CORPORATE FINANCE (FNCE 6001)

GROUP ASSIGNMENT - 2 REPORT

Nike, Inc.: Cost of Capital

- Case Study Report -

# Group Members
1 Madhuri D/O Arjunan

2 Mohammed Muazzam S/O Mohamed Rafi

Submitted by:
3 Sandar Aung
G2 (Group No. 3)
4 Sirsendu Roy

5 Yip Yoke Cheng, Jasmine

6 Zheng Xiang Hng

1. INTRODUCTION
The fundamental aim of this report is to weigh and determine if Nike’s stock is a worthy buy for NorthPoint Group fund.

The objective is executed by calculating the weighted average cost of capital (WACC) coupled with other elements such

as the capital structure weights and tax rate. Points noted to aid in Nike case analysis:

▪ Firm has been experiencing flat revenue for the last 4 years and decline in Net Income

▪ Intends to generate more exposure in mid-price footwear and apparel lines to boost revenue growth.

▪ Seeks to attain long-term revenue targets of 8%-10% & earnings/growth targets of above 15% respectively

along with effective management of expenses.

▪ Market analyst’ had mix signals to these expectations & changes.

2. CASE ANALYSIS
2.1. Should we use a single firm-wide cost of capital or multiple divisional costs of capital to valuate Nike’s
worth in this case?
From the case facts, we surmise that Nike Inc. has multiple verticals of business sections but all catering to the sports

category. The percentage share of total revenue generated from each of these segments –

Footwear Apparel Sports equipment Others

62% 30% 3.6% 4.5%

In terms of the choice between single or multiple cost of capital to evaluate Nike’s net worth, the best judgement would

be to proceed with single cost of capital. We justify this selection on the basis of the following facts:

1) The Risk factor – Nike is majorly into sports footwear business and all the other business where Nike has forayed

i.e apparels, sports gears etc. are all catering to the sports industry. Hence, there is a co-relation in the business

line and risk similarity that is underlying to each business.

2) Individual WACC problem - To calculate individual WACC for each business segment, need to ascertain the

individual percentage debt and capital employed at each business. However, these details are not available based

on the case facts.

3) Cost of equity challenge - The challenges involved in estimating the risk-free rate, market risk premium, beta and

eventually the cost of equity specific to an individual line of business.

Therefore, the most rational judgement is to proceed with a single cost of capital in evaluating Nike’s worth.
2.2. Do you agree with Joanna Cohen’s WACC calculation for the entire firm? Why or Why not?

The estimated WACC and the assumptions considered by Joanna to compute the Re, Rd and the capital structure is not

an acceptable process to forecast an organization hurdle rate. So, we do not agree with her approach. The identified

flaws in her procedure are stated below along with reasoning (blue italic):

1. Historical data in calculating cost of debt: She took the total interest expense for year 2001 and divided by the
company's average debt balance to get cost of debt of 4.3% before tax. This is an incorrect assessment as the cost
of debt should be a rate at which the firm can borrow over the WACC forecast period. Hence, Rd should be estimated
based on the yield to maturity (YTM) based on firm’s long-term debt.
2. Using book value of debt: She used the BV of debt in her calculation which is incorrect. Its apt to use the Market
value of debt in calculating debt value
3. Using book value of equity: She used the BV of equity in the WACC calculation. The BV of equity should never be
used to estimate the equity value since it is usually understated. Right approach is to use the current market value
of share price multiplied with the latest outstanding shares.
4. Incorrect beta: Joanna used the average beta instead of current beta. Historical data is not a true reflection of
systematic risk and the firm’s sensitivity to the market.
5. Cost of debt lower than treasury yields: Her argument was that due to Japanese Yen notes there were cheaper
debts in Nike’s books. The cost of debt is not based on current interest rate the firm bears but on the estimated rate
at which a firm can finance itself in future. The forecasted rate, therefore, must be different from the existing debt
rate.

2.3. If you do not agree with Joanna Cohen’s analysis, calculate your own WACC for Nike and justify your
assumptions.
Since we found some inconsistencies in Joanna’s approach towards the WACC calculation, the new WACC is being

calculated based on revised values and new set of assumptions.

The WACC is the hurdle rate of an organization, which is the minimum return the investors are seeking for investing in

the firm. It is dependent on the weightage of both debt and equity as per the capital structure of the firm along with

the firm’s cost of capital for each security class appropriately weighted (return rate company is expected to pay debt

holders & shareholders to finance its assets). In general, lower WACC means higher value of the firm.

The revised WACC based on our approach is estimated to be: (Detailed calculation in Appendix -1)

Debt Equity
Cost of Rd = 7.16% p.a Re = 9.81%
Weightage D/V =10.19% E/V = 89.81%
Tax rate 35%
𝑫 𝑬
WACC: 𝑽 ∗ 𝑹𝒅 ∗ (𝟏 − 𝑻𝒄) + 𝑽 ∗ 𝑹𝒆 = 7.16%* 0.1019* 0.65 + 9.81% * 0.8981 = 0.44844+8.81126 = 9.28%
Based on the estimated WACC, post discounting the projected cash flows, the share price arrives at $ 44.12, which

seems to be an undervalued stock based on the estimations. (refer Appendix 1, Point H).
2.4. How would your estimate of value change if Nike changed its capital structure on July 5, 2001 to have a
35% debt-to-value ratio based on market value? Show your calculation of the new WACC for Nike.

If Nike’s debt leverage increases to 35%, the new capital structure would be: D/V E/V
35% 1-35% = 65%
Therefore, new WACC: 7.16% x (1-35%) x 0.35 + 9.81% x 0.65 = 8.0054%

The new WACC rate above should be cautiously used to discount cash flows due to certain provisions not being factored

as a part of the calculation:

a) Change in debt structure - Using M&M Theory of Capital Structure Case III assumption: We need to consider the

possibility of Nike having taxes and bankruptcy/default risk costs. As the D/E ratio increases, the probability of

bankruptcy increases resulting in an increase in expected bankruptcy cost. Therefore, there is a trade-off between

the value of the interest tax shield and the expected bankruptcy cost. Currently, the probability of Nike facing

bankruptcy is very low at about 4% but this factor should not be ignored.

b) Optimal D/E ratio - According to static theory, the tax savings that comes from debt is offset by lack of sufficient

revenue to meet its financial obligations. The optimal capital structure is achieved when the additional gain and

the financial distress costs comes to a breakeven point and to do so we need to find the optimal debt to equity

ratio. However, in real life it is very difficult to find the optimal value because the target debt ratios varies from

firm to firm due to asymmetry of information whereby the managers know more about the firm than the lenders

and shareholders, who might not act in the firm's best interests.

3. RECOMMENDATION
From the above analysis, it can be clearly seen that Nike stock is undervalued compared to current market price. Hence

our recommendation is a BUY for NorthPoint Group fund. Once the future cash flows (from period 2002 onwards) are

estimated based on the revised organization strategy – i) Revenue growth of 10% YoY and ii) Net Income of 15%, the

discounted cash flows (based on our WACC) will definitely be much higher. Eventually that will lead to higher valuation

of the organization and strong market sentiment for share price growth.

4. CONCLUSION
It is important to remember that the entire exercise is just a expected estimate with some caveats to repudiate the

estimation. Few such scenarios could be - failure to reach revenue target, failure in expense cuts, facing varied taxes,

credit risk, transaction costs, and inefficient markets can jeopardize the valuation and future share price of Nike.
 APPENDIX
1. Appendix 1

The five components that are required to calculate the WACC are:
1) Ratio of debt (D) against the value of the firm (V)
2) Ratio of equity (E) against the value of the firm (V)
3) Cost of debt (Rd)
4) Cost of Equity (Re)
5) Corporate tax rate

A. Cost of Debt:
By computing the current or future situation, yield to maturity of Nike's publicly traded debt should be a more
accurate measure to generate debt cost.
Based on case data provided under Exhibit 4 (Nike’s publicly traded debt).
PV= 95.60, N=40, C = 6.75/2=-3.375 FV=-100; Rd =?
The equation for the present value of the bond is given by:
𝑪 𝟏
PV = 𝑹𝒅 ∗ [𝟏 − 𝑹𝒅 𝑵
] + 𝐅𝐕/[(𝟏 + 𝐑𝐝/𝟐)^𝐍]
(𝟏+ )
𝟐

Using IRR method, we calculate Rd = 7.16% annually

B. Cost of Equity:
The Cost of equity is calculated based on the Capital Asset Pricing Model (CAPM). The CAPM equation is
given by: Re=Rrf+β∗(Rm−Rrf)
Re = Expected return on equity,
Rrf = Risk-free rate
Β = equity beta and
Rm−Rrf = Equity market premium

Based on case data provided under Exhibit 4, the following were chosen:
20-year Risk-free rate: 5.74% (US treasury yield data)
Nike YTD Beta: 0.69
Geometric mean historical equity risk premium: 5.90%

So, expected return on equity (Re): Risk-free rate + beta*equity risk premium
=5.74% + 0.69*5.90%
 Re = 9.81%
C. Value of equity (E):
Total outstanding shares x current share price: $42.09 * 271.5 million shares= 11,427.44 million

D. Value of Debt (D):

Total value of outstanding debt is given by = Current portion of long-term debt + notes payable + Long term
debt
 5.4+855.3+435.9 = 1,296.6 million

 The value (V) of Nike is equal to (E+D) = 11,427.44+1,296.6 = 12,724.04 million

E. Weightage of equity (E/V) =11, 427.44/12,724.04= 0.8981 = 89.81%

F. Weightage of debt (D/V) = 100-89.81 =10.19%

G. Calculate WACC:
𝑫 𝑬
The WACC formula is given by: ∗ 𝑹𝒅 ∗ (𝟏 − 𝑻𝒄) + 𝑽 ∗ 𝑹𝒆
𝑽

 7.16%* 0.1019* 0.65 + 9.81% * 0.8981= 0.44844+8.81126= 9.28%

H. Calculate Equity Value:

 PV of cash flows based on 9.28% = $13,275.92
 Equity value = ($13,275.92 - $1,296.6)/271.5 = $44.12

WACC estimation assumptions:

1. The long-term debt is considered as the cost of debt

2. Cost of debt is calculated by finding the yield on Nike debt and is found based on the IRR method
3. Company beta is assumed to be average beta since the value has been in that range since 1996
4. The 20-year yield on US treasury is being considered as the risk-free rate and the GM return of risk
premium as 5.9%
5. We also consider the compounding effect to determine the investment performance by using the
Geometric mean instead of Arithmetic mean.
6. Outstanding shares considered same as of year 2001
7. Corporate tax rate considered to be 35%, assuming no increment over the years
8. No change in capital structure for the forecasted period
9. No change in risk of new projects