The Weighted Average Cost of Capital (WACC) is the overall required rate of return on a firm as a whole. It is important to calculate a firm’s cost of capital in order to determine the feasibility of a particular investment for a firm.
I do not agree with Joanna Cohen’s WACC calculation. She calculated value of equity, value of debt, cost of equity, and cost of debt all incorrectly. For value of equity, Joanna simply used the number stated on the balance sheet instead of multiplying the current stock price by the number of outstanding shares.
The correct calculation is $42.09 x 271.5M = $11,427.435M. The correct method of calculating the value of debt is to multiply the price of publicly traded bonds by the amount of debt outstanding. This calculation results in 95.60% x $1296.6M = $1,239.550M. The sum of debt and equity is equal to $12,666.985M.
Therefore, the weight of equity is 0.902 and the weight of debt is 0.098. In order to determine the cost of debt, the yield to maturity of the debt must be calculated.
Using a financial calculator (N=30, PV=-$95.60, PMT=$3.375, FV=$100), the YTM is equal to 7.24%. This is the cost of debt. The cost of equity can be determined using the Capital Asset Pricing Model (CAPM). Joanna was correct in using the 20-year yield on U.S. treasuries as her risk-free rate and was also correct in using 5.90% as her risk premium. However, she should have only used the most recent year’s beta instead of using an average of multiple years. The correct calculation is 5.74% + 0.83(5.90%) = 10.64%. This is cost of equity. Using a 38% tax rate, we can now calculate the WACC. WACC = 90.2%(10.64%) + 9.80%(7.24%)(1-38%) = 10.03%
Using the Dividend Discount Model, the cost of equity can be calculated as the sum of the dividend yield and the dividend growth rate. In this case, it is ($0.48/$42.09) + 5.50% = 6.64%. Using the earnings capitalization ratio, the cost of equity can be arrived at by dividing the projected earnings per share by the current market price of the stock. Therefore, $2.32/$42.09 = 5.51% is the cost of equity using this model.
The advantage of using CAPM is that it is relatively easy to calculate, but a disadvantage is that it assumes perfect asset valuation, which does not always happen in reality. An advantage of the dividend discount model is that it allows investors to value stocks based on the dividends they pay and it is also easy to calculate. However, not all companies pay dividends so another method would have to be used for those firms.
Kimi Ford concluded that at discount rates below 11.17%, Nike’s stock would be undervalued. At Nike’s cost of capital rate of 10.03%, Kimi Ford should invest in the company.