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John Ekelund
Lauren Finkenbeiner
James Toomarian
Nike, Inc.
Kimi Ford, a portfolio manager for NorthPoint Group, is looking for value opportunities.
Specifically, Nike has caught Fords attention in its recent drop in share price, and she would like
to know as to whether this would be a good company to add to the NorthPoint Large-Cap Fund,
which Ms. Ford manages. After finding significantly conflicting conclusions from reputable
analyst reports across the board, Ford decides her own independent research and forecasting will
clear the air. Through a sensitivity analysis of a discounted cash flow forecast, Ms. Ford feels
Nike would be a value opportunity at discount rates below 11.17%. Ford decides to delegate the
task of calculating Nikes weighted average cost of capital to Joanna Cohen, her assistant.
If you do not agree with Cohens analysis, calculate your own WACC
for Nike and be prepared to justify your assumptions.
We calculate Nikes weighted average cost of capital to be 7.54% based on the following
assumptions:
Capital Structure:
We started by verifying Nikes capital structure weights. We used market values for both
debt and equity. Preferred stock is given, however there is not enough information to calculate
the cost of preferred stock, and its final weight is negligible regardless. Regarding debt, we used
the sum of Current Portion of Long-term Debt, Notes Payable, and Market Value of long-term
debt. We found MV of L.T. Debt by adjusting the book value of L.T. Debt against its current
trading price of .956 of par. Regarding equity, we simply multiplied shares outstanding by the
most current price of Nike publicly traded common stock.
Cost of Debt (7.17%)
We calculated Nikes cost of debt by finding the YTM of Nikes corporate bonds. The
information given includes the coupon rate of the bond, the maturity date, and the current price
of the bonds. We then used the RATE function in excel while adjusting for semi-annual payments
to arrive at a cost of debt of 7.17%.
Cost of Equity (7.89%)
We calculated Nikes cost of equity by using the CAPM model. For the risk-free rate, we
used 10-year U.S. Treasuries, as these more liquid than the also provided 10-year U.S.
Treasuries. Regarding the equity risk premium, we decided to use the 2001 Implied Equity Risk
Premium calculated by Aswath Damodaran of NYU Stern. We do not feel comfortable using the
given 5.9% geometric mean or the arithmetic mean of 7.5% going back to 1926. Averages going
back that far run the risk of being contaminated by noise, or variability cause by no longer
relevant market environments. An example of the sensitivity of geometric mean of equity
premiums can be found on page 4 of this report, and Damodarans risk premiums can be found
here. Finally, we used the most recent market beta for Nike which is given at 0.69.
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?
CAPM (7.54%)
CAPM is one of the most widely used models to estimate return on equity. It is very
elegant in the way that it ties risk to return. This elegance comes at a cost. The degree to which
the CAPM model is reliable is directly tied to the assumptions that are put into CAPM; in a
sense, this is a second way in which CAPM ties risk to return.
DDM (6.70%)
The Dividend Discount model is also a popular tool when measuring return on equity.
However, it does not account for risk in the way that beta does. In addition, DDM only uses two
data points for dividends and then extrapolates the growth of those dividends at a constant rate.
This type of assumption will degrade quickly over time periods of scale unless used on
companies that have a very consistent track record of dividend payments as well as a solidified
dividend policy.