Nike Inc. - Cost of Capital

1368 Words May 2nd, 2011 6 Pages
What is he WACC and why is it so important to estimate a firms cost of capital?
The WACC (weighted average cost of capital) is a percentage figure resulting from a calculation method by which the adequate cost of capital of a firm is expressed. It considers the composition of a company’s funding, be it debt or equity. A corporation whose source of funding is equity by 100 percent will have a WACC equal to the cost of equity. By contrast, a levered company will have to reflect the cost of debt as well. The WACC takes their respective quantitative contributions to the entire amount of funding, serving hence as an allocation base, into account. As there is a direct relationship between the two portions, debt and equity, in order to calculate
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The cost of debt (cd) as used by the WACC refers to the costs a company incures by raising parts of its funds through debt. As debt has a prior position to equity in terms of claiming it is in most cases supposed to be “cheaper” than equity (moreover the debt costs depend on the leverage). The overall market value of debt of a company can be retrieved by adding all debt positions less excess cash and short-term investments (net debt). Expressed as a relative portion of entire assets and multiplied by the cost of debt it yields the contribution to the WACC figure.
By contrast, the cost of equity (ce) is a quantitative result which can be derived from the CAPM e.g. (capital asset pricing model). It suggests that the cost of equity is equal to the sum of the risk-free rate and a risk premium of an average market portfolio adjusted for a company-specific factor beta. This beta reflects the risk associated with the company whereas a beta of 1,0 is equal to the market risk.
The importance of estimating the WACC properly becomes evident when using it for the valuation of a company. There is a direct and strong correlation between the exact cost of capital and the preciseness of resulting figures. Future free cash flows of orders of magnitudes are discounted sometimes. Hence, the resulting present value is subject to enormous sensitivity and an arbitrary rounding off of the second decimal as in the NIKE case is