Assessment of current Weighted
Average Cost of Capital
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)
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
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.
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.
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.
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
EJ1She used geometric mean, but the arithmetic mean is higher (ie
indicates a higher risk). Could this suggest a higher cost of equity?