Case 15

Nike, Inc.: Cost of Capital

This case is intended to serve as an introduction to the calculation of the weighted-average cost of capital (WACC) of the firm. The case provides a WACC calculation that contains errors based on conceptual misunderstandings. The task of the student is to identify and explain the mistakes in the analysis. The case assumes that students have been exposed to the WACC, CAPM, the dividend discount model, and the earnings capitalization model.

This case is about selecting and choosing weather or not Kimi Ford, a portfolio manager at NorthPoint Group, a mutual-fund management firm, should to invest in Nike, Inc. based on past performances of Nike, Inc., future plans and evaluation of Nike, Inc. The NorthPoint Large-Cap Fund invested mostly in Fortune 500 companies, with an emphasis on value investing, for examples, ExxonMobil, and General Motors. The NorthPoint had performed very well in the past according to the firms past return performances compared to the markets returns.

On June 28, 2001, Nike had held an analysts meeting to disclose its fiscal-year 2001 results (Year Ended May 31). Kimi Ford had been given the following data which are consisted of Consolidated Income Statements (exhibit 1), its gross profit and net income of all the years shown are pretty much the same. The Discounted Cash Flow Analysis (exhibit 2), assumptions were assumed from year 2002 to year 2011 and they were approximately the same. Its free cash flows increased respectively along the timeline. The Consolidated Balance Sheets (exhibit 3). The Capital-Market and Financial Information On or Around July 5, 2001 (exhibit 4), and the Joanna Cohens Analysis, Kimi Fords new assistant (exhibit 5). In addition, Nikes market shares in U.S. athletic shoes had fallen from 48%, in 1997, to 42% in 2000 and had the adverse negative effect of a recent strong dollar to affect the revenue.

According to Joanna Cohens Analysis to Kimi Ford, she discussed about four assumptions, single o multiple costs of capital, methodology for calculating the cost of capital, cost of debt, and cost of equity; while the estimation of cost of capital was 8.4% by using CAPM (capital-asset-pricing-model). Cohen concluded to compute only one cost of capital for the whole company although Nike, Inc. is composed of selling variety of categories. She came up with 27.0% debt and 73.0% equity of total capital by using the WACC method based on the latest balance sheet, May 31, 2001. The estimation for cost of debt is 4.3%, and declines to 2.7% after adjusting for tax, and the tax rate used was 38%.

Assigned Questions

1. What is the WACC and why is it important to estimate a firms cost of capital? Do you agree with Joanna Cohens WACC calculation? Why or why not?

Sources of capital of a firm come from 2 main sources which are debts and equity while a firm has costs on those sources of funds. Cost of debt is an interest and cost of equity is returns to equity owners. Weighted Average Cost of Capital (WACC) is a calculation of a firms costs of capital in which each category of capital is proportionately weighted. When a firm doing business, it needs funds and those funds require returns from a firm. Thus WACC represents minimum required rate of return of a firm. If a firm generates 15% of returns while WACC is 5%, a firm will gain 10% after costs of capitals. It also helps predict risk would be happening with a company (risk management). Moreover, estimate a firms or projects cost of capital help investors can diversification their investment, reduce risk in invest, maximization profits. Those are reasons why a firms cost of capital is important.Joanna calculated weighted average cost of capital (WACC) as 8.4% using CAPM model and we do not agree with her calculations as below reasons;

Joannas calculation uses the book value for both debt and equity. To determine the costs of debt, she should use the current market rate that a firm is paying on its debts. As the book value of debt is as an estimate of market value and the book value of equity should not be used when calculating cost of capital. The market value of equity should be calculated by multiplying the stock price of Nike Inc. by the number of shares outstanding. Also, the market value of debt should be used in the calculation of the cost of debt instead of the book value used by Joanna. She should have discounted the value of long-term debt that appears on the balance sheet ($ 435.9) at Nikes current coupon. Hence, this led to incorrect weights for the cost of equity and cost of debt. Joanna took the average of Nikes betas from 1996 to present, it means that she used historical average beta which may not reflect current risks. So we think using current beta is more appropriate. As we can see from exhibit 4 that average beta is 0.8 while latest beta is 0.69, those two betas are quite different so using historical beta may not reflect the correct cost of equity in the future.2. If you do not agree with Cohens analysis, calculate your own WACC for Nike and be prepared to justify your assumptions.

To compute the WACC we have to calculate separately the financial return expected by the cost of equity (KE) and the financial return expected by the providers of the cost of debt(KD), so as to compute a weighted average of the two expected returns according to their respective proportion in the capital structure of the company. The WACC is obtained by using the following formula:

Cost of debt

We think Cohen mistakenly uses the historical data in estimating the cost of debt by dividing it in the average balance of debt to get 4.3% of before tax cost of debt. The rate is lower than Treasury yields and may not reflect Nikes current or future cost of debt. We calculate the appropriate cost of debt by using data provided in Exhibit 4 as below;

Current Yield on Publicly Traded Nike Debt:

ItemAmount

Current Price (PV)95.60

Period in semi-annually (N)40

Coupon paid semi-annually (Pmt)-3.375

Future Price (FV)-100

As data above, we can calculate interest as 3.58% (semiannual) or 7.16% (annual), thus after tax cost of debt = 7.16%(1-38%) = 4.44%

Cost of equity

Cohen estimates the cost of equity using the CAPM as following:10.5% = 5.74% + (5.9%)*0.80Her assumption is risk free rate comes from 20-year T-bond rate, average beta from 1996 to July 2001, 0.80, and market risk premium 5.9% from Geometric mean. We think that risk free rate and market risk premium are reasonable. However, we dont agree that Cohen uses average beta from 1996 to July 2001, 0.80 to be the measure of systematic risk because the appropriate beta should be most representative to future beta. Therefore, we recommend using the most recent beta estimate, 0.69. Our estimate of cost of equity will be:

5.74% + (5.9%)* 0.69 = 9.81%

In addition, based on the data in exhibit2, Cohen is wrong to use book values as the basis for equity weights. She should calculate weights by using the market values to reflect current capital of the firm. For book value of debt, 1,296.6, is reasonable to calculate weights due to lack of information of the market value of debt.

Weights of capital components:

Market value of equity = current share price* current shares outstanding = 42.09* 271.5 = 11,427.44Book value of debt = 1296.6The market value weight for equity is 11,427.44 / (11,427.44 +1,296.6) = 89.8%; the weight for debt is 10.2%.

Based on the assumptions above, our calculation of the WACC is as follow:

4.44%*0.102 + 9.81%*0.898 = 9.26%

3. Calculate the costs of equity using CAPM, the dividend discount model, and the earnings capitalization ratio. What are the advantages and disadvantages of each method?

Capital Asset Pricing Model (CAPM)Risk Free Rate5.74%

Market Risk Premium5.90%

Beta0.69

CAPM9.81%

Advantages: The model is simple to use and generate a range of possible outcomes around the required rate of return. Only systematic risk is being considered as it can be assumed that the investors would have a well-diversified portfolio and the unsystematic risks has been diversified away. Can be used when exploring business opportunities when the business mix and the financing differ from the current business. Takes into account the companys level of systematic risk relative to the market as a whole.

Disadvantage: Risk-free rate yield change daily and can create volatility Market return (capital gains and dividends) can be negative at any given time and must be utilized to even this out. Moreover, it is not a true representative of future market returns as it focuses more on backward-looking Unfair assumption is made that individual investor can borrow at the same rate as the government (risk-free rate), which means the actual model is more steep than what we might expect in reality It is extremely difficult to estimate betas for many projects Corporate risk is sometimes overlooked as market risk becomes the main focus

Dividend Discount ModelDividend (2001)0.48

Growth Rate5.50%

Price of Stock (2001)42.09

DDM6.70%

It should be noted that Nike Inc. does not payout dividend after June 30, 2001 to justify using this model as it will not be a good representative of the cost of capital.

Advantage: Most commonly used and easiest to understand Value companys stock without taking into account the market condition (can specified sensitivity testing and changing circumstances) Flexibility for investor when estimating future dividend earnings Allow for calculating the desire stock price by matching the market assumptions for growth and expected return.

Disadvantage: Does not take into account non-dividend factors such as: brand loyalty, customer retention and intangible assets ownership. All of which impact companys value Sensitive to small changes in the input assumptions Overreliance on valuation that is from data estimations

Earning Capitalization RatioEPS FY20022.32

Price of Stock (2001)42.09

Earning Capitalization Ratio5.51%

This model does not take into account the growth of the company, therefore we agreed that it will not be a good representation of the companys cost of capital.Advantages: An income-based method that is commonly used to value small companies or no-growth firms Reflects the investors risk-adjusted required rate of return and includes a factor reflecting future growth.Disadvantages: Projected future earning may be wrong and resulted in high deviations from the expected rate of return Model does not match the size and growth potential of Nike Inc. so would be inappropriate for the situation. Does not factor companys assets in calculation

4. What should Kimi Ford recommend regarding an investment in Nike?

To discount cash flows in Exhibit 2 with the calculated WACC is 9.26%, the present value of Nike approximately $57.05 per share, which is much higher (1.36 times) than Nikes current market price of $42.09. So Nike shares price is underestimate and undervalued by $14.09 as Nike is currently trading in 2001. Some might think this value is still understated, due to that current growth rate (6% to 7%) is much lower than that estimated by manager is 9.27% (8% to 10%). Moreover, Nike also changed their business strategy by more concentrate in mid-priced segment, which is Nike less concentrate for a long time before. Thats mean their total of sales might increase, lead to avenue increase, lead to profit increase, of course, Nikes share prices and dividend will beincreasein long-term.

Using thisdata,we found thatNorth Point Large-Cap Fund should buyNikeInc., sharesatthis timebecause the stock is undervalued because ithas growth potential that would be beneficial to the fund.Along withthis fact, managementhas goals for the near future that could provide a great deal of profit for Nike Inc.As we know that in conference, Nike was showed that the company is heading on the recovery path with new strategy andthere is potential forabnormal profits given the growth capacity andthe settargets by the management areeasily achieved if they stay focused since theyhave the capacity. Technical analysis also supports a buy decision, because looking on thepast performance of the NikeInc., share against the market index. It has shown that Nike can outperform the market returns and now that it had gown down, it is left with the upside given plans that are being put in place.

In conclusion, based on all data including history data and future data, it is clearly thatdecision is Kimi Ford should buyNikes shares because it quite safe, underestimate of market andgrowth dramatically compare with its history. Overall, Nikes shares are very potential.Indetails, Kimi Ford also should consider before buy Nikes shares depend on some of reasons. First of all, Nikes shares long-term always is wonderful investment, but short-time buying also should becarefulbecause of the changing fast of industry, the changing of Nike, the changing of trend in footwear industry and so on.

Discount cash flow analysis