Assessment of current Weighted

Average Cost of Capital

(WACC)

calculation.

The following is an assessment of the assumptions and basis used by

Joanna Cohen in the computation of the Weighted Average Cost of Capital (WACC)

of Nike.

4.1

single OR MULTIPLE

cost of capital

Based on the characteristics of Nike it seems reasonable to adopt a

single cost of capital approach despite the apparently many business segments.

The reasons are summarized in the following.

Nike’s main business segment is footwear that contributes to the

revenue with about 62%, with the second largest segment being apparel

contributing with 30%. Products like sport balls, timepieces, eyewear, skates,

bats, and other equipment designed for sport activities contributes with only

about 3.5%, whereas non-Nike branded products contribute by merely 4.5%. Nike

apparel and products together with non-Nike branded products do contribute

significantly to the revenue. However, this is due to the following

deficiencies not sufficient to consider them as cost of capital distinct from

footwear:

Except for the non-Nike branded products, which only contribute

little to the revenue, there are no significant differences in the risk rates

for the different business segments.

Business activities such as marketing, distribution, customer

service, quality and guarantee are common for the Nike branded products that

are further displayed in stores having similar designs.

4.2

COST OF debt

The WACC is used for discounting cash flow in the future. Hence, in

such an assessment all components must be current and forward looking to

describe a company’s future ability to raise capital. In her assessment Joanna

Cohen used historical data in estimating the cost of debt. In doing so she made

the mistake of not considering the future interest that Nike is obligated to

pay on its new borrowings. Instead the cost of debt or borrowing should be

estimated by maturity of bonds and also the credit rating of Nike.

4.3

COST OF equity

To estimate the cost of equity Joanna Cohen chose the CAPM (Capital

Asset Pricing Model) to estimate the cost of equity, with:

·

Risk free rate as 20 year T-bond

·

An average of Nike’s historical Beta

·

A market risk premium (based on the geometric mean)EJ1

The arithmetic mean for the market risk premium is actually higher

than the geometric mean, but the latter is commonly used for valuation of

investment options as it is an independent measure of the risk.

There are alternatives to the CAPM but they tend to be more

subjective, are not necessarily valid for the present case. The chosen model is,

despite its limitations, a

useful device for understanding the risk return relationship as

it provides a logical

and quantitative approach for estimating risk.

4.4 Debt

Equity Ratio

Since the objective is to assess a company’s ability to raise

capital in the future it is important that the market value and not a

historical book value is used as the basis for as the basis for debt and equity

weights, i.e. consider current share price, average shares outstanding and

debt.

EJ1She used geometric mean, but the arithmetic mean is higher (ie

indicates a higher risk). Could this suggest a higher cost of equity?