Nike, Inc.

: Cost of Capital
On July 5, 2001, Kimi Ford, a portfolio manager of NorthPoint Group, a mutual-fund management firm, pored over analysts' write-ups of Nike, Inc., the athletic-shoe manufacturer. Nike's share price had declined significantly from the beginning of the year. Ford was considering buying some shares for the fund she managed, the NorthPoint Large-Cap Fund, which invested mostly in Fortune 500 companies, with an emphasis on value investing. Its top holdings included ExxonMobil, General Motors, McDonald's, 3M, and other large-cap, generally old-economy stocks. While the stock market had declined over the last 18 months, the NorthPoint Large-Cap Fund had performed extremely well. In 2000, the fund earned a return of 20.7%, even as the .S&P 500 fell 10.1 %. At the end of June 2001, the fund's year-to-date returns stood at 6.4% versus -7.3% for the S&P 500. Only a week earlier, on June 28, 2001, Nike had held an analysts' meeting to disclose its fiscal-year 2001 results.1 The meeting, however, had another purpose: Nike management wanted to communicate a strategy for revitalizing the company. Since 1997, its revenues had plateaued at around $9 billion, while net income had fallen from almost $800 million to $580 million (see Exhibit 1). Nike's market share in U.S. athletic shoes had fallen from 48%, in 1997; to 42% in 2000.2 In addition, recent supply-chain issues and the adverse effect of a strong dollar had negatively affected revenue. At the meeting, management revealed plans to address both top-line growth and operating performance. To boost revenue, the company would develop more athletic shoe products in the mid-priced segment3 – a segment that Nike had overlooked in recent years. Nike also planned to push its apparel line, which, under the recent leadership of industry veteran Mindy Grossman,4 had performed extremely well. On the cost side, Nike would exert more effort on expense control. Finally, company executives reiterated their long-term revenue-growth targets of 8% to 10% and earnings-growth target of above 15%. Analysts' reactions were mixed. Some thought the financial targets were too aggressive; others saw significant growth opportunities in apparel and in Nike's international businesses. Kimi Ford read all 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 flow forecast to come to a clearer conclusion. Her forecast showed that, at a discount rate of 12%, Nike was overvalued at its current share price of $42.09 (Exhibit 2). However, she had done a quick sensitivity analysis that

Something: Nike's insularity and Foot-Dragging Have It Running in Place. she asked her new assistant. Cohen submitted her cost-of-capital estimate and a memo (Exhibit 5) explaining her assumptions to Ford. to estimate Nike's cost of capital.. . She was the former president and chief executive of Jones Apparel Group's Polo Jeans division. Cohen immediately gathered all the data she thought she might need (Exhibits 1 through 4) and began to work on her analysis. 4 Mindy Grossman joined Nike in September 2000." BusinessWeek. Douglas Robson.revealed Nike was undervalued at discount rates below 11. At the end of the day.17%. 3 Sneakers in this segment sold for $70-$90 a pair. "Just Do .. (2 July 2001). Joanna Cohen. 1 2 Nike's fiscal year ended in May. Because she was about to go into a meeting.

is to take into account only long-term debt. Incorrect Equity – We found that Ms. preferred stock. and debt.74% as the Risk free rate was incorrect and she should have used the short-term rate (12 months or less) instead. which in this case is 3. 3. Incorrect Debt – We found that the debt of the firm was calculated improperly when Ms.8 instead of the using the most current year-to-date beta of 0. Cohen used the average of Nike’s historical betas which comes to 0.69 that was just calculated recently. Ms.59%. in the case of Nike.Questions: 1. The WACC is calculated based on (1) estimates of the component costs of common equity. and (3) Debt-to-Value and Equity-toValue ratios.000 which was incorrect because when calculating the equity she should have used the current market value should be included which is calculated by multiplying the current stock price by the current number of shares outstanding. Cohen used a tax rate of 38% which is incorrect since we believe that she should have used a tax rate of 36% which is the most recent tax rate paid by Nike in 2001 and is therefore more likely to be the most accurate rate. .494. Cohen added short-term debt and notes payable to the long-term debt. and debt. When calculating the WACC the correct method. Cohen.Cohen calculated the Equity figure by including all of the shareholders’ equity to arrive at a figure of 3. 4.500. 2.. What is the WACC and why is it important to estimate a firm’s cost of capital? Do you agree with Joanna Cohen’s WACC calculation? Why or why not? WACC is the weighted average cost of capital and is a blended measure of a firm’s overall cost of capital and is comprised of all of the firm’s various components’ costs. preferred stock. After reviewing all of the information available to us regarding the firm and the subsequent calculations presented by Ms. Incorrect Tax Rate – We found that Ms. 5. Inc. or the required rate of return on each capital component. Incorrect Risk Free Rate – We found that Ms. which are: 1. (2) the firm’s expected tax rate (both federal and state). The WACC represents the minimum rate of return that the firm expects to earn on any capital investments they may make and is the correct cost of capital to use when analyzing capital budgeting decisions. such as common stock. Incorrect Beta – We found that the beta used by Ms.Cohen’s decision to use the 20-year bond rate of 5. we found that we did not agree with the methods she used to reach the WACC results due to the fact that she made several assumptions that we believe to be incorrect. Cohen is also incorrect.

If you do not agree with Cohen’s analysis.1674% (1 – 36%) x (435.9 + 11.001683 + .50% Risk Free Rate = 3.1674% (64%) x (.59% β = 0. calculate your own WACC for Nike and be prepared to justify your assumptions.863.000 = 11.863.288% x (11.59%) => 3.427.75/2) = 3.91%) => 3.427.69 Debt.09 x 271.698 => 6.5% .9 Equity.3) + 6.59% + 2.427. D = 435.288% x (.4/11. E = 42.288% WACC Calculation: WACC = rd(1-T) x (D/V) + re x (E/V) => 7.59% + (0.3 Solving for Rd and Re and Tax Rate Tax Rate = 36% Cost of Debt N = 40 PMT = (6.500.3.50% Re = rf + β(rm – rf) => 3.69)( 7.1674% Rd = 2 x I/Y = 7.1674% Cost of Equity (via CAPM method) rf = 3. β = 0.9/11.69 rm = 7. Formulas Used in Calculation: WACC = rd(1-T) x (D/V) + re x (E/V) Re = R + Credit Risk Rate (1-t) D = Long Term Debt E = Current Stock Price x Number of Shares Outstanding rm = Market Risk Rate rf = Risk Free Rate CAPM .59% + (0.60 FV = 100 I/Y = 3.288 Re = 6.5837 x 2 = 7.Re = rf + β (rm – rf) Value = E + D Case Study Data Factors: Tax Rate = 36% Market Risk Rate = 7.4 Value.9633) => 0.0367) + 6.4 = 11863.375 PV = -95.06057 .2. V = 435.3) => 7.59% Beta.69)(3.

S.09 = 0.52% .59%) = 3.09 + . We believe that short-term debts (listed under current liabilities) should only be used when calculating the WACC for small firms in the U.50% DDM Calculation: r = Div1/P0 + g = . Calculate the costs of equity using CAPM.23% Justification of Assumptions: a. Cost of Equity using Earnings Capitalization Ratio: Given an estimated EPS of $2. the dividend discount model.32 / $42.288% II.48.062253 WACC = 6.50% .09. 3. b.0552 Re = 5.59% + . Cost of Equity using Dividend Discount Model: Given the following: P0 = $42.64% III.055 = .= .70% Re = 6.69(7.055 = . c. and the earnings capitalization ratio.0114 + . and other international firms that rely upon it on a continuous basis for operations. Div1 = . d. What are the advantages and disadvantages of each method? I.48/42. We believe that rather than using the average historical beta it is more prudent to use the current year-to-date beta of the firm will more likely represent the current credit risk that the firm is currently operating under and therefore it will increase the accuracy of the estimated cost of equity and the subsequent WACC. We believe that using the current yield on 20-year Treasuries for the risk free rate is incorrect due to the fact that the CAPM is a short-term model that calls for a short-term interest rate such as the current yield on short-term Treasuries (12 months or less).32 and a current stock price of $42. We believe that using the most recent tax rate that the firm has paid more accurately reflects the current tax environment and thus is more likely to represent the actual tax rates the firm will encounter.09 gives us the following estimated cost of equity: $2.59% + 2. Cost of Equity using Capital Asset Pricing Model: CAPM Calculation: Re = rf + β (rm – rf) = 3. g = 5.3.0664 Re = 6.

Equity: 96. Ford immediately invest a substantial amount of the NorthPoint Large-Cap Fund in Nike.67% ii. c. Debt: 435.17%. . 3) Taking these component costs into account. Ford in which she concluded that Nike is undervalued at discount rates below 11. Debt: 3. Therefore rather than compute multiple costs of capital we thought that it would be appropriate to use to a single cost of capital for the entire company. Ms. Debt: 7. we calculated their cost of capital using the after-tax WACC method (based upon financial figures available) which gave us the following results: a. Inc.4 Component Costs of Capital i. since it is a definite value investment with its discount rate of 6.4. What should Kimi Ford recommend regarding an investment in Nike? Based upon the information available to us we reached the following conclusions: 1) Since non-Nike brands accounted for only 4.33% Market Value (in millions) i. debt and equity.23%. along with all of the additional relevant numbers available to us we calculated Nike’s after-tax WACC to be 6. that based upon the analysis by Ms.427. Equity: 11.23%.17% ii.29% b.9 ii. We would strongly recommend. 2) Since Nike utilizes two capital components.5% of Nike’s total revenue and the only non-sports related business segment was their Cole Haan line it was very likely that all of the various business segments faced the same risk factors. Equity: 6. Capital Structure i.

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