1. According to Welch I (2005), WACC or amply the weighted average cost of capital is a rate to the firm that shows the cost of capital of running that firm. It is a calculation of a firm’s cost of capital showing how each category is weighted proportionally showing the categories percentage of the total capital of running the firm. In the calculation of the WACC, all capital sources like stock (common and preferred), debentures, bonds, and other sources including short and long-term debt are incorporated in the calculation of WACC. It should also be noted that WACC is a rate which increases as the data and rate of return of firm’s equity also increases (Welch. I, 2005). We however should note that the increase in WACC shows a decrease in valuation and shows a high risk.
The WACC formular without taxes is given by. By expanding the expression, we have.. But because debt and equity literally own the firm, we have. This will now yield for us
.Where weight of debt is and weight of equity is
In this formular, WE is the weight of equity, rE is the percentage of equity of the total capital, WD is the debt weight and rD is the percentage of debt of the total capital.
Since any firm’s assets are financed by debt and or equity, the average of these costs are weighed by their respective use in a given situation. This helps to see how much interest the firm has to pay for every unit cost of financing.
The firm’s WACC overall is required and is used internally by the directors so that they can determine the economic situation and feasibility of opportunities of expansion and or mergers (Adair, T.A, 2006).
Having seen the derivation of WACC, showing that a firm’s value is the sum of expected value of debt and expected value of equity and comparing this with the Ms. Joanna Cohen, her calculation with returns the WACC as 8.4% because it incorporates all components of the WACC calculation. It however does not involve tax and preferred stocks.
2. Capital asset pricing model (CAPM), according to Corporate Finance (2008), is the expected rate of return can be calculated from. This gives us Advantages of CAPM
It considers only systematic risk which reflects reality in which most investors have diversified portfolios and from the same unsystematic risk has been eliminated.
CAPM generates theoretically- derived relationship between the required rate of return and the systematic risk which is subject to frequent real research and testing.
CAPM is applied to all companies as long as data for such companies can be computed.
Disadvantages of CAPM
It requires estimating the expected premium of market risk and this varies over time.
We need to estimate beta for the company, which varies over time
CAPM relies on past data to predict the future, and this is not always reliable.
Dividend Growth Model
The dividend growth model is calculated from the formular
Where Re is the rate of return of equity, P is the price earnings per share, C is the current share price and Rg is the rate of dividend growth. We now have
It is easy to understand and use. However, the dividend growth model (DGM) is not all very reliable as it has demerits. According to Watson D & Head A (2007), some of the demerits of the DGM are that;
The DGM is mainly (or only) applied to companies that are paying dividends to their shareholders at the time the DGM is used to determine the cost of capital when it is made.
The DGM is also not applied where the dividends being paid by the company are not growing at a recognizable steady rate.
The other point to note about the DGM is that it does not explicitly take into account all the risks that are associated with the capital used to run the company at the particular moment in time.
Dividend growth model does not also explicitly consider risk.
P/E Ratio.
This price – earnings ratio compares the current share price and the earnings from the same over a period of about four quarters. From the given data, the current share price is $42.09 and the earning per share is $2.16. A high P/E ratio would mean that we invest in the shares of the firm. The P/E is given therefore from. According to Magginson, W L (1996), this ratio however does not explicitly tell the story about the rate of return to advise whether or not to invest in the company.
This ratio has disadvantages in that it does not fully give advice about the firm in question. it is only useful when it is used compare different companies in the same industry, comparing a firm to the general market or to the firm history.
A good ratio is about 20 to 25 times.
3. Basing on WACC, CAPM, P/E and DGM ratios regarding Nike Corporation, these comparables all being positive and high, they reflect the market behavior. It is advisable therefore to invest in the corporation shares.
Works Cited
Adair, Troy. A. Corporate finance demystified: Self Teaching Guide. McGraw-Hill, 2006
Corporate Finance. Ventus Publishing Aps. 2008. Downloaded free from BookBoon.com
Magginson W, L: Corporate finance theory. Addison-Wesley, 1996.
Watson D & Head A. Corporate Finance: Principles and Practice. 4th Edition. FT Prentice Hall. 2007.
Welch, Ivo. A First Course in Corporate Finance. Yale University. 2005
