Nike Inc.

, analysis (CFM - Corporate Finance Management)

Hi, I'm Nguyen Dinh Tien

MSc13, UCD 2011-2012.
I've done my main assignment and get good results, so i post my analysis on my blog, if anyone
interested in my assignment, pls enjoy it! ;)

My main assignment including Nike Inc., analysis and Compass Records analysis, so at the end of
Compass Records analysis, i posted my references for my analysis. Compass Records is below this
article.
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Case 1: Nike Inc.,

Summary of the case study

NorthPoint Large-Cap Fund, which invested mostly in Fortune 500 companies, weighing whether to

buy Nike’s 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 Nike’s changes. Kimi Ford

had done a cash flow estimation, and asked her assistant Joanna Cohen to estimate cost of capital.

The mistakes appeared. This analysis will determine basic and general theory about cost of capital

and relations, find out the mistakes in case analysis of Joanna Cohen, give the advises for Kimi

Ford. Moreover, this analysis also giving some of limitations when using DDM, CAPM, WACC for

calculating the cost of capital.

Question 1: Why is it important to estimate a firm’s cost of capital? What does it represent?

Is the WACC set by investors or by managers?

First, cost of capital is required return necessary to make a capital budgeting project/company. Cost

of capital includes the cost of debt and the cost of equity. Cost of debt includes cost of junk bonds,

cost of ordinary bonds, cost of bank loan (liabilities), while cost of equity includes cost of ordinary

shares (Modigliani & Miller, 1958). In general, according to Ibbotson(1999) that “the cost of capital is

function of investment, not the investor”. The marketplace is a place where investors can estimate
the risk of assets, projects and so on. Origin of cost of capital born from marketplace while investors

estimate, assessment the ability success of a project, company (Pratt & Grabowski, 2008).

Estimate a firm’s cost of capital is a very important mission must be done while analyze and find

out the decision about invest in a project or company. These reasons are considered the effect of

capital structure to cost of capital, investment decisions (Myers, 1974), firm value, share price of a

company, which may affect to the value and cost of capital by changing the capital structure. It also

help predict risk would be happen with a company (risk management). Moreover, estimate a firm’s or

projects’ cost of capital help investors can diversification their invest, reduce risk in invest,

maximization profits:

Frist of all, cost of capital using to Capital Budgeting Decision as the measuring for decision an

investment proposal (Myers, 1974). Normally, the company/investors will choose the project

(compare with many other projects) which give a higher return and lower risk on investment. If

company must decide the individual project, company will choose the project which give satisfactory

return on investment (Dixit, 1993). Of course, all of the projects which are chosen must be get higher

return than the cost of capital invest in that projects. It also help determine the acceptability of

investment opportunities.

Secondly, cost of capital also help for Designing the Corporate Finance Structure. In one side,

they always follow the changing of capital market for get information and choose the best way for

capital structure of company. In the other side, managers can use various methods to minimize

company’s cost of capital, changing the market price, the earning per share, bring out the benefit to

company (Pinches, 1982). Many companies before designing their corporate finance structure, they

try to figures their information such as accounting reports, their cost of capital to market. After that,

they listen carefully the market before decide their corporate finance structure. Even they get positive

or negative reply from market, they will have their decisions in designing their corporate finance

structure: cancel or invest in project (Kaua et al., 2008).

Moreover, cost of capital help managers Decide the Method of Financing. Understanding about

financial situations and the rate of interest on loan, normal dividend rate in the market is need
conditions of financial managers. It help managers can give out better react and balancing sources

of finance when faced with requires additonal finance, which help mimimize the cost of capital (Kaua

et al., 2008). Moreover, it also very important when using it for considerations of control relate factors

and reduce the risk for company.

In addition, cost of capital can also help board of management/investors estimate the Performance

of top Managers. The cost of capital can used to estimate, compare managing ability of

fi nancial managers (CEOs, CFOs), which base on evaluation between profi t of projects

(company) and cost of capital. As mention above that a company might listen the

market reply by present their accounting repor t, their cost of capital, a better manager

is a manager can get sensitivity reply from market, reduce the risk, increase the profi t

for company (Kaua et al., 2008) . That means we can use calculating cost of capital for

estimate the work ability of managers by assessment manager’s ability to earn profi t,

reduce risk and errors, manage debt including bad debt. Moreover, it also helps

estimate, manage the actual cost incurred in rising funds when manager require rising

funds for project.

Cost of capital represent by WACC (Weighted Average Cost of Capital ).The required

return will reflect the risk of the investment and the return of alternatives. WACC is sum of cost of

debt (Kd) and cost of equity (Ke). Usually, cost of debt calculating is very easy but cost of equity is

more difficult. Ke calculate by using DDM (Dividend Discount Model) or CAPM (Capital Asset Pricing

Model). In many case, many companies does not pay dividend at the end of the period, it might lead

to inaccurate calculating Ke, that is the reason why CAPM using more popular than DDM. Beside

that, CAPM also have advantages and disadvantages (that we will review and evaluation more in the

part of question 2: which method is the best for calculated cost of equity?).

To find the average cost of capital, we weight individual cost of capital by their proportions in the

firm’s capital structure:

WACC formula: WACC = (Ke x E)/(D + E) + [Kd x (1-Ct) x D]/(D + E)

 As mention above that WACC is required return will reflect the risk of the investment and the return of

alternatives. Companies need information about the cost of different sources of finance in order to

find the overall cost of finance and to make investment, financing decisions. So, basically, WACC set

by investors in the marketplace. According to Pratt and Grabowski (2008:5) is that “The cost of

capital, derived from investors expectation and the market consensus of those expectations, is

applied to expected economic income, usually measured by in term of cash flows, in order to

estimate the present value or to compare investment alternatives of similar of different risk”. WACC

set by investors when they calculate and find out the decisions about invest or reject invest into a

company/project. Managers just listen the market reply and react by estimate their options in invest

in a project or restructure their company, give it all for board of management (investors) who have the

final decisions. Beside that, it also help managers can adjusted share prices, market value of the firm

for firm’s benefit.

Question 2: What was your estimate about WACC? What mistake Joana Cohen make in her

analysis? Which method is best for calculating the cost of equity?

Using WACC formula:

WACC = (E/V). KE + (D/V). KD . (1-T)
 V = D + E = Total Capital
 D: Amount of Debt
 E: Equity
 KD: Cost of Debt
 KE: Equity
 T: Tax rate
According to case study we have:
T = 38% (in Exhibit 2)  1 – T = 0.62
E: Equity 2001 = $3494.5
D: Debt 2001 =
= Current portion of long-term debt + Notes payable + Long-term debt
= $5.4 + $855.3 + $435.9
= $1296.6
Beside that, we have:
E/V = 27% (proportion of equity)
D/V = 73% (proportion of debt)
 o Calculate KE : Cost of Equity

* Using DDM(Dividend Discount Model) for calculate Ke

Ke = D1/Po + g
D1 = D0(1+g)
D0 = 0.48; g = 5.5%
 D1 = 0.48 x (1 + 0.055)
= 0.5064
P0 = 42.09
So we have:
Ke = D1/Po + g
= 0.5064/42.09 + 5.5%
= 1.20% + 5.50%
= 6.70%
Because Nike did not pay dividend for share holders since after June 30, 2001, so this model (DDM)

can not accept for using for calculate Ke in this case because it does not reflect the true cost of

capital.

Using DDM(Dividend Discount Model) have also advantages and disadvantages. Advantages of

using DDM are allow significant flexibility when estimating future dividend streams, provide useful

value approximations even when the inputs are overly simplified, can be reversed so the current

stock price can be used to impute market assumptions for growth and expected return, specifying the

underlying assumptions allows for sensitivity testing and analyzing market reactions to changing

circumstances. Beside that, DDM also have its disadvantages are subjective inputs can result in

unspecified models and bad results, over-reliance on a valuation that is at heart an estimate, high

sensitivity to small changes in input assumptions (Michaud, 1985).

* Using CAPM (popular) for calculate Ke

KE = KRF + (KM – KRF) x Beta
 Beta: is seen as an ‘index of responsiveness’ of changes in a security’s returns relative to changes in
returns on the market, in this case is sport utility industry)
(In Exhibit 4 of Nike Inc., given from 1996 is Average beta = 0.80, beta in 2001 is 0.69)
 KRF: risk free rate
 (KM - KRF) : Risk market premium
 KM: Return on market.
Using KRF = Profitability rate of Government bonds (U.S. Treasury), in Exhibit 4 we have U.S
Treasury 20-year  KRF= 5.74%
According to Joana Cohen, she got risk premium = 5.90% (in Exhibit 4: geometric mean =
5.90%, arithmetic mean = 7.50%)

Because of arithmetic mean is better for one-year period estimated expected returns, while

geometric mean is better for long-term period valuation. So, for long life valuation, we can find stable

valuation (Jacquier et al., 2003). That’s the answer for Joana Cohen choses geometric mean for her

calculated.

Joanna Cohen calculated: KE = 5.74% + 5.90% x 0.80

= 10.46% ( rounding 10.5%)

Cohen uses average beta from 1996 to July 2001, 0.80 to be the measure of systematic risk, but we

need to find out a beta that is most representative to future beta. As such, most recent beta is the

best choice in this situation (Sharpe, 1995). So most recent beta estimate is recent beta at 06 June

2001 is 0.69.

We have : KE = 5.74% + 5.90% x 0.69

= 9.81%
CAPM model of William Sharpe (1964) and John Lintner (1965) has the advantage of simplicity and

can be applied in practice. However, like many other models, CAPM inevitable limitations and

criticism (Vintila, 2006). Maybe the attraction of CAPM is simplicity and easy to apply, but may be

CAPM too simple to apply, it lead to reflect not really true happen, its normally just a model (Fama &

French, 2003). There is only limited discussion highlights some of the CAPM model. These

abnormalities include:

The effect of firm size – it was discovered that the firm’s shares have small market value (market

capitalization = price per share x number of share) might get higher profitability of the firm’s stock

value market, if other factors the same (William, 1983). Effect of PE and MB ratios – it was found that

the stocks of companies with PE ratios (price/earning ratio) and the ratio of MB (market-to-book

value ratio) might get higher profitability shares of companies with PE ratios and high MB.

January Effect – Those who hold share for the period from December to January usually have

higher margins than other months. However, it was also noted that although the ‘January Effect’ was

found in January in many years but not always occur (Thaler, 1987).
 Criticism from researchers ‘Multifactor model’: proponents of ‘Multifactor Model’ that CAPM is

useful though for purposes of corporate finance but it does not provide the precise measurement of

the expected return of a particular stock. ‘Multifactor Model’ for stock that profits fluctuate depending

on many factors, not only the elements of change in general market (Ng et al., 1992), so if other

factors adding to the risk factors to explain the profit risk is much richer than just relying on a single

factor such as CAPM model.

o Calculate KD: Cost of Debt

According to Joanna Cohen: Total interest expense (2001) divide by company’s average debt

balance (With debt balance of May 31, 2000 is $1444.6 millions and 2001 is $1296.6 millions)

The WACC is used for discounting cash flows in the future (Lloyd& Davi, 2007), thus all components

of cost must reflect firm’s concurrent or future abilities in raising capital. But Joanna Cohen uses the

historical data in estimating the cost of debt -> She did a mistake here. 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

Nike’s current or future cost of debt.

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. Cost of capital based on market value not

book value (Pratt & Grabowski, 2008).

For market value of equity = Current Share Price x Average Shares Outstanding

= $42.09 x 273.3m

= $11,503m.

Due to the lack of information of the market value of debt, book value of debt, $1,291m, is used to

calculate weights.

Thus, the market value weight for equity is

= 1-[11,503 / (11,503+1,291)]

= 1 - 89.9% = 10.1%
 So, the weight for debt is 10.1%.

The cost of debt, if it is intent to be forwarding looking, should be estimated by yield to maturity of

bond or 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 Nike’s bond to represent Nike’s current cost of debt.

 PV= 95.60
 n=40
 FV=100
 I = 3.375% (semiannual) 6.75% (annual)
95.6 = I x [1/(1+r) + 1/(1+r)2 + 1/(1+r)3+…+1/(1+r)40] + 100/(1+r)40
<->95.6 = {3.375 x [1-(1+r)-40]/r} + 100/(1+r)40
If r=4% -> NPV1 = 3.375x[1-(1+0.04)-40/0.04] + 100/(1+0.04) 40
= 87.65
If r=3% -> NPV1 = 3.375x[1-(1+0.03)-40/0.03] + 100/(1+0.03) 40
= 108.65
IRR = 3 + (4-3)x [87.65/(108.65-87.65)]
= 7.16%
-> Cost of debt (after tax) is: 7.16%(1-38%) = 4.44% (Tax = 38%)
KD do Joanna Cohen calculated (wrong) = 4.3%
o Apply in to formula WACC:
WACC = (E/V). KE + (D/V). KD . (1-T)
 Joanna Cohen calculated:
WACC = 10.5% x 73.0% + 4.3% x 0.62 x 27%
= 10.5% x 73.0% + 2.7% x 27.0%
= 8.4%
 We have :
WACC = 10.1% x 4.44% + 89.9% x 9.81%
= 0.45% + 8.82%
= 9.27%

Question 3: What should Kimi Ford recommend regarding an investment in Nike?

To discount cash flows in Exhibit 2 with the calculated WACC is 9.29%, the present value of Nike

approximately $58.13 per share, which is much higher (1.38times) than Nike’s current market price

of $42.09. So Nike shares price is underestimate and undervalued by $16.04 as Nike is currently

trading in 2001. Some might think this value is still understated, due to that current growth rate (6%
to 7%) is much lower than that estimated by manager is 9.27% (8% to 10%). Moreover, Nike also

changed their business strategy by more concentrate in midpriced segment, which is Nike less

concentrate for a long time before. That’s mean their total of sales might increase, lead to avenue

increase, lead to profit increase, of course, Nike’s share prices and dividend will be increase in
long-term.

Using this data, we found that NorthPoint Large-Cap Fund should buy Nike Inc., shares at this

time because the stock is undervalued because it has growth potential that would be beneficial to the

fund. Along with this fact, management has goals for the near future that could provide a great deal

of profit for Nike Inc. As we know that in conference, Nike was showed that the company is heading

on the recovery path with new strategy and there is potential for abnormal profits given the growth

capacity that Nike has got as elaborated by ratio analysis. And the set targets by the management

are easily achieved if they stay focused since they have the capacity. Technical analysis also

supports a buy decision, because looking on the past performance of the Nike Inc., share against the

market index. It has shown that Nike can outperform the market returns and now that it had gown

down, it is left with the upside given plans that are being put in place.

Moreover, Look in to exhibit 8 we can see that P/E of Nike Inc., in 2012 is 19.8, higher than other

competitors such as Adidas (14.8), higher than Industry Average (14.0), higher than S&P 500 (13.1).

At the same compare P/E in 2013 (future), Nike also higher than others factors and so on. In other

hand, Nike’s current trailing 12-month earnings multiple is 20.9 compared with the 22.9 industry

average and 17.2 of S&P 500. Over the last five years, Nike’s shares have traded in the range of

10.9x to 21.8x trailing 12-month earnings. So, We can see that Nike Inc., shares not only are very

interest share at present, it also are very potential shares in future.

In addition, EPS Earning Surprise and Estimate Revision History given that from 20 March 2007 to

25 October 2011, EPS nearly the same with market predict or if had, almost time are positive EPS

surprise, just have three time EPS negative surprise. So, basically, almost predict about Nike is right

in long term market and Nike’s shares have a little bit undervalue by market estimated. Beside that,

consensus index also proved that EPS from 13 March 2007 to 18 November 2011 is nearly stable in

a year-period and increased dramatically in five years-period.

In conclusion, based on all data including history data, recently data and future data, it is clearly that

decision is Kimi Ford should buy Nike’s shares because it quite safe, underestimate of market and

growth dramatically compare with its history, other companies in industry and other shares in S&P

500. Overall, Nike’s shares are very potential. In details, Kimi Ford also should consider before buy

Nike’s shares depend on some of reasons. First of all, as we know that “January Effect” not really

happen every year, but it can be happen anytime, at that time, almost every shares become better by

investors feeling and habit. If Kimi Ford buy Nike’s share in this moment, he should be careful

because he might spend much more time than normal market prices. Secondly, Nike’s shares long-

term always is wonderful investment, but short-time buying also should be careful because of the

changing fast of industry, the changing of Nike, the changing of trend in footwear industry and so on.

Beside that, Kimi Ford also don’t forget monitor its activities very closely. If North-Point Large-Cap

Fund want to invest in Nike’s shares in short-term, they should buy Nike’s shares at the end of the

year, while others not really pay attention to much in market and sell it in the first month of next year.

In January, when people have a little overestimate, North-Point Large-Cap Fund can sell for achieve

their profit.

Exhibit 5:
Nike Annual Data Sheet (2001-2011)
200 200 200
2001 2002 2005 2007 2008 2009 2010 2011
3 4 6
Free
Cash 663. 777. 866. 101 1117 1275. 1351. 1483
764.1 1572.7
Flows to 1 6 2 4 .6 1 7 .7
Firm
Terminal 25835.422
Value 65
Cash 663. 777. 866. 101 1117 1275. 1351. 1483 27408.122
764.1
flows 1 6 2 4 .6 1 7 .7 65
The Firm
$17,079
Value
Less:
Current 1296.6
debt
Equity
$15,782
Value
Shares
271.5
Number
Equity
58.13052
Value per
469
share

Terminal 25835.42
Value 265
2012
Cash 1619.881
Flow
Permane
0.03
nt Growth
WACC 0.0927
 Stock Market line

(source: http://finance.yahoo.com)

Exhibit 6:

Nike Annual Data Balance Sheet (2005-2011)

Exhibit 6:

Nike Annual Data Balance Sheet (2005-2011)

(Source: http://finapps.forbes.com/finapps/jsp/finance/compinfo/FinancialIndustrial.jsp?tkr=NKE )