Nike : Cost Of Capital Essay

2297 words - 9 pages

Nike, Inc.: Cost of CapitalThe cost of capital can be thought of as the minimum return required by providers of finance for investing in an asset, whether that is a project, a business unit or an entire company. It needs to reflect the capital structure used to finance the investment (Cornelius, 2002). For companies which raise funds from multiply sources such as bank loans, share issues, venture capitals and so on, an appropriately estimate cost of capital is extremely important.On the one hand, the cost of capital is used as a discount rate to appraise new investments for a company, whether net present value (NPV) approach or internal rate of return (IRR) approach is applied. On the other hand, in an investment appraisal, for instance, a higher/lower cost of capital may cause an underestimate/overestimate of the present value (PV) of the future cash flow, thereby lead to a negative/positive NPV, which may cause a wrong investment decision in rejecting a project that should be accepted or accepting a project that should be rejected. Similarly in IRR approach, a rate of return larger than the cost of capital is usually required. Moreover, as cost of capital includes the cost of equity and debt, Cornelius (2002) suggested that, "the cost of capital formed a link between the investment decision and the finance decision". Finally, the cost of capital not only reflects the capital structure of a certain investment, but also represents the opportunity cost of an investment.To calculate the cost of capital for a company, the weighted average cost of capital (WACC) is widely used and accepted generally. Basically, several figures are needed in calculating WACC. Firstly, the weight of debt (KD) and the weight of equity (WE) are required. Secondly, the cost of debt (KD) and the cost of equity (KE) are required. Therefore, WACC = WD * KD +WE * KE. Detailed figures and methods used to calculate KD and KE will explain later.In Nike's case, when Joanna Cohen calculated the WACC of Nike, she made several mistakes and led to a wrong estimate of the cost of capital. The first mistake comes to the book value of equity used in calculating WD. Nike became a publicly traded company since December 2, 1980, the share price has changed significantly during 20-year's time. So, the market value of equity should be used instead of book value. Then, Cohen calculates the cost of debt by taking total interest expense for the year 2001 and dividing it by the company's average debt balance. This is an approximation for the true cost of the debt, but is too inaccurate and may not reflect Nike's current or future cost of debt. Thirdly, Cohen obtained the corporate tax rate 38% which is used to calculate the adjusted cost of debt by adding state taxes of 3% to the U.S. statutory tax rate 35%. In WACC calculation, marginal tax rate should be used as a corporate tax rate for the future estimate. Practically, if a company has a lower average effective tax rate which are generated...

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