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Kimi Ford from NorthPointGroup is weighing whether to add shares of Nike, Inc., as a new addition in her fund. In our analysis, we examine why it is important to estimate a firm’s Weighted Average Cost of Capital (WACC) and how to estimate Nike’s cost of capital correctly. We also calculate Nike’s cost of Equity using two methods: the Capital Asset Pricing Model (CAPM) and the Discount Dividend Model. After analysing their advantages and disadvantages, we finally conclude whether an investment into Nike is recommended. We will also look at Ford’s projection of the cash flow.
Why estimate a cost of capital and what does it represent.
In order to cover the cost of generating funds in the marketplace, a mandatory positive rate of return must be generated by the company in order to satisfy the investors. Known also as an opportunity cost, investors will only endeavour to invest in the firms bonds and stocks depending upon the risk factor of the firm and how positive their reward would be. If the firm does not achieve the return result shareholders anticipated, investors will not invest in the firm’s debt and equity. As a result, the firm’s value will decline.
The cost of capital exercised in capital budgeting decisions is the weighted average of various types of capital a firm uses, generally debt, stock and equity. It can be used as a hurdle rates for investment decisions and can act as a measure to find the best possible capital structure for the company. Variables which needs to be consider whilst calculating the cost of capital are:
• Value of business
• Risk to business
• Rate of return for business
• Return on investors venture.
Joanna Cohen used Capital Asset Pricing Model (CAPM) and computed a Weighted Average of Cost of Capital (WACC) of 8.3%. This calculation has few errors and we shall recalculate the WACC whilst explaining Cohen’s mistakes.
Value of Equity
The problem is that Joanna...
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