Nike, Inc.

:
Cost of Capital

Nike, Inc.:
Case

Background:

NorthPoint Large Cap Fund weighing whether to

buy Nikes stock.
Nike has experienced sales growth decline,
declines in profits and market share.
Nike has reveal that it would increase exposure
in mid-price footwear and apparel lines. It also
commits to cut down expenses.
The market responded mixed signals to Nikes
changes. Kimi Ford has done a cash flow
estimation, and ask her assistant, Joanna Cohen
to estimate cost of capital.

What is WACC? and why is it important to

estimate a firms cost of capital?
The

cost of capital is the rate of return

required by a capital provider in exchange
for foregoing an investment in another
project or business with similar risk. Thus, it
is also known as an opportunity cost.
Since WACC is the minimum return required
by capital providers, managers should
invest only in projects that generate returns
in excess of WACC.

What is WACC? and why is it important to

estimate a firms cost of capital?
The

WACC is set by the investors (or

markets), not by managers. Therefore, we
cannot observe the true WACC, we can only
estimate it.

Do you agree with Joanna Cohens

WACC estimations? Why or why not?
Issues
Single

cost or Multiple Cost?

Cost of debt
Cost of equity
Weights of capital components

Single cost or Multiple Cost?

Should

Cohen estimate different cost of

capital for footwear and apparel divisions?
I agree with the use of the single cost
instead of multiple costs of capital. The
reason of estimating WACC is to value the
cash flows for the entire firm, that is
provided by Kimi Ford. Plus, the business
segments of Nike basically have about the
same risk; thus, a single cost is sufficient
for this analysis.

Cost of debt
The

WACC is used for discounting cash flows in

the future, thus all components of cost must
reflect firms concurrent or future abilities in
raising capital.
Cohen mistakenly uses the historical data in
estimating the cost of debt. She divided the
interest expenses by the average balance of debt
to get 4.3% of before tax cost of debt. It may not
reflect Nikes current or future cost of debt.

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 by
using data provided in Exhibit 4. We can calculate the
current yield to maturity of the Nikes bond to represent
Nikes current cost of debt.

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

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

Cost of equity
Joanna

Cohen seems to use CAPM to

estimate cost of equity. Her number comes
from following:
10.5% = 5.74% +(5.9%)*0.80

Her risk free rate comes from 20-year T-bond rate

Cohen uses average beta from 1996 to July 2001,
0.80.
Cohen uses a geometric mean of market risk
premium 5.9%

Comments on cost of equity

The risk-free rate
It

is no problem to use 20-year T-bond rate to

represent risk-free rate. The cost of equity
and the WACC are used to discount cash
flows of very long run, thus rate of return a Tbond with 20 years maturity, 5.74%, is the
longest rate that are available.

Comments on cost of equity

The market risk premium
To

use a geometric mean of market risk premium

5.9% is also correct. Using arithmetic mean to
represent true market risk premium, we have to
have independently distributed market risk
premium. It is often found that market risk
premium are negatively serial correlated.

Comments on cost of equity

The market risk, beta

I dont agree that Cohen uses average beta from 1996

to 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 beta
will most relevant in this respect. So I suggest using the
most recent beta estimate, 0.69.

Cost of equity
Therefore, my estimate of cost of equity will be:
5.74% + (5.9%)* 0.69 = 9.81%

Weights of capital components

Cohen

is wrong to use book values as the basis

for debt and equity weights; the market values
should be used in calculating weights.
The reasoning of using market weights to
estimate WACC is that it is how much it will
cause the firm to raise capital today. That cost
is approximated by the market value of capital,
not by the book value of capital.

Weights of capital components

For

market value of equity, $42.09*273.3 mn

shares = 11,503 mn.
Due to the lack of information of the market value
of debt, book value of debt, 1,291 mn, is used to
calculate weights.
Thus, the market value weight for equity is 11,503
/ (11,503+1,291) = 89.9%; the weight for debt is
10.1%.

The WACC
Thus,

my calculation of the WACC is as follow:

4.44%*0.101

+ 9.81%*0.899 = 9.27%

What should Kimi Ford recommend

regarding an investment in Nike?
To

discount cash flows in Exhibit 2 with the

calculated WACC 9.27%, the present value equals
$58.13 per share, which is more than current
market price of $42.09.
Some might think this value is still understated,
due to that current growth rate used (6% to 7%) is
much lower than that estimated by manager (8% to
10%). So the recommendation is to BUY!

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