Group 3: Denise Hamilton, Antonio Finn, Karlyn Small

CASE STUDY
NIKE, INC.: COST OF
CAPITAL
1.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?2. If you do not agree with Cohen’s
analysis, calculate your own WACC for Nike and be prepared to
justify your assumptions.3. 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?4. What should Kimi Ford recommend regarding an
investment in Nike?
 WHAT IS WACC?
• Weighted Average Cost of Capital: The rate of return required by a capital
provider in exchange for foregoing an investment in another project or
business with similar risk.
• Refers to all sources of capital, including common stock, preferred
stock, bonds, and long-term debt. Used as a discounted rate to determine
present value of specific investments.
• Since WACC is the minimum return required by capital providers, managers
should invest only in projects that generate returns in excess of WACC.
• WACC is calculated considering the relative weights of each component of the
capital structure- debt and equity, and is used to see if the investment is worth
taking.
• The WACC is set by the Investors (or Markets), not by managers. Therefore, we
 WEIGHTED AVERAGE COST OF CAPITAL
(WACC)
The method for calculating WACC can be expressed in the following formula:
WACC = Kd (1- t )*( D / V )+ Ke *( E / V )
• Or = after tax cost of debt x Wd + Ke x We
• Where:
• Ke = cost of equity
• Kd = cost of debt
• E = market value of the firm's equity
• D = market value of the firm's debt
• V = E + D = total market value of the firm’s financing (equity and debt)
• Wd = E/V = percentage of financing that is equity
• We = D/V = percentage of financing that is debt
• t = tax rate
 WHY IS IT IMPORTANT TO ESTIMATE A
FIRM’S COST OF CAPITAL?
• It's important to estimate a firm’s cost of capital because it’s a way to measure the cost of
funding future projects. The lower a company's WACC, the cheaper it is for a company to
fund new projects.
• In other words, cost of capital is used to decide whether an investment proposal should be
undertaken or not. A wrong estimation of WACC would lead to selection of a wrong
investment or rejecting a good investment proposal.
• A company is typically financed using a combination of debt (bonds, loans) and equity
(stocks). Because a company may receive more funding from one source than another, we
calculate a weighted average to find out how expensive it is for a company to raise the
funds needed to buy buildings, equipment, and inventory.
• A company looking to lower its WACC may decide to increase its use of cheaper
combinations of financing sources to minimize the cost of capital based on market changes
(interest rate on loans and dividend rates on stocks).
• Also, it is important to estimate the firm’s cost of capital because it can be used as a
measure to evaluate the performance of a firm.
 JOANNA COHEN’S ANALYSIS
Cost of debt 4.3% she estimated by
Joanna Cohen's Analysis taking interest expense $58.7
WACC (Weighted Average Cost of Capital) Comparison million in 2001 divided by average
Total Equity (E) $3,494.50 debt balance $1,370.6 million.
$1,444.6+1,296.6/2
Total Debt (D) $1,296.60

Total Captial (E+D) = $4,791.10 After tax cost of debt 2.7% pulled
Tax Rate (t) 38%
from using the income statement
and 38% tax rate. 4.3%(1-38%) =
Weight of Equity 72.94% 2.7%
Weight of Debt 27.06%
Cost of equity (Ke)= 5.74%
Cost of Debt (Kd) 4.30%
+0.80(5.9%) = 10.5%
Cost of Equity (Ke) 10.50%
Used current year on 20-year
After tax cost of debt 2.70%
Treasury bonds 5.74% as her free
WACC = 8.38% risk rate.

Joanna Cohen’s analysis was based on book values. Used the average beta of 0.80 with
a 5.90% geometric mean as risk
premium.
 CALCULATION FOR WEIGHTED AVERAGE COST
OF CAPITAL (WACC) FOR NIKE INC.
• Based on Joanna Cogen’s calculations of WACC as 8.4% using the Capital Asset Pricing Model (CAPM) model.
• We DO NOT agree with her WACC calculation of 8.4%.
• There are several reasons why we do not agree
1. Joanna’s calculation uses the book value for both debt and equity. The book value of debt is as an
estimate of market value and the book value of equity should not be used when calculating cost
of capital.
2. She did not calculate for the market value of equity. The market value of equity should be
calculated by multiplying the stock price of Nike Inc. by the number of shares outstanding.
3. The market value of debt should be used in the calculation of the cost of debt instead of the book
value used by Joanna. She did not discounted the value of long-term debt.
4. Basically, her miscalculations led to incorrect weights for the cost of equity and cost of debt.

Co AC ula
rr C tio
W lc
WACC = Re x E/(D + E) + Rd x (1-T) x D/(D + E)

ec
Ca

t
WACC = 10.1% x 4.44% + 89.9% x 9.81%= 0.45% +
8.82% = 9.27%

n
 ISSUES WITH JOANNA COHEN’S WACC - COST
OF DEBT & COST OF EQUITY CALCULATIONS
• Cost of Debt Wrongs
• The WACC is used to discount future cash flows, therefore must be a reflection of the
company's future ability in raising capital.
• Cohen made a mistake by using historical data in estimating the cost of debt. She
divided the interest expense by the company’s average debt balance to get 4.3% of
before tax cost of debt. Which, does not reflect Nike’s current or future cost of debt.
• Cost of Debt is generally computed as Yield to Maturity, which is one of the more
common ways to assess cost of debt
• Cost of Equity Wrongs
• Joanna Cohen seems to use CAPM to estimate cost of equity as 10.5%. Her calculation
comes from 5.74% risk free rate from 20 year T-bond rate, 0.80 average beta from 1996
to July 2001, and 5.9% compound average premium of the market over treasury bonds
as her risk premium (geometric mean of market risk premium).
• She supposed to use the current beta of 0.69 instead of average beta in her calculations
to compute for cost of equity because it reflects the most recent trend of Nike’s lower
 CALCULATION FOR MARKET VALUE TO
COMPUTE FOR WEIGHT OF DEBT & WEIGHT OF
EQUITY
WACC = Kd (1- t )*( D / V )+ Ke *( E / V ) = Kd (1- t )*( D / (D+E))+ Ke *( E /
(D+E))
Market value of Equity = current outstanding share x current stock price =
271.5 x $42.09 = $11,427.5
Weight of Debt (Wd) = Debt/Total Market Value = $1,296.6/($1,296.6+
$11,427.50) = $1,296.6/$12,724.04 = 10.19%
Weight of Equity (We) = Equity/Total Market Value = $11,427.50/$12,724.04 =
89.81% WACC (Weighted Average Cost of Capital) Current Calculations
Joanna Cohen's
Calculations
Total Equity (E) $11,427.44 $3,494.50
Total Debt (D) $1,296.60 $1,296.60
Weight of Equity 89.81% 72.94%
Weight of Debt 10.19% 27.06%
 COST OF DEBT CALCULATIONS
After tax Cost of Debt = Kd x (1 – tax rate)
• Computed for Yield to maturity rate (YTM) for the long term bonds issued by Nike Inc.
Coupon rate = 6.75% paid semi- annually = 0.0675/2 = 0.03375
Current price = Present Value = $95.60
Future Value = $100.00
Number of payments = 20 x 2 = 40
Payment (pmt) = 100 x 0.03375 = 3.375
Comp. Semi- annual interest = 6.75%
Comp. Annual interest or Cost of Debt (Kd) = 7.16%
After tax Cost of Debt = Cost of Debt x (1-tax rate) = 7.16% x (1 - 38%) = 4.44%
In Financial Calculator:
PV:96.5; FV: -100; PMT: 3.375; N:40; CPT: I/YTM= 7.16%
 COST OF EQUITY CALCULATIONS
Ke or Re = rf + β x (rm – rf) = 5.74% + 0.69 x (5.90%) = We also estimated cost of equity
5.74% + 0.0407 = 9.81% using the Capital asset pricing
Where: model (CAPM).

rf = the risk free rate Advantage: CAPM is easy to

rm – rf = the market risk premium compute and use, a basic
calculation to derive at a range of
β = beta
possible outcomes to provide
• The risk free rate of 5.74% is the 20-year treasury-bond confidence around the required
rate or yield rate on US Treasuries, in Exhibit 4.
rates of return.
• For the market risk premium, we used the geometric
mean of market risk premium 5.90%, in Exhibit 4, for
long term investment. Disadvantage: Betas do not
• For beta we used the most recent beta 0.69 of Nike in remain stable over time, stability
2001, in Exhibit 4, because it reflects the most recent of betas is a major drawback.
trend of Nike’s lower market risk.
 THE DIVIDEND DISCOUNT MODEL

The Dividend Discount Model ● The Dividend Discount Model would not
Ke=D1/P0+g be an accurate way to reflect the true
D1=Do(1+g) cost of capital because Nike had not Paid
out dividends since June 30,2001.
D0=.48
● Advantages: It uses a discount method to
P=42.09 estimate the present value of a stock.
G= 5.5% Dividends tend to stay consistent over a
D1=.48(1+.055)=.5064 long period of time.
Ke=.5064/42.09+5.5 ● Disadvantages: It cannot be used
evaluate stocks that do not pay dividends
=1.20+5.5 =6.70%
regardless of capital gains. Also it ignores
Cost of Equity would be estimated
the effect of stock buybacks, effects that
to be 6.70%
can make a vast difference in regard to
stock value being returned to
shareholders.
 THE EARNINGS CAPITALIZATION RATIO

• Earnings Capitalization Ratio = EPS/Share Price

• EPS= $2.1 per share ; Share Price = $42.06
• 2.16/42.06= 5.31%
• Cost of Equity would be estimated to be 5.31%
• Advantage: It uses current income as the basis for predicting a rate at
which future income can be expected.
• Disadvantage: The problem with this method is that it assumes a future net
income. This projection must be accurate. The company may make more
or less.
• Disadvantage: This method uses a capitalization rate utilizing current
income to define the future. It essentially uses one year’s income, which
can be mitigated by using an average income.
CORRECT DISCOUNTED CASH FLOW
ANALYSIS
Present Value of flows:
PV=FCF/(1+WACC)^n

Terminal Value = Final

Projected Free Cash
Flow*(1+g)/(WACC-g)
● is the present value at a
future point in time of all
future cash flows when
we expect a stable
growth rate.

Enterprise Value:
EV=(FCF/1+WACC)^1 + (FCF/
(1+WACC)^2) + (FCF/
(1+WACC)^3) + …...(FCF/
(1+WACC)^10)

Equity value per share

=Equity Value/Current shares
outstanding
 RECOMMENDATIONS
• Based on our discounted cash flow analysis with the calculated WACC of
9.27%, the Present Value (PV) = Equity value per share = $58.13 per share,
which is more than current share price of $42.09.
• Nike shares price is undervalued. (Intrinsic value is greater than current
market share price, which indicate the stock is undervalued.)
• We recommend Kimi Ford to purchase stock in Nike, Inc. for her fund,
NorthPoint Large-Cap Fund, because the stock is undervalued and it had
growth potential that would be beneficial to her fund.