values when calculating WACC. An oversight by Cohen was made in calculating the cost of debt by division of the annual cumulative interest by the balance of the corporation’s balance of average debt. This resulted in an estimate of Nike’s cost of debt that may not be reflective of the true position of the firm’s finances. This is because; the figure derived might depict wrong figures in terms of current cost of debt and future projections. The tax rate used in estimating the changed cost of debt was calculated as 38% instead of the 35% corporate tax by the United States government. This is primarily because Cohen included a 3% adjustment for state tax, which should not have been added. Having used yields on treasury bills of the past 20 years, Cohen’s estimates of the cost of equity would then seem irrelevant since the case of North Point was only focused on short-term investments. It would be more relevant to use one year yields in this case.
The shares of Nike being at a figure of 271.5 million and given the share value of 42.09 US dollars, than a calculation of the equity would be 11427.435 million US dollars. This figure represents the amount of the market value of the company’s equity. The debt market value will remain the same as the book value stated at 1296.6 million US dollars. The cost of equity will, therefore, be about 90% of the cost of capital while the rest 10% is the weight of the cost of debt. Cohen opined that one cost of capital should be used to the company has different products. The rationale behind using a single homogenous cost of capital is that the marketing channels are the same. A correct calculation of Weighted Cost of Capital is arrived at by using appropriate figures of the cost of equity and cost of debt. The fact that Nike INC had been valued for over 25 years shows that Cohens use of the 20 year treasury yield was appropriate. The risk free rate is, therefore, 5.74%.
The capital asset pricing model CAPM approach for calculating the cost of equity in the case of Nike Inc uses a beta of 0.08. This is arrived at as the most relevant to be used since it accounts for the variations seen in the past in the corporation’s betas. This is the average better, and it mirrors the preceding practices of Nike businesses. The other approach would be the Divided growth model which puts into consideration the growth rate and is given as KE =D1/P0+g. Using the two models to find the cost of equity resulted in differing results. This is because each of the models operating under different conditions and uses separate assumptions. CAPM may be exposed for lack of accuracy due to the frequently evolving stocks which present unstable returns making it hard to determine the risk premium. The beta is not constant at all times, therefore, these fluctuations contribute to inaccuracy. Dividend growth model on the other angle would present irrelevance in the case of Nike Inc given the fact that the firm had been facing financial stagnation
Conclusion
The discounting rate used by Kimi Ford of 10% lead to the realization of the significant overvaluation of the Nike Inc share. This does not present a true reflection of the share market value of the company and ultimately projects falsely the financial position of the company. Cohen arrived at a more accurate discounting rate of 8.3 that reflects the true market value of Nike corporation. By calculating the Weighted average cost of capital using the Capital asset price model approach, the discounting rate is 9.8765%. This in turn, will culminate in deducing a share price of 36.49 US dollars which depicts that indeed the shares of Nike are overvalued.
With guidance from the data arrived at, it is not advisable to buy into the Nike corporation in the present state. Buying into an overvalued stock means implies that a portfolio or a single stock is worth less than the value that was given up to acquire it. NorthPoint group should hold the prospect of buying into Nike Inc until there is a significant change in dividend growth and also in the market price of its share. The management of Nike INC should put in place more short-term strategies that will improve the performance of its stock and the value of the company. This, however, does not imply that the Nike shares are unattractive stocks because the company can easily bounce back in a short time by changing marketing strategies to regain its market share. The management may also consider cashing in on the most popular products at the expense of the slower selling ones.