Kenkel, Kerins, Kruse, Seifert 1

I. Introduction Kimi Ford, a portfolio manager at NorthPoint Group, was reviewing the financials of Nike Inc. to consider buying shares for the fund she managed, the NorthPoint Large-Cap Fund. A week before Kimi Ford began her research, Nike Inc. held an analysts’ meeting to reveal their 2001 fiscal results and for management to communicate a strategy to revitalize the company. Nike’s revenues since 1997 had ceased to grow from $9.0 billion, and net income had now fallen $220 million ($800MM - $580MM). In addition a study printed in Business Week revealed that Nike’s market share in the U.S. athletic shoe industry had fallen from 48 percent in 1997 to 42 percent in 2000. In the meeting, management planned to raise revenues by developing more athletic-shoe products in the mid-priced range, sold at $70-$90. Nike also planned to push its apparel line and exert more expense control. During the meeting, Nike’s executives expressed that the company would still continue with a long-term revenue growth target at 8-10 percent and earnings-growth targets above 15 percent. Kimi Ford decided that it was necessary to develop her own discounted-cash-flow forecast in order to arrive at a proper investment decision for her mutual fund. Her forecast proved that at a 10 percent discount rate, that Nike’s stock price was overvalued at $5.95 per share. In addition, a sensitivity analysis she created revealed that Nike stock was undervalued at discount rates less than 9.4 percent. Ford was not clear on a decision to buy Nike stock, so she asked Joanna Cohen to estimate Nike’s weighted average cost of capital. II. Cost of Capital Calculations Cohen calculated a weighted average cost of capital (WACC) of 8.3 percent by using the capital asset pricing model (CAPM) for Nike Inc. The problem with Cohen’s calculations is that she used the book value for both debt and equity. While the book value of debt is accepted as an estimate of market value, book value of equity should not be used when calculating cost of capital. The market value of equity is found by multiplying the stock price of Nike Inc. by the number of shares outstanding.
Market Value of Equity E= Stock Price $42.09 E= $11,427.44

# Shares Outstanding 271.5

This figure is much different than the book value of equity that Joanna Cohen used ($3,494.50). In addition, for market value of debt, Cohen uses the book value, when in fact she should have discounted the

Bond 7. we felt the average beta reflected the historical business practices of Nike Inc. which is 5.05% /D+E $12. Treasuries as the risk free rate.86 /D+E $12. Seifert 2 value of long-term debt that appears on the balance sheet.9 percent. and the company’s capital structure.75% coupon semi-annually (See Appendix A). better. The logical choice was to use the average (0.. and long-term debt discounted at Nike’s current coupon. Just as important as choosing a risk free rate is choosing the appropriate market risk premium.) are not very different and would experience similar risks and betas. to have a single cost of capital since its multiple business segments (shoes. Because there is no other given yield that is comparable to a 25-year valuation period. Therefore.427. We felt that the YTD beta was a reflection of current business practices.40 D= $1. we had to decide on a beta to use for Nike Inc. From here. The market value of debt is found by adding the current portion of long-term debt. we can now find the market value of Nike Inc.42 10. debt was valued over 25 years.704.704. etc. Weight of Debt W= W= Weight of Equity W= E W= $11. for use in the CAPM approach. sports equipment.S. notes payable.277.30 LT Debt (discounted) $416.Kenkel.8Average Nike Beta .74 percent.S.95% D $1. our risk free rate used in calculations is 5.44 89. We assumed Nike Inc. but the goal of Nike Inc.51% Rf MRP Beta 5.86 The next issue at hand is finding the correct costs of debt and equity in order to find an accurate calculation of WACC. we chose to use the geometric mean to coincide with the choice to use the 20-year yield on U. There are two historical equity risk premiums given for a time period from 1926 to 1999: Geometric mean and arithmetic mean.80) to account for the large fluctuations seen in Nike’s historic betas. The cost of equity was calculated as follows: Cost of Debt K(d) = Cost of Equity K(e) = CAPM Rf + Beta*(MRP) 10.277. Treasuries. Next. was to look forward and gain back market share and increase revenues. Kerins.74%20 Year Yield on US Treasuries 5.46% YTM on 20 Year Nike Inc.90%Geometric Mean 0. debt with a 6.72 Using these figures. which we found to be the correct figure given that Nike Inc.42 Notes Payable $855. Consequently. we calculated the cost of debt and equity. Market Value of Debt D= Current LT $5. Cost of debt was calculated by finding the yield to maturity on 20-year Nike Inc. apparel. Cohen used the 20-year yield on U. The geometric mean is a better estimate for longer life valuation while the arithmetic mean is better for a one-year estimated expected return. Kruse.

We already established that we found this discount rate to not reflect the true market value and solved for a discount rate that would be more accurate.14.48(1+.8765% The weighted average cost of capital for Nike Inc.4682% 9. Kerins.09. The earnings capitalization model calculations were found this way: ECM ECM = E1/Po 216/42. Along with this fact.8765 percent. We found the weighted average cost of capital by using CAPM. Kruse. using the weights and costs of debt and equity. This makes Nike Inc. is overvalued by $5. management has goals for the near future that could provide a great deal of profit for Nike Inc. we found that Nike Inc. Therefore. is 9.60 per share.31% III. finding a discount rate of 9. The calculation is as follows: DDM DDM = [Do(1+g)/Po] + g [0. The assumption made with this model is that the company pays a substantial dividend.49. Therefore we chose to reject this calculation. WACC WACC = Wd*Kd(1-T) + WeKe Wd*Kd(1-T) WeKe 0. share price overvalued by $5.055 6.055)/42. we rejected this model because it does not reflect the true cost of capital.09 5.Kenkel. should not be added to the NorthPoint Large-Cap Fund at this time because the stock is overvalued.8765 percent. The formula used is: WACC = wdkd(1-T) + weke. Seifert 3 At this point. The problem with this model is that it does not take into consideration the growth of the company. but Nike Inc. The next model that we used to calculate the cost of capital was the dividend discount model.70% The final model used to compute the cost of capital was the earning capitalization model. meaning that Nike Inc.4083% 9. She should keep a close eye on the company because Nike Inc. we calculated the WACC of Nike Inc. Recommendation Kimi Ford used a discount rate of 10 percent to find a share price of $36.95 as Nike is currently trading at $42. does not. All of the plans laid out at the .09] + . What Kimi Ford can do is wait for a better buy period when this stock is trading closer to the proper value. has growth potential that would be beneficial to the fund. Using this data. This discount rate results in a share price of $36.

. Kerins. Seifert 4 executive meeting display that the company is taking steps to move toward the future. making this a stock that could be attractive at a later date.Kenkel. Kruse.

Sign up to vote on this title
UsefulNot useful