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IMT-NAGPUR

Cost of Capital NIKE INC


CORPORATE FINANCE
1/4/2013

Submitted by
TWINKLE JAIN- 2012343 UDIT MITTAL-2012344 UJJAWAL ASHOK BAID-2012345 UMANG RITOLIA-2012346 UPENDRA.KS-2012347 UTKARSH SHRIVASTAVA-2012348

Submitted To
Dr.KULBIR SINGH

Group 5 Section F

Contents
SUMMARY OF CASE ................................................................................................................................ 2 NIKEs PLAN ......................................................................................................................................... 2 WACC CALCULATION........................................................................................................................... 2 MARKET VALUES OF DEBT AND EQUITY ......................................................................................... 2 Cost of DEBT and EQUITY using CAPM :.......................................................................................... 3 Cost of Equity using DIVIDED DISCOUNT MODEL ........................................................................... 4 Cost of Equity using EARNING CAPITALISATION MODEL: ............................................................... 4 LIQUIDITY RATIO: ................................................................................................................................ 4 CONCLUSION:.......................................................................................................................................... 6

Group 5 Section F

SUMMARY OF CASE
Portfolio manager Kimi Ford of NorthPoint group is very much confused whether to buy Nikes stock. Nike has experienced sales growth decline in income from almost $800 million to $580 million and market share had fallen from 48% in 1997 to 42% in 2000. In addition recent supply chain issues and adverse effect of a strong dollar had a negatively effect on revenue.

NIKEs PLAN
To boost revenue Nike wants to develop more athletic-shoe products in mid-priced segments. Nike also plans to push its apparel line. On cost side, Nike would exert more effort on expense control. Finally company reiterated their long term revenue growth targets of 8% to 10% and earnings growth targets of above 15%. Kimi Ford read all the reports of Nike and now is confused. Lehman Brothers report recommended a strong buy of shares while an USB Warburg and CSFB analyst recommends a hold of buying shares. Hence Kimi ford develops his own discounted cash flow forecast.

WACC CALCULATION
The weighted average cost of capital (WACC) is the rate (expressed as a percentage, like interest) that a company is expected to pay to debt holders (cost of debt) and shareholders (cost of equity) to finance its assets. It is the minimum return that a company must earn on existing asset base to satisfy its creditors, owners, and other providers of capital. Companies raise money from a number of sources: common equity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants, and options, pension liabilities, executive stock options, governmental subsidies, and so on. WACC is calculated taking into account the relative weights of each component of the capital structure- debt and equity, and is used to see if the investment is worthwhile to undertake

WACC

=
WACC = (

Cost of DEBT

Cost of Equity

MARKET VALUES OF DEBT AND EQUITY Market value of equity (E) = current market price of share * current share outstanding = 42.09* 271.5 = 11427.435 Market value of Debt (D) = long term debt (discounted) + notes payable + current liability = x(408.337) + 432.0 + 5.4 = 1269.037 Weight of debt = 1269.037 / (11427.435 + 1269.037) = .09995 (9.995 %) Weight of equity = 11427.435 / (11427.435 + 1269.037) = .90005 (90.005%)

Group 5 Section F Cost of DEBT and EQUITY using CAPM : Using Capital asset pricing model we shall calculate the cost of equity.

The next issue at hand is finding the correct costs of debt and equity in order to find an accurate calculation of WACC. Because there is no other given yield that is comparable to a 25-year valuation period, our risk free rate used in calculations is 5.74%. Therefore = 5.74 %

There are two historical equity risk premiums given for a time period from 1926 to 1999: Geometric mean and arithmetic mean. The geometric mean is a better estimate for longer life valuation while the arithmetic mean is better for a one-year estimated expected return. Therefore, we chose to use the geometric mean to coincide with the choice to use the 20-year yield on U.S. Treasuries, which is 5.9%. Therefore market risk premium = 5.9 % Next we turn our attention to calculate . As it is given that average value of is 0.8 we take that value in our calculation. Therefore = 0.8

= 0.1046 (10.46%) Cost of debt was calculated by finding the yield to maturity on 20-year Nike Inc. debt with a 6.75% coupon semi-annually. We assumed Nike Inc. to have a single cost of capital since its multiple business segments (shoes, apparel, sports equipment, etc.) are not very different and would experience similar risks and betas. 956 = The value of can be calculated using the formula
( )

where

M = maturity amount P = current market price of the bond C = coupon amount (6.75 % of 1000 = 67.5) N = maturity period (for semi-annual bond its n*2 (40))

Substituting the values Hence Cost of debt

or Effective

7.137.

Group 5 Section F WACC = ( WACC = = 0.0948 or 9.483% Cost of Equity using DIVIDED DISCOUNT MODEL The assumption made with this model is that the company pays a substantial dividend, but Nike Inc. does not. Therefore, we rejected this model because it does not reflect the true cost of capital. The calculation is as follows: where D is the divided expected to be paid, is the current market price of share is 42.09 and is 0.48 . ) ( )

and g is the growth rate of divided. It is given that g is forecasted as 5.5% , Hence substituting in above equation we get

Cost of Equity using EARNING CAPITALISATION MODEL: The final model used to compute the cost of capital was the earning capitalization model. The problem with this model is that it does not take into consideration the growth of the company. Therefore we chose to reject this calculation. The earnings capitalization model calculations were found this way ECM = where is earning per share for next period and is current market price of share. Substituting the values ECM = = = 0.05511 or 5.511%

LIQUIDITY RATIO:
Current ratio is used to estimate the solvency of company in short term. The current ratio of 2:1 represents a highly solvent position. Current ratio = = = = 2.029 for the year 2001 = 1.68 for the year 2000

Liquidity ratio is good for the year 2001 since the Nike can able to meet is assets with its current liability.

Group 5 Section F ADVANTAGES AND DISADVANTAGES of various methods used in calculating Cost of Equity METHODS ADVANTAGES More realistic since it considers only systematic risk More theoretically derived relation between risk and market premium Good flexibility when estimating future dividend streams DISADVANTAGES Its difficult in calculating beta for all projects People sometimes focus on market risk to exclusion of corporate risk and make mistakes Subjective inputs can result in miss specified models and bad results COST OF EQUITY

CAPM

10.46%

6.64%

DIVIDEND DISCOUNT MODEL

EARNING CAPITALIZATION MODEL

Provides value approximation even when the inputs are overly simplified Avoids force fit assumptions into the model Allows sensitivity testing and analysing market reactions to changing circumstances Very easy to calculate

High sensitive to small changes in input

Not good for growing firms but appropriate for no-growth firms.

5.51%

Following are the reasons to why it is important to estimate a firms cost:Capital Budgeting Decision: It is important to estimate a firms cost of capital to decide Capital Budgeting Decision. Cost of capital is used to decide whether an investment proposal should be undertaken or not. A wrong estimation of WACC would lead to selection of a wrong investment or rejecting a good investment proposal. Method of financing decision: The WACC can be observed constantly to see the market changes in interest rate on load and dividend rates on stocks to make a better choice of the source of financing when the firm needs financing. The idea here is to minimize the cost of capital based on market changes.

Group 5 Section F Firms Performance: This can also be used as a measure to evaluate the performance of the firm based on comparing the returns that it is getting from a selected project and the cost it is incurring in raising the finance for this project.

CONCLUSION:
When Joanna Cohen used the cost of capital as 8.4%, as per the sensitivity analysis the price of share becomes $63.50, but the current market price of the share is 42.09. Hence the share is undervalued for $21.41. As per our calculation by WACC (9.438%) using CAPM model the sensitivity analysis report points the price of share is $55.68 while the current market price of the share is 42.09. Hence it is under-valued by $13.59. By the above analysis we conclude the NIKE INC can be added to North Point group portfolio since the prices are under-valued. Management of NIKE INC is also planning for profit maximizing and cost reduction techniques. All of the plans laid out at the executive meeting 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 elaborated by ratio analysis.