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Financial Management Case analysis: Nike Inc.: cost of capital
Group 4 - MBA (2nd term) Sugam Adhikari (12301) Sneha Amatya (12303) Suraj Bansal (12304) Monika Maheshwari (12319) Rojen Shestha
Date: 20th August 2012
management was presenting its plans to improve and perform better. On this regard. net margin ratio. Nike management addressed several issues that were causing the decrease in market sales and prices of stocks. . Thus we support the opinion of Lehman Brothers as a ‘Strong Buy’ as the stock of Nike can yield higher return to the investors in the future.54% and we calculated that below 11. is looking into the viability of investing in the stocks of Nike for the fund that she manages. investment ratios and the debt ratio.Synopsis The company's cost of capital is a critical element in decision making and is important to estimate precisely the weighted average cost of capital (WACC). Kimi Ford. came up with the cost of capital of 8.4% that was contradictory to Ford’s cost of capital of 12%. Cohen. This makes Nike a good investment and Joanna should buy the stocks of Nike even though the revenue has decreased as there is future growth potential in the stock which will lead to great returns for the investors. Thus we tried to conform to all the principles of finance to calculate the WACC and found that the stock of Nike was undervalued as the WACC was found to be 9. This case addresses the flaws in Cohen’s assumption and recalculates the WACC to obtain the most accurate cost of capital. liquidity ratios. The Stock being a sound investment was a big question? Thus we tried to see whether the stocks of Nike was a good buy or not and we have recalculated the WACC of Nike as many mistakes were found in the one calculated by Joanna. later. In this case.2% the stocks of Nike was undervalued. Not only that but we also tried to justify our findings by calculating the various financial ratios such as the profitability ratio. We also performed the SWOT analysis of Nike to determine the strength and opportunities of the firm which will subsequently lead to growth in the value of the stocks of the firm. a portfolio manager of a large mutual fund management firm. On the other hand. Kimi Ford asked her new assistant Joanna Cohen to estimate the Nike’s Cost of Capital with a keen interest to add Nike’s share to her portfolio.
Aside from footwear that makes 62% of the revenue. hockey jerseys and many other products. the mid.Joanna Cohen’s WACC calculation A firm's WACC is the overall required return on the firm as a whole and. Nike also sells apparel that makes 30% of the apparel complementing its footwear.Haan line. is reasonable. skate blades. Since the apparel and footwear are sold through the same marketing and distribution channels so they face same risk factors. Moreover Haan line comprised only a small portion of the revenues so she calculated only one cost of capital for the whole company. Nike has multiple business segments. Due to this.Nike branded products such as Cole.priced athletic shoes could be treated as a new product and thus may have a different risk as compared with the other business segments. Hence it is better to use only one cost of capital. This analysis seems very fair. But Nike has been planning to develop more athletic shoe products in the mid-priced segment which it was overlooking for many years and as well as to push its apparel line which is recently doing well. 1 . as such. Nike also has some of the non. it is often used internally by company directors to determine the economic feasibility of expansionary opportunities. But then while comparing these business segments whether they had different enough risks from each other or not she concluded that it was only the Haan line whose profile was different from the others. Thus due to this reason multiple cost of capital especially for the new project. ice skates. However. weight-age of capital for these new projects are not mentioned in the case. mixture of debt and equity. Since for every new project a different WACC is calculated due to the difference in the mixture of debt and equity used for every project. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm. Here in the case Joana Cohen has calculated the WACC by using the formula: WACC= Kd (1-t)*D/ (D+E) + Ke* E/ (D+E) Joanna has calculated the WACC on the basis of various assumptions and the appropriateness of the assumptions are mentioned below: Single cost of capital: Joanna has computed only one cost of capital for the whole company. the data like the rate of return. hockey sticks.
However the investment horizon is of 10 years (as per Exhibit 2).S. It would have been appropriate had she used the similar investment horizon i. the after-tax cost is used. because interest expense is deductible. Also GM is appropriate if a longer investment horizon is used. To calculate the Cost of Equity Joanna has used average method i. This can be measured in either before. Hence this seems to be appropriate as GM considers the compounding effect (Time value effect). Usually there are two methods to calculate the cost of equity: Discounted cash flow.e.S. however. The major sources for the debt were current portion of long term debt. However the Yield to Maturity method to calculate the cost of debt gives more accurate information. This seems to be appropriate but had she used the marginal tax rate the data would had been more appropriate. This seems appropriate but if she had beta for more years. Hence this method used by Joanna seems to be quite inappropriate to calculate the cost of debt. this would also include the riskiness and a more systematic risk would had been obtained. Cost of Equity Calculation: The cost of capital is the rate of return that a firm must earn on the projects in which it invests to maintain the market value of its stock. and CAPM. at 10 years investment horizon on the treasuries. Cost of debt calculation: It is the effective rate that a company pays on its current debt. Notes Payable. Joanna has used a tax rate of 38 % which she obtained by adding state taxes of 3% to the U. For the other factor required in the formula of CAPM that is risk premium on the market (RPm) she has used Geometric Mean (GM) to calculate the risk premium. she took the average of the past betas from 1996-2000. Also after evaluating the cost of debt the tax rate is deducted to obtain the required cost of capital. According to CAPM method: Ke= Rf + (RPm) β Joanna has assumed the risk free rate for 20 years on the U. Joanna has calculated the cost of debt by simply dividing the total interest expenses by average debt balance. But this marginal tax rate could not be 2 .e. statutory tax. long term debt.or after-tax returns. Treasuries. Joanna has used CAPM method to calculate the Cost of Equity. But calculating for this horizon is also appropriate.
But it is better to use the market value as the true picture of the firm is shown by the market value. hence it would be better to calculate the multiple WACC. as described below. The cost of debt should include the current market yield on Nike's publicly traded debt. Cohen simply divided the interest expense by the average balance of the interest. Cost of debt: To calculate the cost of debt. and a number of errors. Weightage used for capital structure: The weightage Joanna has used to calculate is the book value of equity and debt. Cost of Japanese debt: The risk related to Japanese debt comes not only from interest rate risk. Nike is a public company. Hence it is more appropriate to use the market value for determining the weights. Decision to use only one WACC: Joanna divided each division by revenue. she has assumed that the risks of the segment are same and thus she has used a single WACC. or to assign a WACC to each segment. Evaluation of Joanna Cohen's WACC Calculation Hence. Weighting the capital structure: She weights the capital structure using the book value of equity. and its market value is a more relevant for equity than the book value of equity. In deciding whether to use an overall WACC. but also more significantly from foreign currency exposure. This is not accurate. This risk has not been accounted for and is actually a more risky to the debt than fluctuations in the yield to maturity. Cohen's WACC calculation has a few issues. But since in the case it’s given that the Nike is also about to explore new segments.calculated as the data is not given. Marginal tax rate is the tax rate that is applicable to the company on the additional income. 3 .
It is the total cost of financing which in turn is the return that the investors expect out of investing in the company.09) = $11427. We have calculated the cost of debt by using the formula for YTM and the cost of debt is found to be 7.5%. Value of debt: The value of debt has also been calculated at the book value which will provide misappropriation in the weights of the debt and equity in the WACC calculation. It would have been 4 . WACC is normally used in the investing decision in a company. This made the weight of equity to appear a lot less than what it actually is. Had she used the market value of cost capital in her calculation of weight then she would have found that the market value of equity as (271.18%. Thus we calculate the market value of debt as $1277.42 which brings the weight of debt down to 10.4516%. As we know that even a minor increase or decrease in the WACC brings about a vast swing in the cost of financing for the company.Mistakes that Joanna Cohen made in her analysis: Joanna Cohen has made various mistakes in calculating the WACC and has gone against various principles in finance for the calculation. Cost of debt: The cost of debt has been calculated by taking the total interest expense for the year 2001 and dividing it by the company’s average debt balance and the cost of debt was calculated as 4.435.86. Hence.5 × $42. Here the cost of debt should be calculated by calculating the yield to maturity (YTM). Taking the market value for the debt value calculation would have been more appropriate as it provides a more real scenario in the weighted cost calculation. This is a wrong method to calculate the cost of debt. the weight of equity would be 89.05% of the total value of capital. Tax rate: The tax rate used is the addition of the statutory tax rate that is 35% and the state tax rate that is kept at 3% as Nike’s state tax rate ranges from 2.3%. And the total value of capital would be $12704. This leads to wrong projection of the portion of equity in the total capital which will jeopardize the weighted average cost of capital.95% of the total value of capital. Therefore analyst should be very careful as well as practical while calculating the WACC. These are the mistakes made by Joanna while calculating the WACC: Value of equity: The first thing that she did is she calculated the WACC on the basis of the book value of equity. Therefore the after tax cost of debt is 4.5% to 3.
42 *Par value of Nike’s Bond is assumed to be $100.9 X 95. 5 . and the company’s capital structure. 5. we can now find out the market value of Nike Inc.44 2.better if the firm’s marginal tax rate was used instead of this tax rate as this provides a more real picture of the after tax cost of debt and subsequently affects the weighted cost of debt in the weighted average cost of capital.e.60) 100* = $5. But in our calculation due to the lack of sufficient information related to the tax in the case we are also compelled to use the same tax rate as used by Joanna Cohen. This has not been justified as the cash flow of only 10 years has been provided.72 = $1.40 + $855. Therefore we have used the 10 year Treasury bond’s rate as the risk free rate and kept the geometric mean equity risk premium as geometric mean considers the time value and is useful for long term investment horizon. Market Value of Equity (E) Calculation: E= Stock Price X Number of Shares Outstanding = $42.9% as the risk premium.277. Using the above figures. Joanna Cohen has used long term risk free rate and risk premium which might be an inappropriate move towards calculation of the cost as small change can lead to huge difference in the total cost.5 = $11..427.09 X 271.30 + $416. Value of Debt Market Value of Debt (D) Calculation: D= Current LT Debt + Notes Payable + LT Debt (435. Also matching the investment horizon and the term of the risk free rate would have been a more appropriate approach to calculate the cost of equity. Calculation of WACC 1. Cost of equity: The cost of capital has been calculated on the basis of 20 year term Treasury bond as the risk free rate and the compound average premium of the market over Treasury bonds i.
86) =10. Next. 4. better. instead of the 20 year. we used the current yield on 10 year bond (5.05% We=E/(D+E) =(11427. Consequently.3. we chose to use the geometric mean to coincide with the choice to use the 10-year yield on U.S. Cost of debt was calculated by finding the yield to maturity on 20-year Nike Inc. treasuries. we calculated the cost of debt and equity. For the risk free rate. for use in the CAPM approach.95% We have not used redeemable preferred stock as no sufficient information about it (like dividend costs) is given in the case.39) U.9 percent. From here. Cost of Debt and Equity In order to find an accurate WACC we need to find the correct costs of debt and equity. debt with a 6. 6 .80) to account for the large fluctuations seen in Nike’s historic betas.86) =89. There are two historical equity risk premiums given for a time period from 1926 to 1999: Geometric mean and arithmetic mean.42/(12704. we felt the average beta reflected the historical business practices of Nike Inc. was to look forward and gain back market share and increase its revenues. we have to select the beta to use for Nike Inc.75% coupon semi-annually. but the goal of Nike Inc. We felt that the YTD beta was a reflection of current business practices. The logical choice was to use the average (0. Therefore. Treasuries. as the 10 year matches the duration of cash flows for the Nike's investment project (Exhibit 2) and because it is relatively less exposed to unexpected changes in inflation and the liquidity premium when compared to the longer 20 year bond.44/12704. Weightings The weights of debt and equity are calculated using the market values of debt and equity as follows: Weight of Debt(Wd) Weight of Equity(We) Wd = D/(D+E) =1277. The geometric mean is a better estimate for longer life valuation while the arithmetic mean is better for a one-year estimated expected return.S. which is 5. Likewise choosing the appropriate market risk premium is also very important.
39% 10 Year Yield on US Treasuries RPm= 5. It is generally seen as a much better method of calculating the cost of equity than the dividend growth model (DGM) in that it explicitly takes into account a company’s level of systematic risk relative to the stock market as a whole. It generates a theoretically-derived relationship between required return and systematic risk which has been subject to frequent empirical research and testing.8 Average Nike Beta KE = Rf + β(Rf .375+ 100-95.59% semiannually Kd= 7.8*5.90% Geometric Mean Beta = 0.6 40________ 100+191.2 3 =3.39 + 0.11% 5. Cost of Equity Capital Asset Pricing Model (CAPM) Reasons for selecting CAPM: It considers only systematic risk. Cost of Equity (KE) Rf = 5. 7 . CAPM was found to be more superior to other methods of calculating cost of equity. hence the cost of equity used in the WACC is one derived by CAPM. Cost of Debt Kd = YTM on 20 Year Nike Inc. Bond = C + FV-MV (n*2) FV+2MV/3 =3.Rm) = Rf + Beta*( RPm) = 5. reflecting a reality in which most investors have diversified portfolios from which unsystematic risk has been eliminated. Weighted Average Cost of Capital (WACC) for Nike Inc.18% annually.90 =10.
profitability of Nike is also improving.5413% The weighted average cost of capital for Nike Inc. Financial performance appraisal: Ratio Analysis 1.95%*10.The formula used is: WACC = Wd*kd(1-T) + We*ke. is 9. Gross Margin: The gross margin is the percentage gross profit on sales.e.11% = 0.4473858% + 9. 8 .Given the above trend and the management’s forecast the gross profit margin seems to improve.5% in 1998 and then recovering ever since till 2000 and turned down again . The Net profit margin is recovering from a low of 4% in 1998 to 6% in 2001 and has been consistent with the Gross profit margin as well as expenses management improving as well hence. The graph shows the percentage going as low as 36. the percentage of profit after operating expenses. WACC = Wd*Kd (1-T) + We*Ke = 10.5413 percent. Profitability ratios A. B.18 %( 1-38%) + 89.094% = 9. Net Margin = Net profit/Sales The graph shows a trend in the net profit margin i.05%*7.
6 times Acid test ratio = (Current Assets-Stock)/Current liabilities = (3596. Financial/Investment Ratios: Year 2000 2001 Return on Capital Employed (ROCE) = Net profit/Capital Employed 9 .7 2.03times Current Ratio = 3596.7 1.1)/1786. Year Current Asset Ratio = Current Assets/Current liabilities 2000 2001 3625.4/2140 = 1.3/1786.e. Nike Inc. D.C.2 times Comment: The liquidity ratios are rated good i.4-1446)/2140 = 1.e. is able to meet its current liabilities with current assets even when we have removed inventory (which is considered illiquid among the current assets). Nike is still sound on its liquidity position and has even improved from the preceding year 2000.3-1424. Therefore.005 times (3625. its ability to meet short term obligations with short term assets. Liquidity Ratios: These ratios measure the liquidity position of the firm in question i.
35% in 2001. E. 2. 3. Opportunities 10 . Strength Number one Sports brand in the world.63% in 2000 to 13.e. Debt ratio = Debt/ (Debt + Equity) Year 2000 = 580.35% The debt ratio of Nike Inc. Weakness Most of the profit margin comes from the shoe sector.4/4032.9 = 15.62% ROCE is a measure of the returns that a company is realizing from its capital employed.9/3716. The result shows that though performance had slowed a bit Nike Inc.= 579. A low leverage for a mature company is not healthy as can be seen that leverage has decreased from 15.7/4032.9 = 15. It manufactures wherever it can produce the highest quality products for the lowest price. with the improvement in profitability on the business it sets to improve.5% 589.9 14. The retail sector is very price sensitive. No factories that tie up cash in buildings and manufacturing. Questionable factory working conditions. has got a low financial risk and given the size of Nike and its establishment it should improve its leverage by use of debt in order to maximize shareholder value. Furthermore. Strong R&D and innovation. It is commonly used as a measure for comparing the performance between businesses and for assessing whether a business generates enough returns to pay for its cost of capital. SWOT Analysis 1.1/3716.63% 2001 538. is still giving shareholders a return which is more than the cost of capital.9 13. is very low i. Leverage Ratio This is a measure of financial risk within a firm and is calculated as follows. Global Brand.
We can conclude Nike Inc. Could develop sportswear. We also did the ratio analysis of the company’s performance. Threats Nike is exposed to the international nature of trade. 13.S. The declining market share in U.09. The plans laid out by Nike’s executives display that the company is heading on the recovery path and there is potential for abnormal profits given the growth capacity that Nike has got as shown by ratio analysis. So. expense control and other incentives.54% will be approximately $ 55.35% as on 2001 which signifies lower financial risk and it 11 . weaknesses. We also have performed SWOT analysis of the company in order to identify its strengths. seems a sound investment to put your money on by specially taking into consideration the fact that the stock of Nike is clearly undervalued and North-Point Group can take the advantage of the undervaluation to increase its investors wealth. sunglasses and jewelry. as it is investing in mid-priced segment that was previously overlooked. management has goals for the near future that could provide a great deal of profit for Nike Inc. Make efforts to reduce pollution generated from Nike manufacturing factors.e.21 per share which is certainly the good opportunity to grab. 4% net margin) and move higher to 6% in 2001.2%. Reduce prices in Asian and third world countries to increase market share.30 while the current price is $ 42. Even the debt-equity ratio is very low i. Though the initial analysis. Competitive market for sports shoes. It can capitalize on the various opportunities to increase its market share and profits by overcoming its weaknesses and minimizing the various threats. It has clearly leaped the low of 1998(i. Secondly. and the opportunities and threats in the Nike’s environment. Nike Inc. the difference between the intrinsic value and market value is $13. Conclusion and Recommendations From the above calculation and analysis. taking 12% discount rate shows stock to be overvalued. pushing its apparel line.54% which is less than 11. Customer looking for better deal. 4. which makes Nike a good investment as sensitivity analysis shows that Nike is undervalued at discount rates below 11.2%. is strong company. our calculation computes the WACC to be 9.e. which clearly shows the company’s financial position is sound and its targets can be achieved if the plans are effectively implemented as they have the resource to dream big and achieve it. Thus the value per share taking WACC of 9. This entire managerial plan seems a good bet and can provide a healthy return and diversify its risk.
Looking on the past performance of the Nike Inc.got a financial power to restructure its capital to include higher portion of debt to further reduce its cost of capital. share against the market index it has shown that Nike can outperform the market returns and now that it had gown down and is undervalued as well so we would recommend to buy its shares. So we would certainly support the opinion of Lehman Brothers as a ‘Strong Buy’ which can yield higher return to investor and future is certainly bright for any investor willing to invest in Nike Inc. 12 .
investopedia.asp#ixzz23uQjDaT9 http://emfps.References: http://www.html http://www.blogspot.com/doc/21188529/Nike-Case-Study .scribd.com/2011/06/case-analysis-of-nike-inc-cost-of.com/terms/w/wacc.
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