Finance Case 13

Use of the current cost of debt. The relevant pre-tax cost of debt is theinterest rate the firm would pay if it issued debt today.Use of historical average return on stocks with the current risk free rate. Acase could be made either using the historical risk premium or the currentone, but it is wrong to subtract the current risk free rate from the historicalrate of return on the market.Use of book values of debt and equity to estimate their weights in WACC.Although debt may have close market and book value, the market value of equity may differ significantly.2. Adjusting the Cost of Capital for RiskNike is planning to focus mainly on two projects in the next year: To developmore athletic-show products in mid-priced segment and to push its apparelline which has already done extremely well. It seems that these two projectshave different risks: mid-priced athletic shoes could be treated as a "new"product for Nike while apparel is already successful and both projects are indifferent business segments. Also, Nike provides plenty of other products.We can say that the use of multiple costs of capital, especially for the newproject, is reasonable. However, we do not have enough data to support suchapproach.3. Estimating the Market Risk Premium for CAPM The market risk premium RPM=kM - kRF can be estimated either on thebasis of ex-post or historical data or on a basis of ea-ante or looking forwarddata. Although, historic risk premiums are results of a very complete andaccurate study (available from Ibbotson Associates) are usually treated withlow confidence from the investors.Ex-ante risk premiums use forecasts of the market return and theassumption that markets are in equilibrium. Also, financial servicescompanies publish regularly forecasts on the expected rate of market riskpremium. However, there are potential problems as well. Many considerthese forecasts the analysts and not the investors' expectations-althoughthis probably is not a major problem as many studies have shown-and thatthere are many financial companies that give different forecasts, so apotential investor needs to take the average from several forecasts.4. Use of Historical Arithmetic Mean of Risk PremiumsAlthough we did extended research to find Value Line's forecasts for the rateof return on the market or the risk premium for 2001, we did not findanything due to limited access on relevant data. We decided to use thearithmetic mean based on the reasons we gave above but we still believethat the use of current values is better when estimating CAPM.

5. Calculationsc1. Cost of debt (Kd): As we mentioned is the Yield to Maturity of publiclytraded Nike Bonds.(Values inserted in financial calculator)PV: -95.6FV: 100n: 40Pmt: 6.75/2= 3.375 (as it pays semiannually) → i* = 3.5813semiannually, so, I/Y=(i*) * 2 →i: 7.1627% = YTM= Kd= 7.16%c2. CAPM for Nike's cost of equityKe = Krf+β(Km-Krf) = 5.39+0.8(7.5)=