cAsE 13

iΨ*fi

Ι\Ιike, Ιnc.: Cost οf Capita1-

on July 5, 20O1, Kimi Ford, portfoΙio manager at NoπhPoint Group, a mutuaΙ_fund-man-

a
agement Γrrm, pored over anaΙysts' write-ups of Nike, Ιnc., the athletic_shoe manufacturer.
Nik"'r share price had declined significantly from the start of the year. Ford was consider-
ing buying some shares for the fund she managed, the NorthPoint Large-Cap Fund, which
invested mostly in Foπune 50O companies, with an emphasis on value investing. Ιts top
hoΙdings included ExxonMobil, General Motors, McDonald's, 3M, and other large-cap,
generally old_economy stocks. While the stock market had declined over the Ιast 18
months, NoπhPoint Large-Cap had performed extremeΙy weΙΙ. Ιn 2000, the fund earned a
return of 20.1percent even as the S&P 500 fell 10.1 percent. The fund's year-to-date re-
turns at the end of June 2OOl stood at6.4percent versus the S&P 500's -7.3 percent.
only a week ago, on June 28, 20ol' Nike hetd an arιalysts' meeting to disclose iω
fiscal_year 2001 results.l The meeting, howeveη had another puφose: Nike management
wanted to communicate a strategy for revitalizing the company. Since 1997' Nike's rev-
enues had pΙateaued at around $σ biilion, while net income had fallen from almost $800
miΙtion to $sεο million (see Exhibit 1). Nike's market share in U.S. athletic shoes had
fallen from 48 percent iπ |997 to 42 percent in 2000.2 Ιn addition, recent supply_chain is_
sues and the adverse effect of a strong doltar had negatively affected revenue.

lNike's fiscal yearended in May.

3omething: Nike's Ιnsularity and Foot-Dragging Ηave Ιt Running in Place,'' 8ηsi-
2Dο,rgΙas
Robion, "Just Do ...
ness Week July 2,2001.

176
 Case 13: Nike, Inc.: cost of capitaΙ |77

At the meeting, management revealed plans to address both top-line groιvth and oper-
ating perfoΠnance. To boost revenue, the company would develop more athletic_shoe prod_
ucts in the midpriced segment3-a segment that it had overlooked in recent years. Nike also
planned to push its apparel line, which, under the recent leadership of industry veteran
Mindy Grossmana had performed extremely well. On the cost side, Nike would exert more
effort on expense control. Finatly, company executives reiterated their long-terrn revenue-
growth targets of 8-lO percent and earnings-groιγth targets of above 15 percent.
Analysts'reactions ιvere mixed. Some thought the financial targets too aggressive; oth-
ers saw significant growth oppoπunities in apparel and in Nike's international businesses.
Ford read aΙl the analysts' reports that she could find about the June 28 meeting, but the
reports gave her no clear guidance: a Lehman Brothers report recommended a "Strong
Buy;'while UBS Warburg and CSFB analysts expressed misgivings about the company and
recommended a "Hold.'' Ford decided instead to develop her own discounted_cash-floιv
forecast to come to a clearer concΙusion.
Ηer forecast shoιved that, at a discount rate of 10 percent, Nike was overvalued at its
cuΙτent share price of $42.09 (see Exhibit 2). She had, howeveη done a quick sensitivity
analysis that revealed Nike νιas under valued at discount rates beΙow 9.4 percent. As she
was about to go into a meeting, she asked her neιry assistant, Joanna Cohen, to estimate
Nike's cost of capital.
Cohen immediateΙy gathered alΙ the data she thought she might need (Exhibits 1,2' 3,
and 4) and began to work on her analysis. At the end of the day, she submitted her cost-of-
capitaΙ estimate and a memo (Exhibit 5) explaining her assumptions to Ford.

3Sneakers in this
segment sold for $7G-$90 a pair.
oMindy
Grossman joined Nike in September 20Φ. She was the former president and chief executive of Jones Ap-
parel Group's Polo Jeans Division.
 l78 Case l3: Nike' Ιnc.: Cosι of Capitat

EXHΙBΙT 1
ConsoΙidated Ιncome Statements
ξF@
Year Ended May 31
(in millions except
per share data) 1995 1996 ι997 199E 1999 2000 2001
Revenues 4,760.9 6,470.6 9, 186.5 9,553.1 8,776.9 8,995. ι 9,488.8
Cosι of goods sold 2,965.3 3,906.7 5,503.0 6,065.5 5,493.5 5,403.8 5,794.9
Gross profit 1,E95.6 21563.9 3r683.5 31487.6 31283.4 3β91.3 3,703.9
SeIΙing and administrative l,20g.g 1.588.6 2,303.7 2,623.8 2,426.6 2,606.4 2,699.7
Operating income 685.9 9753 ι1379.E E63.8 E56.8 9E4.9 ιr0t4.2
Ιnteresι expense 24.2 39.5 52.3 6ο.Ο 4.t 45.0 59.7
Other expense, net ll.7 36.7 32.3 20.9 2t.5 23.2 34.1
Restructuring charge, net 129.9 45.1
Ιncome before income taxes ω9.9 E99.1 tr295.2 653.0 746,1 9!9.2 921.4
Ιncome taxes 250.2 34s.9 499.4 253.4 294.7 340.1 33ι.7
Net income 399.7 553.2 795.E 399.6 451.4 s79.1 599.7

Diluted earnings per common sharel 1.36 2.68 1.35 1.57 2.07 2.16
Average shares outstanding (diΙuted) ι
1.88
294.0 293.6 297.0 296.0 287.5 279.9 273.3
Groιryth (Ψo)
Revenue 35.9 42.0 4.0 (8.1) 2.5 5.5
Operating income 42.2 41.5 (37.4) (0.8) 15.0 3.0
Net income 38.4 43.9 (4e.8) ι3.0 29.3 l.g
Margins (Ψo)
Gross margin 39.6 40. I 36.5 37.4 39.9 39.ο
operaιing margin r5.l 15.0 9.0 9.8 l0.g t0.7
Net margin 8.5 8.7 4.2 5.1 6.4 6.2
Effecιive tax rate (To)' 38.5 38.6 38.8 39.5 37.0 36.0
'The U.s. staιuιory tax raιe \ryas
35Ψo.The Sιaιe ιax varied yearly from 2.5Ψo lo 3.5Ψo.
Source: Company's lO-K SEC filing, UBS Warburg.

1
ΠρoφαvΦg fxεl κdvεl α0ξηoη M.K. καl uπoλoγiζεl EPS oτo dΘρoloμα παλΦv
καl v€ωv μετo1Φv
 Case l3: Nike, Ιnc.: Cost of Capita| |79

ExΙΙΙBΙT 2
Discounted- Cash-Florv Α nalysis
*ΞGτ...%efuFryΦ .+g. :FdΦry,@ΦΞ$

2002 2003 2005 2006 2007 2008 2009 2010 2011

Assumptions:
Revenue groιvth (%) 7.0 6.5 6.5 6.5 6.0 6.0 6.0 6.0 6.0 6.0
cocs/SaΙes (Ψo) ' 60.0 60.0 59.5 59.5 59.0 59.0 58.5 58.5 58.0 58.0
S&Α/Sales (Ψo) "" 28.0 27.5 27.0 26.5 26.0 25.5 25.0 25.0 25.0 25.0
Tυι rate (Ψo) 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.0
Cuπent assets/Sales (Ψo) 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.Ο 38.0 38.0
Cuπent liabilities/Sales (To) :,
t 1.5 Ι l.5 r 1.5 I 1.5 I 1.5 I 1.5 I 1.5 r r.5 I 1.5 Ι l.5
Yearly depreciation equals capex.
Cost of capital (To) 10.0
Terminal growιh rate (Ψo) 5.0

Discounted Cash Florr

Operating income |,218.4 1,351.6 1,554.6 1,717 .0
,950.0 2,135.9
I 2,410.2 2,554.8 2,790.1 2,957.5
Tιτes 463.0 5 13.6 590.9 652.5 741 .0 8l 1.7
915.9 970.8 1,060.2 1.123.9
NoPΑr η
755.4 838.0 963.9 l'064.5 l'2ο9.0 |,324.3 l,494.3 l,584.0 l'729.9 l'833.7
Capex, net of depreciation
Change in NWC (171.9't ( 186.3 ( 198.4) 195.0) (206.7) (219.t) (232.3) (26 r .0)
Free cash floιγ 7ω.l 663.l 777.6 866.2 1,014.0 l,ll7.6 1,275.2 1,35 1.7 1,483.7 1,572.7
Terminal value 12.733.3
Total floιvs 7ω.l 663.l 777 .6 866.2 1,014.0 I ,l 17.6 5.2 l ,35 l .7 l ,483.7 I4.3Ο6.0
l ,27
Present value of floιγs 694.7 549.0 594.2 591.6 629.6 630.8 654.4 630.6 629.2 5,515.6
Enιeφrise value I I , 108.8
Less: cuπent ouιStanding debt 1.296.6
ξuity value 9,812.2
Cuπent shares outstanding 271.5
Equity value per share Cuπent share price: tΓ42_091

Sensitiνity of equity ναlue to discount rαte:

Discount rate Equity value
8.o0Ψo $ 64.02
8.50 53.87
9.ω 46.38
9.36 42.09
9.50 40.65
10.00 36.14
10.50 32.51
1l.ω 29.53
1l.5ο 27.M
12.00 24.93

t^Cost
of goods sold
jnd admΙnistrative eΧpenses
1 Q"lling
I Crpital expenditure
' Νet opeΓatΙng profit after tax

ι
λ
l80 Case l3: Nike. Ιnc.: Cosι of CapitaΙ

EXHΙBIT 3 '
Consolidated Balance Sheets (in miΙlions )
'|....;ξξ:!}|':.:'.:|.:'1i;'.::tr;fii:,:::;f:ΙΞiiiin:v;:ri]:j,Ξ':;j:Ι'iii*lir''''i::..,.}!'ΙΙι#Ε'?'*',^::':ξl'.:i9:i'ξ':ξ:::'.1::': '':\l''2

May 31,

2000 200 I

Assets
Cuπenι asseιs:
Cash and equivalents $ 254.3 $ 304.0
ι,569.4 1,621.4
Accounts receivable
I,446.0 |,424.1
Ιnventories
I I1.5 I 13.3
Defeπed income taxes

ffi ffi
Prepaid expenses 2ι5.2 162.5

Total current assets

1,583.4 1,618.8
Propeπy, plant and equipment' net
4t0.9 397.3
tdentiΓrable intangible assets and goodwill, neι
Defeπed income taxes and other assets _ 266.2 178.2

Total assets $Jrg56'2 $ 5,819.6

LiabiΙities and shareholders' equity

Cuπenι Liabilities:
Cuπent poπion of long-term debt $ 50.1 $ 5.4
924.2 855.3
Notes payable
543.8 432.0
Accounts payable
62t.9 472.1
Accrued Ιiabilities
lncome taxes payable
2t.9
Total cuπent Ιiabilities 2,140.0 w8f^:.

470.3 435.9
Long-terrn debt
10.3 102.2
Defeπed income tΞιxes and oιher liabilities I
0.3 0.3
Redeemable prefeπed stock

Shareholders' equity:
2.8 2.8
Common stock, par
369.0 459.4
Capital in excess of stated value
(I 1.7) (e'e)
Unearned stock compensaιion
Accumulated other comprehensive income (l l l.ι) (152.1)

Retained earnings 2.887.0 _3. 194.3

3,136.0 3,494.5
Total shareholders' equity
Total ΙiabiΙities and sharehoΙdens' equity $ 5.856.9 $ 5.819.6

Source: Company l0-Κ sEc Γtling.

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I82 Case I3: Nike, Ιnc.: Cost of Capital

EXHΙBΙT 5
Joanna Cohen'S AnaΙysis
To: Κimi Ford
FROM: Joanna Cohen
DATE: July 6, 2001

SUBJECT Nike's Cost of Capiral

Based on ιhe foΙlowing assumptions' my estimate of Nike's cost of capital is 8.3 percent:

Ι. Single or Multiple Costs of CapitaΙ?

The first question Ι considered was whether to use singΙe or multiple costs of capital given that Nike has
multiple business segments. Αside from footwear, ιγhich makes up 62 percent of revenue, Nike also selΙs ap-
parel (30 percent of revenue) that complement its footwear products. In addition, Nike sells spoπ balΙs' ιime-
pieces, eye\ryear, skates, bats, and other φuipment designed for sports activities. Equipmenι products account
for 3.6 percent of revenue. Finally, Nike also sells some non-Nike branded products such as Cole-Haan dress
and casual footwear, and ice skates, skate blades, hockey sticks, hockeyjerseys and other products under the
Bauer trademaτk. Non-Nike brands account forJ.S percent of revenue.
Ι asked myself whether Nike's business segments had differcnt enough risks from each other to ιγaΙτanι
different costs of capital. Were their proΓrΙes reaΙly different? Ι concluded ιhat it was only the Cole-Haan line
that ιvas somewhaι different; the rest werc aΙl sports_rclated businesses. Howeveη since Cole-Haan makes up
onΙy a tiny fraction of revenues, Ι did not think it necessary to compute a separate cosι of capital. As for the ap-
parel and footwear lines, they are sold through the same mπketing and distribution channels and arc often mar-
keted in "coΙlections'' of similar design. Ι betieve they face the same risk factors, as such, Ι decided to compute
only one cost of capital for the whole company.

Π. Methodotog5r for Cdculating the Cost of Capital: ιryAcc

Since Nike is funded with both debt and equity, Ι used the li/eighted Average Cost of Capital (WΑCC)
meιhod. Based on the latest available batance sheet, debt as a μοportion of total capital makes up 27.0 percent
and equity accounts for 73.0 percent:
Capiιal sources Book Values
Debt
Notes payabΙe $ 855.3
Long-terτn debt 435.9
$1,291.2 -), 27 .0γo of total capitaΙ
Equity $3,494.5 + 72.0γ0 of total capital

ΠΙ. Cost of Debt

My estimate of Nike's cost of debt is 4.3 percent. I aπived at this estimate by taking totaΙ intercst ex-
pense for the year 2Φl and dividing it by the company's aγerage debt balance.l The rate is lower than Treasury

'Debt balances as of May 3l, 2OoO, and 2Ool, were $t,444.6 and $ι,29l.2, respectively.
 Case 13: Nike, Ιnc.: Cost of Capital l83

yieΙds buι that is because Nike raised a portion of iκ funding needs through Japanese yen notes' which carry
rates betv,reen 2.0 percent to 4.3 percent.
After adjusting for ιax, the cost of debt comes out to 2.7 percent. I used a tax rate of 38 percenι which Ι
obtained by adding sιate{ω(es of 3 percent ιo ιhe U.S. statutory tω( rate. Ηistorically' Nike's state taxes have
ranged from 2.5 percent to 3.5 percent.

tV. Cost of Equity

Ι estimated the cost of equity using the Capital Αsset Pricing Model (CΑPM). other methods such as the
Dividend Discount Model (DDM) and the Earnings CapiιaΙization Ratio can be used to estimate the cost of eq-
uity. Howeveη in my opinion, the CAPM is the superior method.
My estimate of Nike's cost of equity is t0.5 percent. Ι used the curent yield on 2Gyear Trcasury bonds
as my risk-free raιe, and the compoυnd average premium of the market over Trcasury bonds (5.9 peΙcent) as my
risk prcmium. For beιa, Ι took the average of Nike's beιa from 1996 to the present.

V. Putting itΑll Together

Ιnpuning atl my assumptions into the I${ACC formutη my estimaω of Nike's cosι of capital is 8.3 percenι

}vAcc : Ιζd (1 _ E) + ξ
t) * D/(D + * E/(D + E)

= 2.7To * 27.0% + t0.5% * 72.0%

= 8.3To
Questions

1. What is WACC and why is it important to estimate a firm's cost of capital?

2. Do you agree with Joanna Cohen's WACC calculation? Why orwhy not?

3. lf you do not agree with Joanna's analysis, calculate your WACC for Nike
and be ready to justify your assumptions.

4. Galculate the costs of equity using CAPM, the dividend discount model
(DDM), and the eamings capitalization model (ECM). What are the
advantages and disadvantages of each method?

5. \Mat should Κmi Ford recommend regarding an investment in Nike?