6.0 ratio computation should be based on current

6.0             
 USING CURRENT MARKET RISK,
BETA TO ESTIMATE COST OF
 EQUITY

The average beta from 1996 to July 2001 used by Joanna
which is 0.80 may not be representative to be the measure of the existing systematic
risk for Nike. As such, the recent beta of 0.69 will more relevant in measuring
the future beta of Nike.

Hence, the
revised cost of equity for Nike will be:

RS = Rf + ?i x (RM – RF)

RS is expected return on Nike

RF is Bond with T 20 years maturity to represent risk free rate = 5.74%

?S is systematic risk of Nike =
0.69

RM – RF is geometric mean market risk premium = 5.9%

The new cost
of equity for Nike, RS  = 5.74% + 0.69 (5.9%)

                                                                                                =
9.81%         

6.1
      DEBT EQUITY RATIO

The estimation for the debt equity ratio
computation should be based on current market value of Nike instead of net book
value. The rationale for using market value to estimate WACC is that it is how
much it will cause the firm to raise capital today.

Market value of equity            = current share price x average
outstanding shares.

               = $ 42.90 x 273.3 million

                                                            =
$ 11,503 million

Market value of debt = Book value of debt as at 31 May 2001

=
$ 1,291 million

Equity (%)                                           = $ 11,503 million /
($11,503 million + $1,291 million)

=
89.9% or 0.899

Debt (%)                                             =
100.0 % – 89.9%

=
10.1% or 0.101

6.2                   CALCULATION
OF COST OF EQUITY

6.1                   Capital
Asset Pricing Model (CAPM)

In the case, Joanna Cohen uses the
Capital Asset Pricing Model (CAPM) to calculate Nike Ink’s cost of equity.

The formula for Cost of Equity can be
expressed as such:

KE
– Rf + ? (RPm)

Whereby,

KE             = Cost of Equity

Rf              = Risk-free Rate

RPm =
Market Risk Premium

?   = Beta Value of the Stock in Question

Joanna Cohen’s calculations is reflected
as below:

10.5%
= 5.74% + 0.8(5.9%)

Whereby her risk-free rate is derived
from the current yield from the 20-year Treasury bonds, and the geometric mean
of the historical risk premiums as market risk premium. Her beta value is
derived from the average of historic betas, which is 0.80.

There is reason to believe that Joanna’s
calculations might have overestimated Nike Inc’s cost of equity. As it is, Kimi
Ford is looking into investing in Nike Inc’s shares at the current date,
therefore using the year to date Beta value of 0.69 is more informed than using
an average Beta value of historic Betas, as it is more representative of future
Beta, which is more relevant information to potential investors.

Therefore using 0.69 as Beta value using
the CAPM equation, the cost of equity of Nike Inc can be recalculated as such:

KE = 5.74% + 0.69(5.9%)

KE = 9.81%

Advantages of using CAPM to estimate
cost of equity

1.        
It considers only
systematic risk, i.e risk that cannot be diversified away. This is truer to
reality especially in firms with diversified portfolios that therein eliminates
unsystematic risks.

2.        
CAPM’s
theoretically-derived relationship between systematic risk and required return
has been frequently tested empirically, and all confirm the legitimacy of the
theory.

3.        
It takes into
consideration a company’s level of systematic risk in relation to the overall
stock market, which gives a clearer picture of a company’s cost of equity.

4.        
It is applicable to
companies that do not pay dividends, or have dividend growth rates that are
difficult to estimate.

Disadvantages

1.        
Betas are unstable
through time, and the Beta value that is used in the CAPM is derived from
historic data. This is especially disadvantageous if the model is used to
evaluate future investment decisions.

2.        
A true risk-free rate
is unattainable in reality. Therefore the model’s calculation can only be
indicative rather than conclusive when it comes to estimating cost of equity.

6.2                   Dividend
Discount Model (DDM)

The Dividend Discount Model approach
uses a formula to calculate the discount rate of a firm, which tells you the
cost of equity capital. The formula is expressed as such:

Whereby

Rs        = Discount Rate

Div =
Expected dividend to be received next year

P          = Price per share

g          = expected growth rate

 

We can therefore calculate Nike’s cost
of equity as per below:

The advantage of the DDM approach is
that it is fundamentally simple, and allows enough flexibility when estimating
future dividend streams. Although inputs can be overly simplified, the value
approximations can be fairly useful. The formula is also reversible, which
makes it easy to make market assumptions for growth and expected return.

The disadvantages that come with this
model are that it is not applicable to firms that don’t pay steady dividends,
and does not explicitly account for risks in its estimations. There are also
more measurement errors, in terms minor data entry or formula errors when
making use of spreadsheets. If the evaluator is subjective with their inputs,
it can also result in misspecified models and less than ideal results.

6.3                   Earnings Capitalization Ratio
(ECM)

Another model that can be used to
calculate the cost of equity is the Earnings Capitalization Ratio (ECM). The
formula can be defined as such:

Whereby

KE        = Cost of Equity

E1        = Expected Earnings per share

P0        = Price per share

Therefore, using this approach, the cost
of equity for Nike Inc would be

This method is simple, however it is the
poorest method among the three, as it doesn’t accurately show the cost of
equity of a company. It is only reasonably acceptable to estimate equity costs
for companies that no longer expect to grow. However, in Nike Inc’s case, they
expect to grow even further therefore it is not applicable to use this model to
estimate the cost of equity. 

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