Nike Inc.

Case Study

Student’s Name: Abeer khodari , Donna Alsuqae

Jude Kurdi ,Lamar albeladi

Students ID’: 1510473 -1710233 - 1810192

Instructor : Dr. Karima Saci

Submission : Due on 30\9\2021

Contents
Executive Summary.........................................................................................................................3

Introduction......................................................................................................................................4

Weighted Average Cost of Capital (WACC)..................................................................................5

Importance of WACC..................................................................................................................6
Who Sets WACC between Managers and Investors?..................................................................7
Analysis of Cohen’s WACC Calculation for Nike Inc....................................................................8

Recalculation of the Company Beta Using the Changes in Assumptions.......................................9

Calculation of the Costs of Equity Using Capital Asset Pricing Model (CAPM).........................10

Advantages of Capital Asset Pricing Model (CAPM)...............................................................11

Business and financial risk variability― if the business risk and financing differ, CAPM can
be used to calculate the estimated return...................................................................................11
Disadvantages of Capital Asset Pricing Model (CAPM)..........................................................11
Calculation of Costs of Equity Using Dividend Discount Model.................................................12

Advantages of Dividend Discount Model.................................................................................12

Disadvantages of Dividend Discount Model.............................................................................13
Calculation of Costs of Equity Using Earnings Capitalization Ratio............................................13

Advantages of Earnings Capitalization Ratio............................................................................14

Disadvantages of Earnings Capitalization Ratio.......................................................................14
The Most Appropriate Method between CAPM, Dividend Discount Model, and Earnings
Capitalization Ratio for Nike.........................................................................................................15

Kimi Ford Recommendations Regarding Investing in Nike.........................................................15

Conclusion.....................................................................................................................................16

References......................................................................................................................................17
 Executive Summary

Kimi Ford is a portfolio manager at Northpoint Group and has the task of analyzing whether it is

worth purchasing Nike Inc. shares at the current price of $42.09. Kimi carried out a sensitivity

analysis as one of the methods of determining whether Nike shares are overvalued or

undervalued. Kimi requested Cohen to calculate the WACC of the company to determine the

expected rate of the company's cost of capital. Other models of determining the cost of capital,

such as CAPM, DDM, and earnings capitalization ratio, have been analyzed to help Kimi make

the right recommendation to Northpoint Group.

 Nike Inc. Case Study

Introduction

In the early 2000s, Nike Incorporation's share prices saw a significant decline, prompting

potential investors to reconsider investing in the company. For instance, Kimi Ford, a portfolio

manager at Northpoint Group and one of Nike's potential investors in the early 2000s, had to

analyze the possibility of investing in Nike shares critically. Nike responded to the declining

share price by calling a meeting to discuss 2021 financial results and enable its analysts to

recommend alternative investment strategies. Besides, the management was tasked with

communicating a practical approach that would revitalize the company's operations. Nike

revenue has been around $9 million per year for the last several years, and net income declined

from $800 to $580 million in 1997. On the other hand, its market share decreased from 48% to

42% (1997 to 2001).

Despite the firm's financial results, its management had anticipated long-term growth of

8% to 10% and earnings growth targets of 15% and above. Such caused mixed reactions among

analysts concerning these financial targets since the majority deemed them too aggressive. In

contrast, other analysts believed the figures presented a significant growth opportunity for the

company. Hence, for Kimi to buy Nike's shares, he must carry extensive research, starting with

analyzing the meeting's report. However, Nike's report from the meeting did not provide clear

guidance on whether to buy its shares or not. Such prompted contradicting conclusions from

different analytics companies. For example, based on the Lehman's Brothers report, it was the

appropriate time for investors to purchase Nike's shares. In contrast, UBS Warburg and CSFB

analysts advised that it was not the right time to invest in Nike's share, advising investors to wait
and analyze its performance over time. For Kimi to make a practical investment decision, he had

to contact Joanne Cohen to estimate Nike's capital costs. Cohen used different methods to

calculate capital costs in her analysis. These techniques include weighted average capital costs

(WACC) and capital asset pricing model (CAPM). Calculating WACC and CAPM using the

information provided in the case study is essential in understanding Cohen's analysis and

acknowledging the advantages and disadvantages of these techniques, which, in turn, would

enable suitable recommendations to Nike's potential investors.

Weighted Average Cost of Capital (WACC)

Weighted average costs of capital (WACC) are the average after-tax of a firm's various

capital sources, such as common stock, bonds, preferred stocks, and debts. Company capital

funding mainly comprises of two elements, which are equity and debts (Stubelj, Dolenc &

Jerman, 2014). Both the lenders and the shareholders expect to receive certain returns on funds

invested in the company. The amount that these lenders and shareholders anticipate receiving is

the company's cost of capital. Hence, weighted average capital costs (WACC) show the return

that both the shareholders and debt holders can expect

A company needs to estimate the costs of capital to help the investors make sound

decisions and assist the management in making better decisions. Investors cannot invest in

companies with low capital costs since this will lower the amount they will receive as dividends

at the end of the year. Management uses the cost of capital to determine whether the company's

share is overpriced or undervalued. From the sensitivity analysis, Kimi observed that at the

discount rate of 12%, the company share is overvalued by $42 (the current market price).

However, the shares are undervalued at the same market price at a discount rate of 11.7%.
Hence, the investors can determine the price they will purchase their stocks and wait for them to

be triggered.

Importance of WACC

Management can also use the cost of capital to maximize the company's profitability.

Equity and debts sometimes have different prices. Hence the management needs to find the right

mix that minimizes the company costs. Lowering the company's costs on capital will increase its

profitability, and the extra income can be used to invest in other company's projects. Further, the

management can use the costs of capital to make dividends policies and decisions. The number

of dividends payable to stockholders at the end of the years is based on capital costs

consequently, business entities should ensure that their cost of capital is calculated correctly, as

this will help maximize their profit and make realistic dividend policy decisions for the

company.

The costs of capital of a firm can be used to determine its capital structure. Debt and

equity are the main components of a company's capital, where the stockholders expect to be paid

in the form of dividends. In contrast, debtholders expect the amount they give the company to be

repaid together with interests. In most instances, the cost of issuing shares is not the same as the

cost of securing financial assistance from the financial institution. Managers ensure that the

company has the right mix of the company's capital structure, as this will ensure that the

company is financially stable. Companies whose debt is the primary source of capital are likely

to face some financial problems in the future if the profitability drops or unexpected market

events, such as the Great Recession or the Covid 19 pandemic that adversely affected nearly all

types of businesses. Hence the management should use the cost of capital to determine the

suitable composition of the company's capital structure.

 The costs of capital can be used to evaluate the overall financial performance of the

company. The performance of an organization's top management is measured using the costs of

capital by comparing the profitability of an investment with the overall costs of capital.

Investments whose costs of capital are higher than the expected profitability should not be

invested in. There are several discounting techniques that the management can use to determine

whether a project will be profitable. Some of these techniques include Present Net Value (NPV)

and Discounted Payback Period (DPB). Managers who invest in projects with lower profitability

than the costs of capital are likely to perform poorly, which will not be in line with the goals of a

firm, profit maximization. Hence, before appraising any investment, firms should ensure that

their expected return is higher than the capital costs, increasing the firm's overall profitability.

The cost of capital also helps in managing the working capital of a firm. Carrying

investments in receivables can be calculated with the help of the costs of capital the amount that

will be received from the investment will be used to finance the source of finding, and hence it is

vital to ensure that the receivables have been managed accordingly. Poor receivables

management may lead to liquidity challenges where the firm may not pay its lenders, which

could cripple the company. Further, the costs of capital can be used to manage the inventory that

the firm holds. The company needs to ensure that the inventories do not hold too many funds to

an extent where their liquidity challenges would affect its ability to operate or finance its debt.

Therefore, the costs of capital can be used to help manage the working capital of a firm.

Who Sets WACC between Managers and Investors?

From the importance of weighted average costs of capital (WACC), it is clear that the top

management is the primary user. They use it to determine the composition of capital structure,

working capital management, making dividend policies, and their financial performance is
evaluated using the same WACC. Investors only apply the WACC in investment decisions,

enabling them to ascertain the best time to invest. If they deem the costs of capital too risky or

not worth investing in, they can decide not to invest in the company. Hence, the managers are

tasked with setting the firm weighted average costs of capital (WACC) because it will influence

most of their decision and will also be used to measure their financial performance.

Analysis of Cohen’s WACC Calculation for Nike Inc.

Cohen's analysis estimate that the WACC for Nike Inc. would be 8.4%. However, we

need first to analyze the assumptions that she made before accepting or rejecting her

calculations. First, Cohen is faced with the decision of whether to use single or multiple costs of

capital. Nike Company has several business segments that produce their revenues and incurs

costs individually. Further, it sells eyewear, sports balls, bats, timepieces, skates, and other sports

accessories. These items account for Nike's 3.6% overall revenue. On the other hand, Nike's

branded and non-branded products account for 4.5% of the overall revenue. Hence, the basis of

Cohen's assumption is whether these different segments had distinct risks that could warrant

extra costs of capital. Cohen concluded that the Cole Haan line was the only segment that was

different from the others, and it only made a tiny amount of revenues for the enterprise. Hence,

Cohen did not think it was necessary to compute different capital costs for the organization.

Since all the departments face challenges, she calculated only capital costs from the entire

segment, which was a correct move.

Secondly, Cohen makes the assumptions about the methodology for calculating the

capital costs because of both debt and equity fund Nike Inc. Using the latest available balance

sheet, and the debt portion amounted to 27% of the company's capital while equity amounted to
73%. Hence, the most appropriate method was to combine the cost of debt and the costs of

equity to get the costs of capital for the entire organization. In our opinion, this assumption is

correct because its factors are in the whole capital composition. Calculating the capital costs of a

firm requires that all the elements used in funding the organization should be used. Hence,

Cohen makes a valid assumption regarding the methodology of costs of capital.

Cohen also made assumptions based on the company's costs of debt. She divided 2001's

total interest expense with its average debt balance, resulting in a 4.3% estimation. The figure

was lower than treasury yields since Nike had raised a portion of its funding through Japanese

yen notes, which had lower rates. Hence, with such realization, costs of debt were calculated

correctly. However, it is impossible to obtain Japanese Yen notes each year. In her assumption,

she did not consider the changes in financial service providers with different rates. In my view, I

would propose to use the treasury yield rate, which was 5.02%, since it was possible to find other

lenders with a similar cost of debt. After adjusting the costs of capital using the corporate tax rate

of 38%, the new debt costs will be calculated as (1-38%)*5.02%, which is 3.224%. Hence the

cost of debt that should be used in recalculating the cost of capital should be 3.224%. Using

CAPM, Cohen also estimated the costs of equity as 10.5%. She used the 20-year treasury bonds

as her risk-free rate and compounded the average premium of the market over total treasury

bonds. For the beta, she used Nike's betas from 1996 up to date. Hence, these assumptions were

valid.

Recalculation of the Company Beta Using the Changes in Assumptions

WACC=Kg (1-t)*(D/D+E) +Kg*E (D+E)

=10.19%*7.16 %*( 1-38%) +89.81%*9.81%

=9.26%
 After analyzing Cohen's assumptions and our recommendations, the WACC for Nike Inc.

should be adjusted from 8.4% to 9.26%. The change in the company WACC is attributed to the

treasury yield rate used in the computation as the costs of debt rather than the rate proposed by

Cohen (Japanese Yen note). The investors will use the cost of capital to determine whether they

should invest in the business or not. On the other hand, Nike's management expects a long-term

growth of 8% to 10%. Hence, Kimi should choose when to invest in Nike Inc. shares.

Calculation of the Costs of Equity Using Capital Asset Pricing Model (CAPM)

CAPM model helps in establishing the relationship between regular risks and the expected

return. CAPM is used to determine the prices of risky assets and stocks in a company. The

formula for calculating CAPM is as follows

Re=Rf +beta*(Rm-Rf)

Where RE is the expected return on the assets or stock

Rm is the market risk premium

Rf is the risk-free rate

For Nike Inc., the expected return using the CAPM will be;

Re=0.574+ 0.69*0.059

=9.81%

Hence, using CAPM, the cost of equity is 9.81%. However, in the calculation of CAPM,

several assumptions have been made. Firstly, the risk-free rate has been assumed to be for the

longest period of 20 years bond. Secondly, the beta for Nike has been assumed geometric mean

for market risk. Finally, the most recent beta has been used.
Advantages of Capital Asset Pricing Model (CAPM)

There are several advantages of CAPM, which includes;

Ease of use― CAPM is easy to calculate and can easily be tested to derive the possible

outcomes as this will increase confidence around the required rates.

Diversified portfolio― CAPM assumes that an investor holds a diversified portfolio,

eliminating all the unsystematic risks.

Systematic risk― CAPM considers systematic risks by incorporating the beta into its

calculation which is left out in other models such as the dividend discount model. Regular risks

are significant when determining capital costs since they are unforeseen and hence cannot be

entirely mitigated. Therefore, in determining the cost of equity, Nike should implement the

capital asset pricing method.

Business and financial risk variability― if the business risk and financing differ, CAPM can

be used to calculate the estimated return.

Disadvantages of Capital Asset Pricing Model (CAPM)

CAPM is a scientific model that has several drawbacks which originate from the model's inputs

and assumptions. Some of the disadvantages include;

Risk-free rate― the model uses a risk-free rate as the yield on short government securities.

Government securities yield changes daily and hence has high volatility.

Return on the market― when the market return is negative, the long-term market growth is

used to factor in for negativity which creates uncertainty.

The ability to borrow at a risk-free rate― CAPM assumes that it is possible to borrow at a

risk-free rate, while in an actual situation, it is difficult to borrow funds at a risk-free rate.
 Calculation of Costs of Equity Using Dividend Discount Model

The dividend discount model (DDM) is a quantitative technique used to predict a

company’s stock price. The model assumes that the stock price today is the same as the sum of

all the future payments that an investor will receive in the form of dividends once they are

discounted to the present value (Daske, Gebhardt & Klein, 2006). Hence, the model does not

consider the prevailing market condition, which might affect the price of the stock. The formula

for the dividend discount model is as follows;

Re=D1/Po +g

Where D1 is the next period projected dividends

Po is the current price of the company's shares

g is the dividend growth rate

For Nike Inc., the expected return will be;

D1=Do (1+g)

= 0.48(1+5.5%) =0.5064

Re=0.5064/42.09+ 5.5%

=6.7%

Advantages of Dividend Discount Model

Justification― businesses are perpetual, and hence when an investor buys shares in a company,

he is paying the price today, which entitles benefits. In this case, the future benefits are the

dividends that an investor will receive each year. Further, due to changes in the business

environment and inflation, the amount of dividends paid is expected to increase in the future.

Consistency― companies experience a lot of volatility in measures like earnings and cash flows,

but the dividend discount model ensures that the dividends paid remain consistent over a long
period. Consistency of dividend payments prevents the company from having high expectations

that will lead to a decline in the market value of the company stock.

No requirements of control― payments of dividends are the only valuation measure available

to minority shareholders. Majority shareholders can influence the dividend payout policies

because they control the company, however, the minority shareholder will be guaranteed to

receive dividends at the end of the year.

Disadvantages of Dividend Discount Model

Limited use― the model is only applicable to stable organizations that have shown consistency

in their payment of dividends. Small and unstable companies may not pay a consistent dividend

throughout, and hence the formula is not applicable.

May not be related to earnings― the model assumes that the dividends paid out are correlated

to earnings. Hence, higher earning will translate to payment of higher dividends by the company.

However, such is not the case since businesses endeavor to maintain stable dividend payouts

even when experiencing high earnings variations.

Too many assumptions― the approach has too many speculations concerning taxes, interest

rates, and growth rates. These assumptions are a significant drawback to this model.

Calculation of Costs of Equity Using Earnings Capitalization Ratio

The earnings capitalization ratio refers to a measure that indicates the rate at which investors will

capitalize the firm's expected earnings. The ratio is calculated as;

= total capital/(total capital + shareholders equity)

=1296.6/(1296.6+3494.5)

=27%

Hence, the earning capitalization ratio for Nike is 27%.

Advantages of Earnings Capitalization Ratio

Ease of use- the earning capitalization ratio is easy to calculate and to interpret. The method is

straightforward as it only uses two readily available variables.

Accurate- the earnings capitalization ratio determinates accurately the rate at which the investors

will capitalize the firm's expected earnings in a perfect market.

Disadvantages of Earnings Capitalization Ratio

Evaluating share values based on future earnings has various limitations. To compute the

expected annual earnings per share, the market growth is used. In most cases, the annual growth

is not constant, and hence it is difficult to determine the expected annual earnings correctly

(Nagel, Peterson & Prati, 2007). Secondly, a start-up business in operation for less than two

years may lack efficient data for evaluation. Finally, the method assumes that the payment of the

dividends will have constant growth.

 The Most Appropriate Method between CAPM, Dividend Discount Model, and Earnings

Capitalization Ratio for Nike

Using the three methods of valuation, which are the Capital Asset Pricing Model

(CAPM), Dividend discount model (DDM), and earning capitalization ratio, the best method that

Nike Inc. can adopt is the CAPM. This is because CAPM is easy to calculate and can be easily

tested to derive the possible outcomes, increasing confidence around the required rates. Further,

it also presumes that investors hold diversified portfolios that eradicate all the unsystematic risks.

CAPM also considers systematic risks by incorporating the beta into its calculation which is left

out in other models such as the dividend discount model. Systematic risk is important when

estimating the expected return because it is unforeseen and cannot be completely mitigated.

Hence, the best method for any company to use in capital asset pricing should be CAPM model.

Kimi Ford Recommendations Regarding Investing in Nike

From the sensitivity analysis, Kimi observed that Nike's share value is overvalued at a

discount rate of 12% at its current price of $42.09. However, for a discount rate below 11.17%,

the share price of the company was undervalued. Using weighted average costs of capital

(WACC), the company's cost of capital is 9.26%. This value lies below 11.7%, and hence Nike

Inc. shares are undervalued.

Using the capital asset pricing model (CAPM), the discount rate for capital costs is

9.81%. This rate is below 11.7%, and hence the company stock is undervalued. However, due to

the limitations of this model, it cannot be used solely to decide whether Kimi should recommend

to Northpoint Group to purchase the shares in Nike Inc. Whereas, using the dividend discount

model (DDM), the expected return is 6.7%, lower than 11.7%. Therefore, this model shows that
the company's shares are undervalued. Using the method, Kimi should recommend Northpoint

Group to purchase shares in Nike Inc. Further, the dividend paid is expected to have constant and

consistent growth.

Nike Company has long-term revenues growth targets of 8% to 10%, and the earnings

growth targets are above 15%. Hence the organization is likely to be profitable in the future,

which will prevent the dilution of the company's share price. Lack of dilution for the company's

shares price will ensure that the market price per share increases, and hence it is worth investing

in the company.

Based on all the financial models used, Nike's share is undervalued, and hence Kimi

should advise Northpoint Group to purchase shares in Nike Inc. the market price per share is

expected to increase, and the company's net earnings will also increase. Investing in the

company's share will give Northpoint Group a guaranteed dividend per year and an increase in

the value of their stocks.

Conclusion

Financial models such as WACC, CAPM, DDM, and earnings capitalization ratios can

help investors calculate the expected return on their investments. Where the value of the share in

a company is overpriced, the investors should wait before purchasing. Through the simulation

analysis, Kimi was able to identify the discount rate at which the value of the share in Nike Inc.

is undervalued. Kimi Ford uses these financial models to determine whether it is worth

purchasing the shares in Nike Inc. Through the use of the models, the company's share is

undervalued, and hence, it is worth investing in the company.

References:

Daske, H., Gebhardt, G., & Klein, S. (2006). Estimating the expected cost of equity capital using

analysts’ consensus forecasts. Schmalenbach Business Review, 58(1), 2-36.

Nagel, G. L., Peterson, D. R., & Prati, R. S. (2007). The effect of risk factors on cost of equity

estimation. Quarterly Journal of Business and Economics, 46(1), 61-87.

Stubelj, I., Dolenc, P., & Jerman, M. (2014). Estimating WACC for regulated industries on

developing financial markets and in times of market uncertainty. Managing Global

Transitions: International Research Journal, 12(1), 55-77.