Nike, Inc.: Cost of Capital On July 5, 2001, Kimi Ford, a portfolio manager at NorthPoint Group, a mutual fund ‘management firm, pored over analyst write-ups of Nike, Inc., the athletic shoe man- uufacturer. Nike's share price had declined significantly from the start of the year. Ford \was considering buying some shares for the fund she managed, the NothPoint 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 declined over the last 18 months, NorthPoint Large-Cap had performed extremely well, In 2000, the fund earned a return of 20.7 percent even as the S&P 500 fell 10.1 percent. The fund's year-1o-date returns at the end of June, 2001 stood at 6.4 percent versus the S&P 00's minus 7.3 percent. Only a week ago, on June 28, 2001, Nike held an analysts’ meeting to disclose its fiscal year 2001 results.' However, the meeting had another purpose: Nike man- ‘agement wanted to communicate a strategy for revitalizing the company. Since 1997, Nike’s 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. ath- Tetic shoes had fallen from 48 percent in 1997 to 42 percent in 2000. 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 segment’ —a segment that it had overlooked in recent ‘years, Nike also planned to push its apparel line, which, under the recent leadership "Nike al year ended in Mas. Robson, Douglas, “ust Do... Something: Nike's insularity and fot raging have it runing in place” Basness Week, Say 2, 2001 Sneakers in this segment so for $70-390 a pair “This case was prepared from publicly available information by Jessica Chan under the supervision of Professor Robert F. Brune. The financial suppor of the Baten Inst is gratefully acknowledged. This ‘ase was site a a asi for class discussion ater than lsat effective or inetective handling of fn administrative sation, Copyright © 2001 by the University of Virginia Daren School Foundation, (Charonesvile, VA. Allright served. To order copies, sen an email 0 slex@dardeapblishing com. No port ofthis publication may be reproduced, stored in a rviesl system, ued ina spreadsheet, oF ransmited {nan form or by any neans—electroni, mechanical, photocopying, recording, or otherwise—without the permission ofthe Danden School Foundation. Rev. 10S 9s196 Pan The Estimating the Cost of Capital of industry veteran Mindy Grossman,* had performed extremely well. On the cost XH side, Nike would exert more effort on expense control. Finally, company exec eG reiterated their long-term revenue growth targets of 8-10 percent, and earings growth o targets of above 15 percent er ‘Analyst reactions were mixed. Some thought the financial targets to be 100 aed aggressive; others saw significant growth opportunites in apparel and in Nike's inter- a national businesses. ah Kimi Ford read all the analyst reports that she could find about the June 28 meet- So ing, but the reports gave her no clear guidance: a Lehman Brothers report recom- op mended a ‘Strong Buy’ while UBS Warburg and CSFB analysts expressed misgivings ine about the company and recommended a ‘Hold’. Ford decided instead to develop her or own discounted-cash-flow forecast to come to a clearer conclusion. es Her forecast showed that at a discount rate of 12 percent, Nike was overvalued tne at its current share price of $42.09 (sce Exhibit 2), However, she had done a quick . Wvity analysis that revealed Nike was undervalued at discount rates below 11.2 percent, Since she was about 10 go into a meeting, she requested her new assis- Di tunt, Joanna Cohen, 10 estimate Nike's cost of capital Cohn immediately gathered all the data she thought she might need (Exhibits 1 through 4) and set out to work on her analysis. At the end of the day, she sub- riled her cost of capital estimate and a memo (Exhibit 5) explaining her assump- tions to Ford. fs Mat Go One Net Ete “The “Minay Grossman joined Nike a September 2000, She waste former president and chief executive of ones Appate! Groups Poo Jeans division.© cost utives rowth, ve 100 inter- meet ivings op her valued ‘quick below hibits 2 sub- sump- EXHIBIT 1_ | Consolidated Income Statements (Case 13. Nike, Ine: Cost of Capital 197 ‘Year Ended May 31 (in millions except per-share data) 1995 199619971998 199920002001 Revenues $47608. $6,4706 $9,1865 $95531 $87769 $8.9951 $9.4088 Cost of goods sold 2965.3 3006.7 5.5030 6.0655, 54038 57849 Gross profit 1,895.6 25639 36835 3.4876 3.2834 3,591.3 3,703.9 Seling and adminiswatve «1.2008 1/5886 2.9087 e238 24255 2.6064 2.6807 Operating income 6858 975.3 13798 863.8 856.8 «= NEKO 1.0142 Interest expense 22° 905 823800 4145.0 BT Other expense, net NT) M7 eB OSS kt Restructuring charge, net = = = 19 451 5 rs Income before income taxes 649.9 «809.1 1.2052 653.0746... 21.4 Income taxes 2502 59 4004 25342087 HO Net income $3907 _$ 5532 $ 7958 $ 3096 $ 4514 $ 5731 _$ 5097 Diluted earnings por ‘common share $196 $1.88 $268 $195 S187 S207 $2.18 ‘Average shares outstanding (diutod) 2980 © 2036 ©2070-2980 28752798283 Growth (%) Revenue a9 20040) as 5s (Operating income #22 0 45 G74) (08) 150 20 Netincome waa 439 a9) 13028 18 Margins () Gross margin m6 015k D380 (Operating margin qs 18090 98 10907 Net margin 85 ar 42 54 ea 62 Efsctive tax rate (%)° ses see eS 80800 “Tha US. staan tx rate was 25%. Te stato ax vaio yea rom 25% 193.5% Sowee: Company’ 10K SEC ting, UBS Warburg.198 Par Thre Estimating the Cost of Capital EXHIBIT 2 Discounted Cash Flow Analysis zoue 200320082005 2008 00720082009 2010201 Assumptions: Revenue row 0) 7 65 65 65 60 60 60 80 60 80 Cossiles oo 600 SS 585 500 5905S BS AO 580 sansa) 70 775 20-25 2502552050828 Taxa) sao 520 98098080830 BBO RO amen assets) 30380-38038 380808 HO Conentiabaieseaes(x) NSS NSS SMS SSNS ‘Yeatysepredaton and capex nua each thet - Cost tapi) 120 Temina vive gowh ra). so Discounts Cash Flow Gpertrgincone 12184 $19518 $1,540 $1,7170 $19600 $2.1959 S24102 S25540 52.7901 $29575 Tass ‘30516 sme ess 7610 SN? 9159 9703 10802 1.1209 NoPaT Tab4 e060 9699 10685 12000 1.9049 143 15840 17209 16337 ated thie RS ee Se Change in WC a8 749) (1063) (1904) (1950) (2067) (2181) se) 482) _ BOLO) Fro cas tow Feet c6a1 7778 eo? tore VAIS 12752 10517 14837 18727 Temna vale 79867 ott tows Wat 660) 7778 e662 foro 4176 12762 10817 1aB07 195715 Provorivaue olfows $0823 $ 5286 $ 5505 § S505 $ S154 $ S662 $ S768 $ 6459 § 5350 S65015, marae ane —_‘S114157 Less curertousioneg out s1z585 aay vate siona Cant shares ‘usansng ms uy ve po share m2 ‘cuont nae pce: [SS2] Sens of equity vale to discount ate: ote: Terminal values astmats using te conta Discount rate Equity vale grown mode! on = FoF. *(1 + Tein vali growth rt) asox eras 7 = score e125 sox 3508 10.00% sose 050% seat 100% az ss 00 150% oor 200% war(Case 13 Nike, Ie: Cos of Capital 199) EXHIBIT 3. | Consolidated Balance Sheets (tn mitions) Ascats Current assets Cash and equivalents ‘Accounts receivable Inventories Delerred income taxes Prepaid expenses ‘otal current assets Property, plant and equipment, net Identifiable intangible assets and goodwil, net Delerred income taxes and other assets Total assets Liabilities and shareholders’ equity ‘Current abit ‘Current portion of fong-term debt Notes payable ‘Accounts payable ‘Accrued lables Income taxes payable “otal curent abilities Longiterm debt Dotetred income taxes and other Habits Fledeemable preferred stock ‘Shareholders’ equity ‘Commen stock, par Capi in excoss of sated value ‘Unearned stock compensation ‘Accumulated other comprehensive income Ftained earnings “Total shareholders’ equity ‘otal liabilities and shareholders’ equity 21400 4703 103 03 $040 1214 142d a3 1625 38253 19188 3973 1782 S50198 ‘Source: Company 10K SEC fing,‘sar Young mnugeanu 9 af 8661 MONHER BREDOSEY UoREGG|‘seaNNg DUES Bloque ep Jo sens ‘sesodind Supe] popu use ane EO. °%405°S 90.0, 0100-86, WOH} YMHO'D PUBPIAIA JO 1SeDeI04 BUTT aNIEA, wo tet mo te iat as wes re) ote ks foes ks oo aes ‘runs gga enevve wear eae eG som -syseo0104 pur AsoySIH PUBPIAI oe - cozrs:t0e's ep senses om 0 coiceo ak LELPEPLEEELEELEDL ES fo eee rece e ESF Pet wee ae, reo a wo oss sag mom oases saan resto kine soso ven Ayeruue-1we8 Pred %8z'9 ‘wodnog 21900 oN PapeY, Anand YO PIBLA BLIND vase ve0w snowy vow 2ujewoep (oosi-s61) suru ne nt enor 1002's An ot 0002 Avenue eae (00545 01 axnBo4 souEUONaR Boe B10YS HN ueeeat'sn vo spk Wang 1002 “@ Ane punoiy 20 UG UoNeUie;u) jBOUBUI PUP THEN MEO |» LIGIHXaSource of data: Bloomberg Franca! Services, botson Assos Vearbock 1999, Value Une Investment Suey, BES, Case 13. Nike nes Cost of Capital — 201 EXHIBIT 5 | Joanna's Analysis 70: Kimi Ford FROM: Joanna Cohen are: aly 6, 2001 SUBJECT: Nike's Cost of Capital Based onthe following assumptions, my estimate of Nike's cost of capital is 8 4 percent: Single or Multiple Costs of Capital? “The ist question | considered was whether to,use single or multiple cass of capital given that Nike has multiple business segments. Aside from footwear, which makes up 62 percent of revenue, Nike also sels apparel (30 percent ‘of revenue) tat complement its fowear products. Inaction, Nike sels sport balls, timepieces, eyewear, skates, bats, and other equoment designed for sports actives. Equipment products account lor 3.8 porcent of revenue. Finally, Nk also sells some non-Nike branded products such as Cole-Haan dress and casual footwear, and ice skates, skate blades, hockey sticks, hockey jorsoys and other products under the Bauer trademark. Non-Nike brands account fo 5 percent of revenue, | asked myself whether Nike's business segments had diferent enough risks from each other to warrant itlerent costs of capital. Were their profiles realy diferent? I concluded that was only the Cole-Haan line that ‘was somewhat dferont:the rest wore all sports-related businesses. However, since Cole-Haan makes up only a tiny fraction of revenues, 1d nat think it necessary to compute a separate cost of capital. As forthe apparel and footwear lines, they are Sold through the same marketing and distibuton channels and are often marketed in “colecions” of similar design. believe they face the same rsk factors, as Suc, | decided to compute only one ost of capital forthe whole company. Methodology for Calculating the Cost of Capital: WACC ‘Since Nike is funded witn both debt and equity, | used the Weighted Average Cost of Capital (WACC) method, Based on the latest avalable Dalance sheet, debt as a proportion of total capital makes up 270 percent and ‘equity accounts for 73.0 percent: Capital Sources Book Values Deet Current portion of long-term debt $ Notes payable Long-term debt wa 27.0% of otal capital Equiy $4496 > 79.0% of ota capital Cost of Debt My estimate of Nike's cost of debts 43 percent. | rived at this estima by taking total interest expense forthe year 2001 and dividing it by the company’s average debt balance.’ The rate i lower than Treasury yields but that [s because Nike raised a portion of is funding needs though Japanese yen notes, which carry rales between 2.0 percent to 43 percent. ‘Alter adusting for tax, the cost of debt comes out to 2.7 percent. | usad a tax rato of 98 percent, which | ‘obiained by adding state taxes of 3 percent o the USS. statutory ax rato. Historically, Nikos state taxes have ranged from 2.5 percent to 9.5 percent. "Debt balances a o May 31,2000 an 2001 wore $14.6 and$1.206.6rspectnay,202 Par Three Estimating the Cost of Capital EXHIBIT 51 (continuea) Cost of Equity| | estimated the cost of equity using the Capital Assot Pricing Model (CAPM). Other methods such asthe Dividend Discount Model (ODM) and the Earnings Capitalization Ratio can be used to estimate the cost of equity. However, in my opinion, CAPM is the superior method. 'My estimate of Nike's cost of equity is 10.5 parent. used the currant yiold on 20-year Treasury bonds a5 iy risktee rate. and the compound average premium ofthe market over Treasury bonds (6.9 percent) as my risk premium For beta | took the average of Nike's beta trom 1996 to the present. Putting it AllTogether Inputting all my assumptions inte the WAC formula, my estimate of Nike's cost of capital is 8.4 percent WACC = Ky(1=)*D(D +E) +K, BIO +E) 27% 270% + 105% * 73.0% 24%