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 stands for Weighted Average Cost of Capital. It is the rate that a company is expected to pay to debt holders (cost of debt) and shareholders (cost of equity) to finance its assets. It is the minimum return that a company must earn on existing asset base to satisfy its owners, creditors and other providers of capital. WACC is calculated taking into account the relative weights of each component of the capital structure – debt and equity, and is used to see if the investment is worth taking. Following are the reasons to why it is important to estimate a firm’s cost of capital:
Capital Budgeting Decision
It is crucial to estimate a firm’s cost of capital to decide capital budgeting decision. Cost of capital is used to decide whether an investment proposal should be undertaken or not. A wrong estimation of WACC would lead to selection of a wrong investment or rejecting a good investment proposal.
Method of financing decision
The WACC can be observed constantly to see the market changes in interest rate on load and dividend rates on stocks to make a better choice of the source of financing when the firm needs financing. The idea here is to minimize the cost of capital based on market changes.
This can also be used as a measure to evaluate the performance of the firm based on comparing the returns that it is getting from a selected project and the cost it is incurring in raising the finance for this project.
After reviewing all the information and calculations presented by Ms. Cohen, we come to a conclusion that we couldn’t agree with her WACC calculation. The reasons are stated as below:
Single or Multiple Costs of Capital
– However, in this perspective, we agree with Ms. Cohen consideration, which is she decided to compute only single cost of capital for the whole company. This is because most of the Nike businesses are sports-related. Hence, there is not significant differences between every Nike’s segments stand in term of risk rate. In addition, all Nike businesses activities are set at the same state. For instance, their distribution channel and marketing. Thus, it is proper for Ms. Cohen to compute all the segments as single cost of capital for the whole company.
– The market value of debt should be used in the calculation of the cost of debt instead of the book value used by Ms. Cohen. We found that the debt of the firm was calculated improperly when Ms. Cohen added short-term debt and notes payable to the long-term debt. When calculating the WACC in the case of Nike, Inc., Ms. Cohen should take only long-term debt into account.
Incorrect Risk Free Rate
– We found that Ms. Cohen’s decision to use the 20-year bond rate of 5.74% as the Risk free rate was inappropriate. In contrast, she should use the short-term rate (12 months or less) instead, which is 3.59%.
– Since Beta is the index of responsiveness of changes in a security’s returns relative to changes in returns on the market, we found that the beta used by Ms. Cohen is also incorrect. Ms. Cohen should use the latest Beta (06 June 2001) of 0.69 that was just calculated recently instead of using the average of Nike’s historical betas which comes to 0.8.
Incorrect Tax Rate
– In this case, Ms. Cohen used a tax rate of 38% which is incorrect since we believe that she should have used a tax rate of 36% which is the most recent tax rate paid by Nike in 2001 and is therefore more likely to be the most accurate rate.
– The problem with Ms. Cohen’s calculations is that she used the book value for both debt and equity. While the book value of debt is accepted as an estimate of market value, book value of equity should not be used when calculating cost of capital. The market value of equity could be found by multiplying the stock price of Nike Inc. by the number of shares outstanding.