Kim Ford, the portfolio manager, outstanding performance of the fund. In order to evaluate Nikkei as a viable choice, Kim has to calculate the cost of capital for the company and make sure assumptions are a direct function from the estimates. The cost of capital calculation or WAC helps to see if an investment is worthwhile to undertake.
However, the assumptions made to calculate WAC, in this case, are the underlying problem because some of the assumptions made are incorrect. Analysis Nikkei held a meeting to discuss company performance at 2011 end of fiscal year.
In the meeting, management discussed their strategy to improve revenues and net income by developing more athletic shoe products in the misplaced segment of selling shoes at $70-$90 a pair. The company also planned to increase sales for its apparel line, which it had performed really well lately. Management was also concern in the drop of market share from 48%, in 1997, to 42% in 2000. Nikkei was also committed to make an effort in controlling company expenses more diligently. Yet, Nine’s investment value was not clear to Kim Ford. Analysts’ reports had mixed recommendations about the value of the company.
Some analysts were recommending buying the stock and some others were recommending holding the stock. Different recommendations were based on the company’s declining performance and the proposed strategies to improve the same. Weakening revenues and net income since 1997 are displayed in their firm’s consolidated statement showing an improvement in the later years as well. Therefore, Ford had to run her own calculations. Kim Ford performed a discounted cash flow forecast that resulted in a 12% discount rate with an overvalued estimate for Nikkei at the current share price.
Ford also performed a quick sensitivity analysis that showed Nikkei was undervalued. Ford figured the best way to make a choice about Nikkei is by calculating the cost of capital cause Nikkei is financed through equity and debt. Ford asked her assistant, Johanna Cohen, to estimate Nine’s cost of capital. WAC is the cost of capital for a firm as a whole and can be interpreted as the required return on the overall firm (Ross, Westfield & Jordan, 2010). Some of the assumptions made by Johanna Cohen in calculating the cost of capital are incorrect.
As stated before, the correct assumptions are necessary in order to make the right choice. Johanna used the book values for equity and debt. While book values are acceptable values for debt at times, book values for equity are not. Book values may be important from an accounting point of view but market values are forward looking. Therefore, Johanna should have calculated the equity market value. The debt market value calculated by Johanna is also slightly incorrect. Johanna did not include Redeemable Preferred Stock in her calculation.
Consequently, Cone’s To figure out the cost of equity Johanna used CAMP, a widely used method. CAMP tells what to expect in regards to future returns on a share of stock. Johanna did right by using this method; however, her calculations include an average for six years on Betas and it should be an average for five years, since the 6th year is not finished. In addition, the 5. 74% rate on 20- year treasury bonds is sufficient to use as the risk-free rate. The geometric mean for current equity risk premiums is more representative to use.
Under the cost of debt calculation, Johanna missed a simpler way to calculate the cost of debt. “The cost of debt is simply the interest rate the firm must pay on new borrowing. For example, if the firm already has bonds outstanding, then the yield to maturity on those bonds is the market required rate on the firm’s debt” (Ross et al, 2010). Johanna could have simply calculated the YET on Nine’s bonds. Since some of Cone’s assumptions are incorrect, the cost of capital calculation does not reflect an accurate result.