QUESTION
Assignment Details:
1. Reviewing a company’s current cost of capital.
2. Critiquing the review and recommending changes to calculate the company’s cost of capital.
3. Defending assumptions based on WACC concepts.
4. Reference data found in the case to support your values.
5. State a revised cost of capital and discuss how it would affect the company
Company: Nike
Words: 800
ANSWER
Cost of Capital
Cost of Capital in simple words can be defined as the return required by an investor to forego a similar project which had the similar risk characteristics. Whenever we take talk about cost of capital we are in general talking about the weighted average cost of capital.
Cost of capital is internally used by the company to judge whether a capital project is worth the expenditure of resources or not. It is also used by an investor to determine whether an investment that he is making is worth the risk he is taking by making that particular investment.
The cost of capital depends on the mode of financing, if the project is fully financed from equity than cost of capital is equal to cost of equity. If the project fully financed from debt than cost of capital is equal to cost of debt. Most of the companies used a combination of funds such as, equity, debt, retained earnings and preference shares. And when multiple sources of financing are used we calculated weighted average cost of capital. In weighted average cost of capital, each category of capital is assigned weights according to the amount they are being used. Then these weights are multiplied by respective cost of each financing to arrive at the weighted average cost of capital.
A company can have multiple cost of capital or a single cost of capital. Multiple cost of capital is when a company has multiple business segments, and each of them faces different kind of risk. If a company operates in a single segment than company can have a single cost of capital. But most of the times, company uses one common cost of capital for different projects which should not be done as every project is different and such projects have different risk and different source of financing, therefore they should be evaluated on the basis of different cost of capital.
Critique of her Technique
When it comes to choosing Single vs Multiple Cost of Capital, I think that Joanna went the right way by choosing Single cost of capital. This is because majority of the revenues were coming from a single source and even the source of the revenue was complimentary to the primary source of revenue and shared the same risk, therefore, instead of going for the multiple cost of capital, she rightly chooses single cost of capital.
Coming to the weights of each source of financing, here also I think the weights were taken as per the method and I don’t think there could have been any better way of choosing the weights.
Coming to the cost of debt I think that the method chosen of calculating interest rate is wrong, because we don’t know what is the structure of debt repayment and how is the interest being charged. Also, interest expenses include interest for various other things such as accounts payable, income tax and other short-term liabilities. Noticeably, the cost of debt comes below the risk-free rate which in itself raises some serious question that how come a company is able to raise debt at a rate lower than the treasury yield. Even if the loan is taken from japan there is foreign exchange risk. Therefore, the method chosen for the calculation of cost of debt is wrong. I would have taken the cost of debt as 7.06%. This is being calculated by the help of the current yield on the publicly traded debt of the Nike. The company makes two coupon payment of 3.375 in a year. Which totally amounts to $ 6.75 in a year. The current market price of the debt is $95.60. Dividing these will give us the rate of 7.06%. The tax rate of 38% has been correctly taken by Joanna. Subtracting this from pre tax cost of debt will give us after tax cost of debt at 4.59%.
Coming to the Cost of Equity, the risk-free rate taken by Joanna, of 20 years treasury yield, is kind of true but usually the risk-free rate is taken more short term. Therefore, for the purpose of this I would be taking 3 months treasury yield rate, which is considered as the most closet proxy of risk-free rate. Also, while calculating the beta of the share Joanna has taken average beta of last five years but I personally feel that the beta should be taken of the most recent year as it more representative to the future volatility in the market. Rest the geometric mean of market risk premium at the rate 5.9% has been taken correctly.
Comparison
|
|
Joanna |
Mine |
|
Cost of Debt |
||
|
Pre-Tax Cost of Debt |
4.30% |
7.06% |
|
Tax Rate |
35% |
35% |
|
Post Tax Cost of Debt |
2.80% |
4.59% |
|
|
|
|
|
Cost of Equity |
|
|
|
Risk Free Rate |
5.74% |
3.59% |
|
Market Risk Premium |
5.90% |
5.90% |
|
Beta |
0.8 |
0.69 |
|
Cost of Equity |
10.46% |
7.66% |
|
|
|
|
|
Weights |
|
|
|
Equity |
73% |
73% |
|
Debt |
27% |
27% |
|
|
|
|
|
WACC |
8.39% |
6.83% |
As per mine calculation the WACC comes around 6.83% which is lower than that of Joanna.
Looking for best Finance Assignment Help. Whatsapp us at +16469488918 or chat with our chat representative showing on lower right corner or order from here. You can also take help from our Live Assignment helper for any exam or live assignment related assistance