Case 2: NIKE, INC.

BA 280.2
Group 8: Quimpo, Villar, Yam
R. Ybanez
30 June 2015
PROBLEM STATEMENT:
Should Kimi Ford recommend a buy, hold or sell of Nikes stocks? What
improvements should be made to Joanna Cohens WACC computation?
ANALYSES:
I. Cost of Debt
In Joanna Cohens calculation, she used the historical data in estimating the cost of
debt; Joanna divide the interest expenses by the average balance of debt to get
4.3% of before tax cost of debt. The 4.3% cost of debt estimate may not reflect
Nikes future cost of debt.
In choosing for the method to use for calculating Cost of Debt, we will need to
consider if the company, however, has no publicly traded debt, we could look to the
market to see what the yield is for other publicly traded debt of similar companies.
Or, if we are completely using bank financing, we can simply ask the bank to
provide us with an estimated rate.
The group used Yield-to-Maturity (YTM) approach to compute for the Cost of Debt
for Nike. The yield to maturity is the annual return from an investment purchased
today and held till maturity, i.e., it is the rate at which the current market price of
the bond is equal to the present value of all the cash flows from the bond. How do
we figure out the yield to maturity? If we have outstanding debt of an appropriate
maturity, we can assume the YTM on this debt to be our cost. If our company,
however, has no publicly traded debt, we could look to the market to see what the
yield is for other publicly traded debt of similar companies. Or, if we are completely
using bank financing, we can simply ask the bank to provide us with an estimated
rate. The group does not expect any significant default risk to warrant an
adjustment to the YTM rate.

Since interest payments made on debt (the coupon payments paid) are tax
deductible by the firm, the interest expense paid on debt reduces the overall tax
liability for the company, effectively lowering our cost. To calculate the real cost of
debt we take out the tax liability. Using data from Exhibit 4 of the case, we compute
for the after-tax cost of debt as follows: 5.74% (1-38%) = 4.02%.
Similar to Joannas tax assumption, the group likewise used the 38% corporate tax
rate (35% statutory tax rate plus 3% state tax rate).
II. Cost of Equity

Joanna Cohen used CAPM to estimate Nikes cost of equity. Despite apprehension on
assumptions used in the CAPM, generally, this is an acceptable and widely used
estimation for cost of equity. The group looks into the assumptions taken by Joanna
Cohen and improve on these:
A. Risk Free Rate
Joanna Cohen used the yield on 20-year Treasury bonds (5.9%). Despite the
appropriate tenure (20-year) to estimate the holding period for a business (we
assume businesses will exists indefinitely), 10-year tenures are more liquid. The
group recommend using the 10-year Treasury bond (5.39%). Some narratives
recommend using shorter Treasury bills since long-term government bonds carry
risk premium which distorts true risk free rate. Nevertheless, yields on 10-year
Treasury bonds are the norm for estimating risk free rate.
B. Beta
Joanna Cohen used the average 5-year annual beta (0.80). Beta represents the
systematic risk of a stock to the market. The group agrees with Joanna Cohen to use
historical beta to better represent the reaction of Nikes stock price vs market, for
lack of better forward-looking beta estimation.
C. Equity Risk Premium
Joanna Cohen used the geometric mean of historical equity risk premium (5.9%).
The geometric mean is favored as it compounds returns over a series of periods and
is generally lower than the arithmetic mean. The arithmetic mean is favored for
single historical period perspectives or when returns are viewed as independent
from one another. The group recommends the use of the geometric mean (7.5%) as
it provides for an accurate estimate of expected return as required under CAPM.
D. Cost of Equity Computation

The group calculated 10.11% as cost of equity, a 0.35% difference from Joanna
Cohens calculation.
Limitations of CAPM
The group noted a mismatch of data range for a July 2001 valuation, as follows:
Historical equity risk premium is from 1926 to 1999; better if this includes
year 2000

Historical beta is from 1996 to 2000; better if historical inputs where taken up
until May 2001

Other Methods of Estimating Cost of Equity Dividend Discount Model

(DDM)
Considering that Nike is a mature dividend paying company, the group estimates
cost of debt using DDM. Compared to CAPM, DDM is inferior due to the fact that it
does not have constant growth; in 2002 growth is at 7%, from 2003 to 2005 growth
is at 6.5% and 2006 onwards growth is at 6%.

III. Weighted Average Cost of Capital (WACC)

Joanna Cohen has computed a WACC of 8.4% for Nike Inc. An inherent issue with
Cohens WACC is with the use of book values as weights between debt and equity
(27% vs 73%). A more appropriate capital structure weight for NorthPoint Group (as
third party investors) is to use the market value of both equity and debt.
A. Market Value of Equity
Using current stock prices, the group computes for equity capitalization as follows
(in US$ millions):

B. Market Value of Debt

Debt are valued as follows; for current debt taken as book value, for non-current
debt (i.e. long term portion of existing debt), the group used the current price of
Nikes publicly traded debt ($95.60); however, for redeemable preferred shares, the
group took this at book value due to: (1) lack of information to value this particular
security, and (2) relatively small size. Revised ratio between debt and equity value
is 10:90.

C. Target Capital Structure Using Market Value

D. Weighted Average Cost of Capital (WACC)

The group computed WACC of 9.5%, a 1.2% difference (over) from Joanna Cohens
initial computation of 8.4%, and a 2.5% difference (under) Kimi Fords initial
discount rate of 12%.
A firm's WACC is important because it is the overall market consensus required
return for the firm that will reflect the systematic risk of the investment. WACC aids
in valuing a business (for decision making purposes) by giving due consideration for
various types of financing (i.e. debt and equity). In the perspective of Nike, WACC
represents the cost of acquiring capital and serves as a hurdle rate for its return on
investments (ROIC) performance. At ROIC greater than WACC, value is created for
the firm.
WACC moves with the volume of D/E; at low D/E, WACC nears unlevered cost
equity, with moderate D/E, WACC will be less than unlevered cost of equity due
the benefit of tax shields to equity investors; however at high D/E, the benefit
leveraging decreases as bankruptcy costs and agency costs increases both cost
equity and cost of debt resulting to high WACC rates.

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IV. Valuation
The equity value per share was recomputed using the new values based on changes
from Joanna Cohens computation. Following the assumption set by Kimi Ford of a

constant terminal value growth rate of 3%, the following is the result of the
computations: (Alex you added 2001 as part of enterprise value)

At the adjusted equity value per share of $55.5, Nikes shares are currently
undervalued at $42.09. Additionally, a sensitivity analysis can be seen in the table
below; a discount rate of 11.36% would be required to match the current share price
in the market.

(Alex, do you need to revise the sensitivity table I made small changes to
valuation, (1) wacc, and (2) sum of DCF)
RECOMMENDATIONS:
With the stock being highly undervalued at its current price, Kimi Ford should
recommend investing in Nike. Additionally, the sensitivity analysis shows a large
amount of flexibility in terms of the discount rate before the stock reaches its true
equity value per share. This puts the stock at an even stronger position able to
weather slight deviations from expectations.

Annex 1: Valuation using FCFF

At WACC of 9.52%