2011/2012

Executive46

MASTER OF BUSINESS ADMINISTRATION
INSTITUT TEKNOLOGI BANDUNG
2012

MM5009
FinancialManagement
NikeInc.:CostofCapital
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MM5011 Financial Management November 16, 2012

Nike, Inc.: Cost of Capital Page 1

I. Case Background
Kimi Ford, a portfolio manager at NorthPoint Group, was reviewing the financials of Nike
Inc. to consider buying shares for the fund she managed, the NorthPoint Large-Cap Fund. A
week before Kimi Ford began her research, Nike Inc. held an analysts meeting to reveal their
2001 fiscal results and for management to communicate a strategy to revitalize the company.
Nikes revenues since 1997 had ceased to grow from $9.0 billion, and net income had fallen
from almost $800 million to $580 million.

In the meeting, management planned to raise revenues by developing more athletic-shoe
products in the mid-priced segment. Nike also planned to push its apparel line and exert more
expense control. During the meeting, Nikes executives expressed that the company would
still continue with a long-term revenue growth target at 8-10 percent and earnings-growth
targets above 15 percent.

Kimi Ford decided that it was necessary to develop her own discounted-cash-flow forecast in
order to arrive at a proper investment decision for her mutual fund. Her forecast proved that
at a 12 percent discount rate, that Nikes stock price was overvalued at $4.82 per share. Ford
was not clear on a decision to buy Nike stock, so she asked J oanna Cohen to estimate Nikes
weighted average cost of capital.

II. Issues
Here are J oanna Cohens analysis and assumptions:
1. Single or Multiple Cost of Capital?
2. Cost of Debt
3. Cost of Equity
4. Weights of capital components
5. Weighted Average cost of Capital

III. Analysis and Discussion
1. Single or Multiple Cost of Capital?
A single cost is sufficient for this analysis because most of Nikes revenue generated
from kinds of sport product though they also sell non-sport products but it has small
contribution on the total revenue. In addition, the business segments of Nike basically
have about the same risk. Therefore, we agree with Cohen to use the single cost
instead of multiple cost of capital.
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Nike, Inc.: Cost of Capital Page 2

2. Cost of Debt
We dont agree with Cohen in estimating the cost of debt that uses the historical data.
Since the WACC is used for discounting cash flow in the future thus all components
of cost must reflect firms concurrent future abilities in raising capital, historical data
may not reflect Nikes current or future cost of debt.

We can calculate the current yield to maturity of the Nikes bond to represent Nikes
current cost of debt. The more appropriate cost of debt can be calculated by using data
provided in Exhibit 4.
Data given: - current price or PV=$95.60 Nd
- n=20x2=40 years
- CR=6.75%/2=3.375% I=3.375% X $100 =3.375
- Par value=$100

Formula:


YTM =3.375 +{($100-$95.6)/40}
($95.6 +$100)/2
YTM = 3.56% (semiannual); 7.12% (annual)
After tax cost of debt = 7.12% (1-38%) = 4.4%

3. Cost of Equity
We agree with Cohen use 20-year T-bond rate to represent risk-free rate. The cost of
equity and the WACC are used to discount cash flows of very long run, thus rate of
return a T-bond with 20 years maturity, 5.74%, is the longest rate that are available.

We dont agree that Cohen uses average beta 0.80 to be the measure of systematic risk
because we need to find a beta that is most representative to future beta. As such, most
recent beta will most relevant in this respect. So, we suggest using the most recent
beta estimate, 0.69.

We agree that Cohen use the geometric mean as appropriate market risk premium 5.9
percent. There are two historical equity risk premiums given: Geometric mean and
arithmetic mean. The geometric mean is a better estimate for longer life valuation
while the arithmetic mean is better for a one-year estimated expected return. Thus, we
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Nike, Inc.: Cost of Capital Page 3

choose to use the geometric mean to coincide with the choice to use the 20-year yield
on U.S. Treasuries, which is 5.9 percent.

Data given: - Risk free/Rf=5.74% (comes from 20-year T-bond rate)
- Beta/b=0.69 (most representative to future beta)
- Market risk premium/(Rm-Rf)=5.9% (geometric mean)

Formula:

CAPM = 5.74% + {0.69 x 5.9%}
= 9.81%
The next model that we used to calculate the cost of capital was the dividend discount model .
DDM ={Do(1+g)/Po} +g
= {0.48(1 +.055)/42.09} +.055
=6.7 %
The value of 0.48 is the annual dividend for Nike, Inc., the value of .055 is the forecasted
dividend growth, and 42.09 is the current stock price. The base assumption that is made in
this model is for a company that pays a substantial dividend, and Nike, Inc. does not. As such,
CAPM best represents the required cost of equity.

4. Weights of capital component
We dont agree that Cohen use book values as the basis for debt and equity weights.
The market values should be used in calculating weights. Using market weights to
estimate WACC is that how much it will cause the firm to raise capital today. That
cost is approximated by the market value of capital, not by the book value of capital.

Market Value of Debt
Due to lack of information of the market value of debt, book value of debt, is used to
calculate weights. In fact, Cohen should have discounted the value of long-term debt
that appears on the balance sheet.

D =Current portion of long term debt +Notes payable +Discounted long term debt
D =$5.4 +$855.3 +$416.72
D = $1,277.42

CAPM =Rf +{b x (Rm-Rf)}
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Nike, Inc.: Cost of Capital Page 4

The value of 416.72 is obtained by discounting the long-term debt, $435.9 by 4.4%.
The value of 4.4% is the after tax cost of debt.

Market Value of Equity
The book value of equity should not be used when calculating cost of capital; the
market value of equity should be used instead.
E =Stock Price x #Shares Outstanding
E =$42.09 x 271.5
E = $11,427.44

Weight of Debt
W =D / (D +E) =$1,277.42 / $12,704.86 =10.05%
Weight of Equity
W =E / (D +E) =$11,427.44 / $12,704.86 =89.9%
5. Weighted Average cost of Capital
Per the above calculations, the new WACC can be found. The WACC formula takes
the weight of debt (WD), times Nikes current YTM, times one minus the tax rate,
added to the weight of equity (WE), times the cost of equity (which was found using
CAPM).
WACC =Wd*Kd (1-T) +We*Ke
=10.05% * 4.4% +89.9% * 9.81%
= 9.26%

IV. Recommendation

Refer to the results from Discounted Cash flow approach (in excel) with the calculated
WACC 9.26%, the present value of share price $58.24. This is obviously higher than the
current share price of $42.09.

According to these calculations, Nikes stock is currently undervalued. As such, Nike, Inc.
should be added to the North Point Large-Cap Fund at this time. A buy decision for Nike, Inc.
should be recommended as it is currently undervalued at the WACC of 9.26% and, as a result,
has growth potential that would be beneficial to the fund.

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MM5011 Financial Management November 16, 2012

Page 6
Assessing a Companys Future Financial Health