The folllowing sample essay on Nike Wacc discusses it in detail, offering basic facts and pros and cons associated with it. To read the essay’s introduction, body and conclusion, scroll down.
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? WACC is the weighted average cost of capital. It can be calculated as: WACC = (Weight of funding source 1) x (Cost of funding source 1) + … + (Weight of funding source n) x (Cost of funding source n) Usually this will be simply: WACC = (Percentage of debt) x (Cost of debt) + (Percentage of equity) x (Cost of equity)
It is important to estimate a firm’s cost of capital for the appraisal of new projects; a project should only be undertaken if the return from it is greater than that of the capital required to fund it unless there are other compelling (strategic) reasons.
A firm should also be aware of it’s own cost of capital and try to minimise this.
We do not agree with Joann’s WACC calculation: ? Her funding source weightings are wrong ? There is an argument that all debt (including accounts payable etc) or net debt and a blended return on this should be used The debt figure will only ever be an estimate as the balance sheet is one day in the year ? Her analysis assumes Nike debt is trading at par – it is not ? Equity should be based on market value, not book value ? Hence total will be based on market cap.
, not balance sheet ? Her debt cost is wrong ? She should use the current or projected cost rather than a historic one ? i. e. use a Bloomberg terminal (other terminals are available) to research yields on debt of the same credit rating as Nike ? It is unlikely Nike has a cost of debt lower than T bills Raising debt in a foreign currency (Jap Yen) either carries an associated hedging cost or exposes the borrower to FX risk, hence the coupon rate on the notes is not the actual cost of the debt ? Her assumed tax rate is probably wrong, if a firm is paying anywhere near the statutory tax rate they are not doing their job properly. We would expect their actual tax rate to be much lower, even though the case does not show this ? Her equity cost is only an estimate and she has not used all of the tools available to her ? The CAPM only provides an estimate. Her inputs are based on assumptions: We do not know whether 20 year T bills are the most appropriate measure of the risk free rate. If NorthPoint is planning a 20 year investment they might be but we need more information. Any proxy for the RFR will only ever be an estimate ? The market risk premium is even harder to estimate. Although the geometric mean is the better measure she has used numbers based very old data. Markets may well have changed since 1926 and hence a more recent or even anticipated premium should be used ? Nike’s Beta appears to be on a downward trend so an average might not be the best estimate.
A forward looking Beta based on the outlook and expectations for the business would be better ? Because equity markets are forward looking (12 to 18 months) the current Beta is probably the best estimate ? Nike has been very volatile compared to the S&P 500 so the historic Betas smooth reality ? By only considering the CAPM she ignores other methods for calculating the cost of equity and potentially makes a mistake ? A better approach would be to calculate the cost of equity using all available methods then make an estimate based on a larger range of data
If you do not agree with Cohen’s analysis, calculate your own WACC for Nike and justify your assumptions [pic] Assumptions: ? Market value of debt ? Better reflection of actual value of source of funds ? We want to be forward looking, par is a historic number ? Running yield on bonds rather than YTM ? Quicker and easier to use ? Not much difference between them (7. 2 vs. 7. 0) o Capital gain on bond is small over life ? Any new debt would have an issue cost so YTM is not a true measure of funding cost ? Effective tax rate from 2001 The best proxy we have ? Still don’t like this number, feels too close to statutory rate. Interest is low so not much tax shield but what about capital allowances and general mitigation schemes? ? Most current equity market price ? Best information we have ? CAPM cost of equity ? See question 3 below for fuller description of methods ? CAPM is not perfect but: o Dividend Discount Model is too heavily dependent on a ‘black box’ number for dividend growth – we have no understanding of this number o Capitalisation Ratio is quite a crude approach
Calculate the costs of equity using CAPM, the dividend discount model, and the earnings capitalisation ratio. What are the advantages and disadvantages of each method? CAPM: [pic] Risk Free Rate is an average of 1, 5 and 10 year T bills. We assume this as a proxy for Nike’s actual debt profile. We use the current Beta because equity markets are forward looking. If we assume efficiency then all known information is in the current Beta. Betas will change over time so historic data is less relevant; we need to predict the future. Using regression our forecast Beta is 0. 0 so the results are very close. We use 9. 2% as a risk premium. It comes from Brealey & Myers (2000) and is for the S&P 500. It is the number that would have been available and appropriate for Kimi at the time. We may use a different number today based on our expectations of market returns although Brealey & Myers argue that the best approach is to use as much data as possible to remove the effects of market fluctuations. We have to ask ourselves whether market behaviour from 2008 onwards is the new paradigm. Advantages: ? Recognises return for risk Only considers risks that cannot be eliminated by diversification ? Is the most simple way of doing both of these ? Widely used so widely understood ? Does not rely on company financial projections Disadvantages: ? More of an art than a science. Includes estimates and assumptions for ? Risk free rate. Govt. bonds are not always the best proxy, i. e. some European debt. Also, RFR is probably not a real return due to inflation ? Expected market return. If we knew this number we would not be working for a living ? Beta. Decisions a company makes will change Beta.
Depending on what the company is doing historic data may be worthless and hence we need to make our own estimate ? Assumes that Beta is the only reason equity prices move ? Assumes equity indices as proxies for movements in all asset values. This is a simplification of reality as many companies are privately owned ? The perceived required risk premium will change over time ? Investors will have different required rates of return for Nike depending on whether or not they hold it in a portfolio Dividend Discount Model: Problem:Dividends have been constant for the last 3 years.
We are being asked to believe a growth story and perhaps an increase in dividend from that. We have no guidance on future dividend levels so the best we can do is use the Value Line Forecast of 5. 50%. Assuming constant growth and using the Gordon Model: Expected Return = Expected Dividend Yield + Expected Growth = 6. 6% Advantages: ? Very simple (in the constant growth form) ? Based on actual cashflows to shareholders Disadvantages: ? The simplified version of the equation we have used assumes the stock is in equilibrium ? Assumes a constant dividend growth rate, this is highly unlikely We do not have sufficient information to predict non-constant growth dividends to put into the full DDM ? Highly dependent on the expected growth rate which we actually have very little idea about ? Assumes we hold the stock in perpetuity. This is not likely for NorthPoint; as a value based fund they will sell at some point to realise a gain (hopefully! ) and re-invest in something they perceive to be undervalued ? Assumes dividends grow with earnings. We could negate this by assuming dividend irrelevance and basing the analysis on earnings per share Earnings Capitalisation Ratio:
Capitalisation Rate = Projected Earnings / Price Method used:Divide forecast free cashflows by current EV Take average Capitalisation Rate = 8. 6% Advantages: ? Quick and simple ? Can be used when no dividends are paid, hence payout ratio is irrelevant Disadvantages ? Relies on projections which are subjective and uncertain ? Compares future earnings to current EV ? Ignores the time value of money ? Solving the Corporation Valuation Model for WACC would be a better approach What should Kimi Ford recommend regarding an investment in Nike? Based on our WACC of 10. % Nike appears to be undervalued (using Joanna’s model, which we have not checked) so Kimi should recommend a buy. However, Kimi should consider the following: ? Do you really want to buy into a promised growth story? Earnings have been flat for a while; do you believe the growth projections? ? How does market price compare to intrinsic value? ? Is the market efficient? Have we really picked up something that no other analyst has or is everything in the price? ? Does the market even recognise fundamental value or is it driven by other things (fear and greed)? Competitors – we have only analysed one company. It is not possible to invest on this basis alone. The price of Nike must be compared to a suitable peer group ? Other investment appraisal methods should be used for comparison – P/E ratios etc ? Charting (investing technique) could also be considered ? Use her experience (of competitors etc) to estimate a Beta Final recommendation: Growth is uncertain and hence the value of the equity may fall further. This business has low levels of debt (low risk) paying 7% while the required equity return is 11%.
Do not buy the equity. Set up an SPV, leverage this as highly as you can and buy the debt. Even if you can only achieve 50% leverage and 5% cost of borrowing (which should not be too ambitious) then you will achieve an 18% return on your equity in the SPV, all whilst invested in a far safer part of the Nike capital structure. Bibliography BREALEY, R. A. and MYERS, S. C. (2000) Principles of Corporate Finance. Sixth Edition. London: McGraw Hill BRIGHAM, E. F. and HOUSTON, J. F. (2009) Fundamentals of Financial Management. Twelfth Edition. Mason: Cengage