Kimi Ford, a portfolio manager of a large mutual fund management firm, is looking into the viability of investing in the stocks of Nike for the fund that she manages. Ford should base her decision on data onthe company which were disclosed in the 2001 fiscal reports. While Nike management addressed severalissues that are causing the decrease in market sales and prices of stocks, management presented its plansto improve and perform better. Third party sources also gave their opinions on whether the stock was asound investment.The
weighted average cost of capital (WACC)
is the rate (expressed as a percentage, like interest) that acompany is expected to pay to debt holders (cost of debt) and shareholders (cost of equity) to finance itsassets. It is the minimum return that a company must earn on existing asset base to satisfy its creditors,owners, and other providers of capital. Companies raise money from a number of sources: commonequity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants, and options, pensionliabilities, executive stock options, governmental subsidies, and so on. Different securities are expected togenerate different returns. WACC is calculated taking into account the relative weights of eachcomponent of the capital structure- debt and equity, and is used to see if the investment is worthwhile toundertake.Management always takes notice of the cost of capital while taking a financial decision. The concept isquite relevant in the following managerial decisions and hence its importance:
(1) Capital Budgeting Decision.
Cost of capital may be used as the measuring road for adopting aninvestment proposal. The firm, naturally, will choose the project which gives a satisfactory return oninvestment which would in no case be less than the cost of capital incurred for its financing. In variousmethods of capital budgeting, cost of capital is the key factor in deciding the project out of various proposals pending before the management. It measures the financial performance and determines theacceptability of all investment opportunities.
(2) Designing the Corporate Financial Structure.
The cost of capital is significant in designing thefirm's capital structure. The cost of capital is influenced by the chances in capital structure. A capablefinancial executive always keeps an eye on capital market fluctuations and tries to achieve the sound andeconomical capital structure for the firm. He may try to substitute the various methods of finance in anattempt to minimize the cost of capital so as to increase the market price and the earning per share.
(3) Deciding about the Method of Financing.
A capable financial executive must have knowledge of the fluctuations in the capital market and should analyze the rate of interest on loans and normal dividendrates in the market from time to time. Whenever company requires additional finance, he may aver a better choice of the source of finance which bears the minimum cost of capital. Although cost of capital isan important factor in such decisions, but equally important are the considerations of relating control andof avoiding risk.
(4) Performance of Top Management.
The cost of capital can be used to evaluate the financial performance of the top executives. Evaluation of the financial performance will involve a comparison of actual profitability’s of the projects and taken with the projected overall cost of capital and an appraisal of the actual cost incurred in raising the required funds.
2 |Case analysis: Nike Inc, Cost of Capital
structure. It also helps predict risk would be happen with a company (risk management).
Moreover, estimate a firm’s or projects’ cost of capital help investors
can diversification their investment, reduce risk in invest, maximization profits: -Cost of capital using to Capital Budgeting Decision as the measuring for decision an investment proposal. Normally, the investors will choose the project (compare with many other projects), which give a higher return and lower risk on investment. If company must decide the individual project, company will choose the project which give satisfactory return on investment. Of course, all of the projects which are chosen must be get higher return than the costs of capital invest in that projects. It also helps determine the acceptability of investment opportunities. -Cost of capital also helps for Designing the Corporate Finance Structure. In one side, they always follow the changing of capital market for getting information and choosing the best way for capital structure of company. In the other side, managers can use various methods to minimize
company’s cost of capital, changing the market price, the earning per share, bring out
the benefit to company. -In addition, Cost of capital helps managers Decide the Method of Financing. Understanding about financial situations and the rate of interest on loan, normal dividend rate in the market is need conditions of financial managers. It helps managers give out better react and balancing sources of finance when faced with requires additonal finance, which helps mimimize the cost of capital.
Cost of capital represent by WACC
(Weighted Average Cost of Capital). The required return will reflect the risk of the investment and the return of alternatives. WACC is sum of cost of debt (R
) and cost of equity (R
is calculated by using DDM (Dividend Discount Model), Earning Capitalization Model or CAPM (Capital Asset Pricing Model). In many case, many companies does not pay dividend at the end of the period, it might lead to inaccurate calculating R
, that is the reason why CAPM using more popular than DDM. Beside that, CAPM also have advantages and disadvantages. To find the average cost of capital, we weight individual cost of capital by their proportions in
the firm’s capital structure:
WACC = R
x E / (D + E) + R
x (1-T) x D / (D + E)
The WACC is set by investors and not the managers.
WACC set by investors when they calculate and find out the decisions about invest or reject invest into a company/project. Managers just listen the market reply and react by estimate their options in invest in a project or restructure their company, give it all for board of management (investors) who have the final decisions. Besides, it also help managers can adjusted share prices, market value of the firm for fi
III/ Case analysis