Kenkel, Kerins, Kruse, Seifert 1

I. Introduction Kimi Ford, a portfolio manager at NorthPoint Group, was reviewing the financials of Nike Inc. to consider u!ing shares for the fund she managed, the NorthPoint "arge#$ap Fund. % week efore Kimi Ford egan her research, Nike Inc. held an anal!sts& meeting to reveal their '((1 fiscal results and for management to communicate a strateg! to revitali)e the compan!. Nike&s revenues since 1**+ had ceased to grow from ,*.( illion, and net income had now fallen ,''( million -,.((// # ,0.(//1. In addition a stud! printed in 2usiness 3eek revealed that Nike&s market share in the 4.S. athletic shoe industr! had fallen from 5. percent in 1**+ to 5' percent in '(((. In the meeting, management planned to raise revenues ! developing more athletic#shoe products in the mid#priced range, sold at ,+(#,*(. Nike also planned to push its apparel line and e6ert more e6pense control. 7uring the meeting, Nike&s e6ecutives e6pressed that the compan! would still continue with a long#term revenue growth target at .#1( percent and earnings#growth targets a ove 10 percent. Kimi Ford decided that it was necessar! to develop her own discounted#cash#flow forecast in order to arrive at a proper investment decision for her mutual fund. 8er forecast proved that at a 1( percent discount rate, that Nike&s stock price was overvalued at ,0.*0 per share. In addition, a sensitivit! anal!sis she created revealed that Nike stock was undervalued at discount rates less than *.5 percent. Ford was not clear on a decision to u! Nike stock, so she asked 9oanna $ohen to estimate Nike&s weighted average cost of capital. II. Cost of Capital Calculations $ohen calculated a weighted average cost of capital -3%$$1 of ..: percent ! using the capital asset pricing model -$%P/1 for Nike Inc. ;he pro lem with $ohen&s calculations is that she used the ook value for oth de t and e<uit!. 3hile the ook value of de t is accepted as an estimate of market value, ook value of e<uit! should not e used when calculating cost of capital. ;he market value of e<uit! is found ! multipl!ing the stock price of Nike Inc. ! the num er of shares outstanding.
Market Value of Equity E= Stock Price ,5'.(* E= ,11,5'+.55

# Shares Outstanding '+1.0

;his figure is much different than the ook value of e<uit! that 9oanna $ohen used -,:,5*5.0(1. In addition, for market value of de t, $ohen uses the ook value, when in fact she should have discounted the

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value of long#term de t that appears on the alance sheet. ;he market value of de t is found ! adding the current portion of long#term de t, notes pa!a le, and long#term de t discounted at Nike&s current coupon.
Market Value of Debt D= Current LT ,0.5( D= ,1,'++.5'

Notes Payable ,.00.:(

LT Debt (discounted) ,51=.+'

4sing these figures, we can now find the market value of Nike Inc., and the compan!&s capital structure.
Weight of Debt 3> 3> Weight of Equity 3> A 3> ,11,5'+.55 .*.*0B

7 ,1,'++.5' 1(.(0B

?7@A ,1',+(5..=

?7@A ,1',+(5..=

;he ne6t issue at hand is finding the correct costs of de t and e<uit! in order to find an accurate calculation of 3%$$. $ohen used the '(#!ear !ield on 4.S. ;reasuries as the risk free rate, which we found to e the correct figure given that Nike Inc. de t was valued over '0 !ears. 2ecause there is no other given !ield that is compara le to a '0#!ear valuation period, our risk free rate used in calculations is 0.+5 percent. 9ust as important as choosing a risk free rate is choosing the appropriate market risk premium. ;here are two historical e<uit! risk premiums given for a time period from 1*'= to 1***C Geometric mean and arithmetic mean. ;he geometric mean is a etter estimate for longer life valuation while the arithmetic mean is etter for a one#!ear estimated e6pected return. ;herefore, we chose to use the geometric mean to coincide with the choice to use the '(#!ear !ield on 4.S. ;reasuries, which is 0.* percent. Ne6t, we had to decide on a eta to use for Nike Inc. for use in the $%P/ approach. ;he logical choice was to use the average -(..(1 to account for the large fluctuations seen in Nike&s historic etas. 3e felt that the D;7 eta was a reflection of current usiness practices, ut the goal of Nike Inc. was to look forward and gain ack market share and increase revenues. $onse<uentl!, we felt the average eta reflected the historical usiness practices of Nike Inc. etter. From here, we calculated the cost of de t and e<uit!. $ost of de t was calculated ! finding the !ield to maturit! on '(#!ear Nike Inc. de t with a =.+0B coupon semi#annuall! -See %ppendi6 %1. 3e assumed Nike Inc. to have a single cost of capital since its multiple usiness segments -shoes, apparel, sports e<uipment, etc.1 are not ver! different and would e6perience similar risks and etas. ;he cost of e<uit! was calculated as followsC
Cost of Debt (d) = Cost of Equity K-e1 > $%P/ Ef @ 2etaF-/EP1 1(.5=B

!T" on #$ !ear Nike %nc& 'ond +.01B

Ef /EP 2eta

0.+5B#$ !ear !ield on (S Treasuries 0.*(B)eo*etric "ean (..+,erage Nike 'eta

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%t this point, we calculated the 3%$$ of Nike Inc. using the weights and costs of de t and e<uit!. ;he formula used isC 3%$$ > wdkd-1#;1 @ weke.
WACC -+CC =

-d. d(/0T) 1 -e e 3dFKd-1#;1 3eKe (.5=.'B *.5(.:B 9. !"#$

;he weighted average cost of capital for Nike Inc. is *..+=0 percent. ;he ne6t model that we used to calculate the cost of capital was the dividend discount model. ;he assumption made with this model is that the compan! pa!s a su stantial dividend, ut Nike Inc. does not. ;herefore, we reGected this model ecause it does not reflect the true cost of capital. ;he calculation is as followsC
DDM DD" =

2Do(/1g)3Po4 1 g H(.5.-1@.(001?5'.(*I @ .(00 =.+(B

;he final model used to compute the cost of capital was the earning capitali)ation model. ;he pro lem with this model is that it does not take into consideration the growth of the compan!. ;herefore we chose to reGect this calculation. ;he earnings capitali)ation model calculations were found this wa!C
ECM EC" =

E/3Po '1=?5'.(* 0.:1B

III. %eco&&endation Kimi Ford used a discount rate of 1( percent to find a share price of ,:=.15. ;his makes Nike Inc. share price overvalued ! ,0.*0 as Nike is currentl! trading at ,5'.(*. 3e alread! esta lished that we found this discount rate to not reflect the true market value and solved for a discount rate that would e more accurate. 3e found the weighted average cost of capital ! using $%P/, finding a discount rate of *..+=0 percent. ;his discount rate results in a share price of ,:=.5*, meaning that Nike Inc. is overvalued ! ,0.=( per share. 4sing this data, we found that Nike Inc. should not e added to the NorthPoint "arge#$ap Fund at this time ecause the stock is overvalued. 3hat Kimi Ford can do is wait for a etter u! period when this stock is trading closer to the proper value. She should keep a close e!e on the compan! ecause Nike Inc. has growth potential that would e eneficial to the fund. %long with this fact, management has goals for the near future that could provide a great deal of profit for Nike Inc. %ll of the plans laid out at the

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e6ecutive meeting displa! that the compan! is taking steps to move toward the future, making this a stock that could e attractive at a later date.