Professional Documents
Culture Documents
CASE BACKGROUND
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. 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
Unrestricted
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. However, she had done a quick sensitivity analysis that
revealed Nike was undervalued at discount rates below 11.17%. Because she was
about to go into a meeting, she asked her new assistant, Joanna Cohen, to estimate
Nike's cost of capital.
Cohen immediately gathered all the data she thought she might need and began
to work on her analysis. At the end of the day, Cohen submitted her cost-of-capital
estimate and a memo explaining her assumptions to Ford.
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?
Unrestricted
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, which are:
1. Incorrect Debt – We found that the debt of the firm was calculated improperly
when Ms. Cohen added short-term debt and notes payable to the long-term debt.
When calculating the WACC the correct method, in the case of Nike, Inc., is to
take into account only long-term debt.
2. Incorrect Tax Rate – We found that Ms. 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.
3. Incorrect Beta – We found that the beta used by Ms. Cohen is also incorrect.
Ms. Cohen used the average of Nike’s historical betas which comes to 0.8
instead of the using the most current year-to-date beta of 0.69 that was just
calculated recently.
4. Incorrect Risk Free Rate – We found that Ms.Cohen’s decision to use the 20-
year bond rate of 5.74% 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 3.59%.
If you do not agree with Cohen’s analysis, calculate your own WACC for Nike
and be prepared to justify your assumptions.
Unrestricted
D = Long Term Debt
Value = E + D
Beta, β = 0.69
Debt, D = 435.9
Cost of Debt
N = 40
PMT = (6.75/2) = 3.375
PV = -95.60
FV = 100
I/Y = 3.5837 x 2 = 7.1674%
Rd = 2 x I/Y = 7.1674%
Unrestricted
rm = 7.50%
Re = rf + β(rm – rf) => 3.59% + (0.69)( 7.5% - 3.59%) => 3.59% +
(0.69)(3.91%) => 3.59% + 2.698 => 6.288
Re = 6.288%
WACC Calculation:
= .062253WACC = 6.23%
Justification of Assumptions:
b. 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.
c. 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.
d. 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).
Unrestricted
Calculate the costs of equity using CAPM, the dividend discount model, and the
earnings capitalization ratio. What are the advantages and disadvantages of each
method?
= 3.59% + 2.70%
Re = 6.288%
Re = 6.64%
Re = 5.52%
1) Since non-Nike brands accounted for only 4.5% of Nike’s total revenue and
the only non-sports related business segment was their Cole Haan line it was
Unrestricted
very likely that all of the various business segments faced the same risk
factors. 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.
2) Since Nike utilizes two capital components, debt and equity, we calculated
their cost of capital using the after-tax WACC method (based upon financial
figures available) which gave us the following results:
a. Capital Structure
i. Debt: 3.67%
ii. Equity: 96.33%
b. Market Value (in millions)
i. Debt: 435.9
ii. Equity: 11,427.4
c. Component Costs of Capital
i. Debt: 7.17%
ii. Equity: 6.29%
3) Taking these component costs into account, along with all of the additional
relevant numbers available to us we calculated Nike’s after-tax WACC to be
6.23%.
We would strongly recommend, that based upon the analysis by Ms. Ford in which
she concluded that Nike is undervalued at discount rates below 11.17%, Ms. Ford
immediately invest a substantial amount of the NorthPoint Large-Cap Fund in Nike,
Inc. since it is a definite value investment with its discount rate of 6.23%.
Unrestricted