Page 119 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 6: Cost of Capital

2. Uncontrollable Factors: The factors that are not possible to be controlled by the firm and Notes
mostly affects the cost of capital. These factors are known as External factors.
(a) Tax Rates: Tax rates are beyond the control of a firm. They have an important effect
on the overall cost of the capital. Computation of debt involves consideration of tax.
In addition, lowering capital gains tax rate relative to the rate on ordinary income
makes stocks more attractive and reduces cost of equity and lower the overall cost of
capital.
(b) Level of Interest Rates: Cost of debt is interest rate. If interest rates increases,
automatically cost of debt also increases. On the other hand, if interest rates are low
then the cost of debt is less. The reduced cost of debt decreases WACC and this will
encourage an additional investment.
(c) Market Risk Premium: Market risk premium is determined by the risk in investing
proposed stock and the investor’s aversion to risk. Market risk is out of control risk,
i.e., firms have no control on this factor.
The above are the important factors that affect the cost of capital.

Task Weighted average of cost of capital may be determined using book value and
market value weights. Compare the pros and cons of using market value weights rather
than book value weights in calculating WACC.

Self Assessment

Fill in the blanks:
13. The weighted average cost of new or incremental, capital is known as the ………………....
14. Book value weights are based on the values found on the……………………….

15. The ………………..cost of capital lies between the least and most expensive funds.



Case Study Case: Nike, Inc. – Cost of Capital

n July, Kimi-ford, a portfolio manager at North Point Group, a mutual-fund-
management firm, pored over analysts’ write-ups of Nike, Inc., the athletic-shoe
Omanufacturer. Nike’s share price had declined significantly from the start of the
year. Ford was considering buying some shares for the fund she managed, the North Point
Large-Cap Fund, which invested mostly in fortune 500 companies, with an emphasis on
value investing. Its top holdings included Exxon Mobile. General Motors, McDonald’s,
3M, and other large-cap. It had performed extremely well. In 2000, the fund earned a
return of 20.7 per cent even as the S&P 500 fell 10.1 per cent. The fund’s year-to-date returns
at the end of June 2001 stood at 6.4 versus the S&P – 7.3 per cent.
Only a week ago, on June 28,2001, Nike held an analyst’ meeting to disclose its fiscal-year
2001 results. The meeting, however had another purpose : Nike management wanted to
communicate a strategy for revitalizing the company. Since 1997 Nike’s revenues had
plateaued at around $9 billion, while net income had fallen from almost $ 800 million to
$580 million (see Exhibit 1). Nike’s markets in the U.S. had fallen from 48 per cent in 1997
Contd...

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