Cost of Equity

Cost of Equity

In this report we focus on Nike's Inc. Cost of equity 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 equity is a critical element in such decisions and it is important to estimate precisely the weighted average cost of equity (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 equity and its Importance for Nike Inc.

The Weighted Average Cost of equity (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 directors to determine the economic feasibility of expansionary opportunities and mergers. Also, WACC is the appropriate discount rate to use in stock valuation.

II. Calculation of Nike's WACC

The calculating methodology for Nike's Inc. WACC seems to be inconsistent with the principles1 that should be followed when estimating this measure. These are our points of disagreement with the calculations in Exhibit 5:

Calculation of the cost of debt by taking the total interest expense for the year 2001 dividing it by the company's average debt balance, which is not appropriate for the WACC estimation

Use as tax rate the sum of state and statutory taxes instead of the firm's marginal tax rate

Use of the Book Value of equity rather than the market value which is suggested as it gives more precise results

Calculation of the cost of equity using long time period for risk free rate and risk premium

In order to make our justifications more comprehensive we need the formula for estimating WACC:

WACC= Wd*Kd(1-T) + We*Ke

First, we reexamine the cost of debt (Kd) which in this case is the yield to maturity (YTM) on the bonds. The YTM is a good estimate for the cost of debt if a company had issued debt in the past and the bonds are publicly traded just as in Nike's case. Our calculations for Nike's yield to maturity based on the given data showed that Kd= 7.16%.c1 (See Appendix for detailed calculations)

The second variable that should be noted is T or the tax rate. In her calculations, Joanna Cohen added the 3% state taxes ...