Nike, Inc Cost of Capital Case Study

8/11/2019 Nike, Inc Cost of Capital Case Study

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Nike, Inc.:Cost of Capital


2/19

Case Background:NorthPoint Large Cap Fund weighing whether tobuy Nikes stock. Nike has experienced sales growth decline,

declines in profits and market share.Nike has reveal that it would increase exposurein mid-price footwear and apparel lines. It alsocommits to cut down expenses.

The market responded mixed signals to Nikeschanges. Kimi Ford has done a cash flowestimation, and ask her assistant, Joanna Cohento estimate cost of capital.

Nike, Inc.:


3/19

What is WACC? and why is it important toestimate a firms cost of capital?

The cost of capital is the rate of returnrequired by a capital provider in exchange

for foregoing an investment in anotherproject or business with similar risk. Thus, itis also known as an opportunity cost.Since WACC is the minimum return requiredby capital providers, managers shouldinvest only in projects that generate returnsin excess of WACC.


4/19

What is WACC? and why is it important toestimate a firms cost of capital?

The WACC is set by the investors (ormarkets), not by managers. Therefore, we

cannoto b s e r v e

the true WACC, we can onlye s t i m a t e it.


5/19

Do you agree with Joanna CohensWACC estimations? Why or why not?

IssuesSingle cost or Multiple Cost?Cost of debtCost of equity

Weights of capital components


6/19

Single cost or Multiple Cost?Should Cohen estimate different cost ofcapital for footwear and apparel divisions?I agree with the use of the single cost

instead of multiple costs of capital. Thereason of estimating WACC is to value thecash flows for the entire firm, that isprovided by Kimi Ford. Plus, the businesssegments of Nike basically have about thesame risk; thus, a single cost is sufficientfor this analysis.


7/19

Cost of debt

The WACC is used for discounting cash flows inthe future, thus all components of cost must

reflect firms concurrent or future abilities inraising capital.Cohen mistakenly uses the historical data inestimating the cost of debt. She divided theinterest expenses by the average balance of debtto get 4.3% of before tax cost of debt. It may notreflect Nikes current or future cost of debt.


8/19

The cost of debt, if it is intent to be forwarding looking,should be estimated by 1. yield to maturity of bond, or 2.according to credit rating.The more appropriate cost of debt can be calculated byusing data provided in Exhibit 4. We can calculate thecurrent yield to maturity of the Nikes bond to representNikes current cost of debt.

PV= 95.60N=40Pmt=-3.375FV=-100Comp I = 3.58% (semiannual) 7.16% (annual)

After tax cost of debt = 7.16%(1-38%) = 4.44%


9/19

Cost of equity

Joanna Cohen seems to use CAPM toestimate cost of equity. Her number comesfrom following:10.5% = 5.74% +(5.9%)*0.80

Her risk free rate comes from 20-year T-bond rateCohen uses average beta from 1996 to July 2001,0.80.Cohen uses a geometric mean of market riskpremium 5.9%


10/19

Comments on cost of equity The risk-free rate

It is no problem to use 20-year T-bond rate torepresent risk-free rate. The cost of equityand the WACC are used to discount cashflows of very long run, thus rate of return a T-bond with 20 years maturity, 5.74%, is thelongest rate that are available.


11/19

To use a geometric mean of market risk premium5.9% is also correct. Using arithmetic mean torepresent true market risk premium, we have tohave independently distributed market riskpremium. It is often found that market riskpremium are negatively serial correlated.

Comments on cost of equity The market risk premium


12/19

I dont agree that Cohen uses average beta from 1996to July 2001, 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 betawill most relevant in this respect. So I suggest using themost recent beta estimate, 0.69.

Comments on cost of equity The market risk, beta


13/19

Cost of equity

Therefore, my estimate of cost of equity will be:

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


14/19


Cohen is wrong to use book values as the basisfor debt and equity weights; the market valuesshould be used in calculating weights.The reasoning of using market weights toestimate WACC is that it is how much it willcause the firm to raise capital today. That cost

is approximated by the market value of capital,not by the book value of capital.


15/19

For market value of equity, $42.09*273.3 mnshares = 11,503 mn.Due to the lack of information of the market valueof debt, book value of debt, 1,291 mn, is used tocalculate weights.Thus, the market value weight for equity is 11,503

/ (11,503+1,291) = 89.9%; the weight for debt is10.1%.



16/19

The WACC

Thus, my calculation of the WACC is as follow:

4.44%*0.101 + 9.81%*0.899 = 9.27%


17/19

What should Kimi Ford recommendregarding an investment in Nike?

To discount cash flows in Exhibit 2 with thecalculated WACC 9.27%, the present value equals$58.13 per share, which is more than currentmarket price of $42.09.Some might think this value is still understated,due to that current growth rate used (6% to 7%) ismuch lower than that estimated by manager (8% to10%). So the recommendation is to BUY!


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2001 2002 2003 2004 2005 2006 2007 2008Free Cah Flows to Firm 764.1 663.1 777.6 866.2 1014 1117.6

Terminal ValueCash flows 764.1 663.1 777.6 866.2 1014 1117.6 127The Firm Value $17,079Less: Current debt 1296.6

Equity Value $15,782Shares Number 271.5Equity Value per share 58.13052

Terminal Value 25835.422012 Cash Flow 1619.881Permanent Growth 0.03WACC 0.0927


19/19

Stock split: 03-Apr-07 [2:1]

Nike, Inc Cost of Capital Case Study

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