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Nike Inc. Case Essay

1702 words - 7 pages

Lombard, Team 3Amandeep Singh SodhiAmrita JaffarManuel SevillaMartina FilippiPouya FarajpourThanun NirundornIntroductionWeighted Average Cost of Capital (WACC) is a method to calculate a company's cost of capital when each category of capital is proportionately weighted. It is one of the most important estimation of Cost of Capital because practically it represents the minimum return that a firm should earn to satisfy the shareholders and everyone providing the capital (creditors, owners, etc.). WACC in fact includes all capital sources, such as bonds, preferred stock, common stock, any long-term debt. To calculate it sometimes could be laborious, especially if the firm has a complex capital structure.If the beta and the rate of return on equity of the company increase also WACC increases. This cause an increase in the risk and a decrease in valuation. Businesses -included Nike- often use WACC to discount cash flow and determine the Net Present Value. The equation of WACC is:Where:Kd : Cost of debtKe : Cost of equityE : Market value of the firm's equityD : Market value of the firm's debtt : Corporate tax rateThe Weighted Average Cost of Capital (WACC)The WACC changes over time. And this change is caused by external and internal factors. Internal factors that can affect the Weighted Average Cost of Capital are: investor risk aversion, the firm stops risk adjusting the WACC on different projects, the company increases its debt ratio, the firm pays out more of its earnings as dividends. The former two internal factors decrease WACC, the last two increase it.Some of the external factors instead are: an increase in the corporate tax rate (WACC increase), FED lowers the interest rate (WACC decreases).If the company wants to have a valid tool of analysis, it is really important to rebalance the capital structure to maintain the right market-value debt ratio (at least for the near future). In the reality to rebalance the capital structure is not an easy operation, therefore the firms can assume a steady and gradual adjustment in the long-term. This method doesn't work if the company is facing important changes in the capital structure.Managers usually use WACC to make investment decisions. They examine it to check if the company has the right inputs and if there are any changes. This tool is useful to show what is the current market risk premium, to control the firm's risk-free rate, to update and utilize in the best way the historical data. Once the managers have calculate the number, they use it to reflect their ability to time their investments and choose projects that maximize firm's expected return. Thanks of WACC they also assess the opportunity cost to make the best investment decision.When an investment project is being considered, the WACC of that project could depend of multiple things. First, the riskiness of the project is being considered. However, it is not possible to calculate the beta of a project. Therefore, the WACC is estimated mostly...

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