ores Nike, Inc.: Cost of Capital On July.5, 2001, Kimi Ford, a portfolio manager at NowthPoint Group, & motul-fund:-man- agement firm, pored over analysts’ write-ups of Nike, Inc. the athletic-shos manufacwurer SEke'e share price had declined significantly from the start of the year. Ford was consid ing buying some shares for the Fund she managed, the NorthPoint Large-Cap Fund, Which ine ceied smastly in Fortune 500 companies, with an emphasis on value investing. is top holdings included ExxonMobil. General Motors, McLonalg', 3M. an ofter argc generally old-economy stocks..While the stock market had declined over the Tast 18 onthe, NorthPoint L2rge-Cap had pecformed extremely wel. I 2000, the fund esined ¢ snurn of 20.7 percent even as the S&P 500 fell {0.1 percent. The Fund's year-to-date re Tune 2001 stood at 4 percent versus the S&P 500's ~753 percent ‘Only a week ago. on June 28, 2001, Nike held an analysts ne fiscal-vear 2001 results ' The meeting. however, had another purpose: Nike mana; wanted to communicate a strategy for revitalizing the company. Since 1397, Nike's rex aust had platemed at around $9 billion, while net income had fallen from elmo S800 million te $569 maiBien (see Exhibit 1). Nike's masks UES. athlets fallen from 48 percent in 1997 to 42 percent ia 2000? In additiox, recent supply-chain t+ ques and the adverse effect of a strong dollar had negatively affected revenue ing disclose ies neni Nike's fiscal year ended in May: SDonglas Robeon “use Do... Something: Nits Insulaty and Foot Dragging Hove Runeing ness Week, July 2.200' Places” Bist seis cae wan peared rm publicly available infomation by Jestca Chan uns supristn of POEs: Fa ee eid suppo ofthe Batten Insitute srl acknowledged, The cu ws a eae a crate han lust aleve or efesive handing of a8 ainisraine So a ee ol by ae Unies of Virginie Darden School Foundation, haus. VAT 1 and on emai dardenese@ vii. Ne prof piblieaion max ie Fe ete ina spreads or tensed nn form or by ans meatier Si ia neordng cr enerese—itou Ou penmation of the Daren Sct! uses: Merson 18\ Case 13: Nike: tne Cost of Capital 177 At the meeting, management reveaiéd plans to address both top-line growth and oper- ating performance. To boost revenue, the company would develop more athletic-shoe prod- ucts in the midpriced segment’—a segment that it had overlooked in recent years. Nike also planned to push its apparel line, which, under the recent leadership of industry veteran Mindy Grossman‘ 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 8-10 percent and earnings-growth targets of above [5 percent. Analysts’ reactions were mixed. Soine thought the financial targets too ageressive; oth- «15 saw significant growth opportunities in apparel and ins Nike's international businesses. Ford read al the analysts" reports thet 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 CSEB analysts expressed misgivings about the company and recommended 2 “Hots.” Ford decided instead to develop her own discounted-cash-flow forecast to come to a clearer conclusion. : Her fogecast showed that, at a discount rate of 10 percent, Nike was overvalued at its current share price of $42.09 (see Exhibit 2). She had, however, done a quick sensitivity analysis that revealed Nike was under Valued at discount rates below 9.4 percent. As she Was about to go into @ meeting, she asked her new assistant, Joanna Cohea, to estimate Nike's cost of capital. = Cohen immediately’ gathered all the-data she thought she might need (Exhibits 1,2, 3, und 4) and began to work on her analysis. At the end cf the day, she submitted her cost-of- Capital estimate and 2 memo (Exhibit 5) explaining her assumptions to Ford. *Sacakers in cis segment sold for $70-S90-¢ pair. —- — “Mindy Grossman joined Nike in September 2000. She was the former president end ciet exceutive of Hones Ap- pire! Group's Polo Jeans DivisionFR. Case 19; Nike, ln: Cont of Capital EXHIBIT 1 ‘Consolidated Income Statements Year Ended May 31 Ga millions except pet share deta) 199519967998 99920002007 Revenues “e105 Ga10 9186S 95531 87T69 BNR. BABE ‘Coot gots colt 2865339067 55030 6.0655 54935 _ 5.4058 _5.1849 Gross profit Bseyg” 3635 SABC 3753435913 37089 Selling ad adeiniscrative Tos 15886 23037-2638 24166 2.6064" 2.6891 Operating income Bas OES CSS ——«BBBC«RSGBSCOHKI Ioterestexpense 29S 3 DAL 850 Other expense, net 73670028 OMS BD 1299 454 a5) Restructuring charge, net Income before income taxes a Sat i2sa~—«S3O~~«CTGA (992 Income taxes 2502-3459 49842534 2947 340.1 Nat income 399755327988 3996 ASIA S19 SEO Diluted earnings per common share 136 1.88 2.68 135 st 0 Aowage stares bubmanding (hac) 25H, 12936-2970 2960/2815 ABS, Growth (%) Revenue . 359 420 40 en 25 Operating income 422 415° G74 8) 150 wae ae (408) 30 28h Margins (%) Grate margia 396 a1 365 314 399 Operating margin 1s 50 99 98. 109 Secmarzin = 85 87 42 3 64 Efcctive tx rate (HY 385 386 388 33543) tory tax ate was 35%, The nse tx varied yen fom 253550 35%, jas WatureCase U9 Nike, tne. Gost of Capit? EXHIBIT 2 Discounted-Cash-Flow Analysis oe neem ncecreemnennmrnmennenit meee Soren seen oe 2003 2004 2005-2006 +207 -—«-2008 «2009 «20102041 Assumptions: Ke: enue growth (4) 10 68 65 60 60 GHD 8D COGSISales (%) 0 600 595 59090 SSS SES SEO SB S&ASales (%) 280275 25 260 BS 20 DH 15.0 Tas cate (%) 380 38.0 380 380 «23RD AS IK Current assetdSales (2 380 38.0 3eo0 80 OOK 38 Current labilities/Sales (%) us us us us Ss Ns Ss MS ‘Yearly deprecation equals capex. Cost of eapital (%) 100 “Termiral grow rate (E) 50 Discounted Cash Flow (Operating income 12184 1351.6 15546 1.7179 1,9500 21359 2.4102 2.5548 2.7901 29575 Taxes 463.0. 5136 5908 6525 741.0817 _9159_9708 1.0602 _1 NOPAT 755.4 8380 9639 10645 1209.0 1323 16943 1.5640 1.7299 183377 Capex, net of depreciation ee abe fe ee Change in NC 88 _(1749) (1863) (1984) (195.0) 2062) (218.1) 2323) 2462) 61.0) Free cash flow FeAl 6631-7776 8652 1.0160 1UITS 1775.2 13517 14837 15727 ‘Terminal value 127333 Toal flows FAT CRT FTTE BET AON LATS (TIED T3817 14837 14,3060 Pocket otha fas Gai MEG Soa vio CAV OWS e544 530.6 6292 5.5156 Envemprice value 11.1088 Less current outssndiag debt 1296.6 Equity value 93122 Current shaves outstanding -, 2715 a Sees Loh © crorteep els 2s eel ‘Scusitivity of equity value to discount eave Discount rate Equity value " ee ee Peas | 80m 6102 | 830 3387 ie . é or aos F | 936 2203 ; | 950 40.65 ole 31 : 2933 mat 2493 i, aes |78. Case 13: Niko, lee Cast of Capital EXHIBIT 1 ‘Consolidated Income Statements ‘Year Ended May 31 Garmillions except el per-share data) 1995, 1996 1997 1998 199 2000 2001 Revenues 7608 64106 9.1865 9.5531 87769 «8.9951 94BBE Coui of goods sold 5503.0 6065.5 5493.5 _ 3.4038 _5.784.9 Gross profit 36835 34876 32834 = SSS 37039 Selling and administrative 2303726238 2426.6 _2.6064"_2.689.7 ‘Operating income 13798 8638 «8568 9849 1,014 Interest expense 523 0 441 450 $87 Other expense, net 323 208 us Bl 34 Restructuring charge, net = = 1299 45.1 = Income before income taxes 39 Sol 12952 «6530 746.1 p92 Income taxes 2502 3459 49942534 2947 34013317. 399.7 5532 7988 3906 451.4 S791 $89.7 Diluted earings per common share 136 1.88 2.68 135 ist 207 216 ‘Average shares outstanding (diluted) 294.0 2936 ©2970-2960 287.5 28. 2733 Growth (%) Revense 350 420 40 BD 25 55 Operating income 2 aus G14) 8) 130 3.0 et asa ae (298) 30 288 18 Margins (¥) Gross margin 39.6 401 365 ara 399 39.0 Operating margin 15.1 150 90 98 109) 107 Betmargin 85 87 42 sa 4 62 Effective tax rate (%)” 385 386 388 353? 360 35%. TThe U.S. story tax rate was 35%, The state tmx varied yeas from 2.5% Source: Company's 10-K SEC Filing. UBS Wartor.180. Case 13° Nike, Ine: Cont of Cantal EXHIBIT 3 Consolidated Balance Sheets (in millions) May 31 2000 2001 Assets Current assets Cash and equivalents S 2543 s 3000 ‘Accounts receivable 1569.4 14 Inventories late rat Deferred income taxes MLS 1133 Prepaid expenses 2152 1625 ‘Total curtent assets 33964 es 1383.4 16s ~ Ident oll n2t “4109 3913 ‘Deferred income taxes and ciher assets 266.2 1782 Total assets 553569 seaws Liabilities and shareholders’ equity . Current Liabilities: “Curent portion of Tong-term debt sso. Notes payable 2 “Accounts payable 538 ‘Accrued tabi 19 Income taxes payable “Total current liabilities E1408 ot 4703 Defend income taxes and osner Hiabiliies + 1103 ed stock 03 ‘Shareholders’ equity ‘Common stock, Per 28 _Fapita in excess of stated ae 459.4 ‘Uneamed stock compensation 9) ‘Accumulated others comprehensive income asen ‘ Retained earings ‘Total sharenoiders equity Total abilities and shareholders’ equity 5 a Source: Company 10K SEC Hing1st ssa anng wana SRA" BANE SEDO I 05's . ‘90-07 OF 0-B66T HOH) HIDES PUDpIaICL Jo HUDSHN SHE] 2M p uo wo 210 wo ero uo zo ero z10 zr an ovo oro ovo f aoe nea siuaay im, sare yor oy on0t190 GL. a2 002 wD, 6661 i i 005 dS PHN ee ae wo 466 e PP F2.fF Pe? £ 89 ¥ F oF F Seer EFER Re RFR SES ET ERE EE z2e2ee2e2822888228288 8 8 8B ie Koesi-9z60) swmaosg YSN wus oes tore 's Atmg 02 9G ArenuLs Q0SePRS 01 sanjay soUlRAUEHEg aDLsy DIYS 2xIN. eULsEp] UPUEUR PUL TDr]AUH » LIGIAXSIR2_ Case 13: Nike, Ine: Cost of Capital EXHIBIT S Joanna Cohen’s Analysis TO: Kimi Ford FROM: —Joanaa Cohen DATE: July 6,2001 SUBJECT. Nike's Cost of Capital Based on the following assumptions, my estimate of Nike's cost of capital is 8.3 percent: 1. Single or Multiple Co:'s of Capital? The frst question [considered wae whether out single or mule cos of capt given it Nike has taupe busines segment Asie from fotwes, which kes up 6 percent of eveaue, Nike alse sells ap- Fare! (0 percent of vera) thet complement foorsear redo In ado, Nike sel por al, ime Ficces, eyewear. skate, bt, ané other equipment designed for prs aves Equipment products act for 36 percent of reve Finally, Nite a sel ome on-Nike branded products sch as Clean es casual foceay, ed ie sats, sate tades,ckey sich, hockey eseys and oe: pods unde the Bauer wademark: Non-Nike Wands sccount for 45 percentof revenue” © asked myself whether Nike's business segments had different enough risks from each other to warrant ~ different costs of capital. Were their profiles really different? I concluded that it was only the Cole-Hscn line that was somewhat different the rest wer all sports-related businesses. However, ice Cale Hasn males Up only atin faction of rvenes, 1 didnot think necessary to eomput& separ orto expt As forthe p> pel and foorwea lines, they a 01 ough the same mating and distribution chars and ae often mar- keted in “cllction of similar design believe they face the same ak factors, os such, I ecdeatocompute only one cost of capi torte what company. IL, Methodology for Calculating the Cost of Capital: WACC Since Nike is funded with both debt and equity, I used the Weighted Average Cost of Capital (WACC) ‘medhiod, Based on the latest available balance sheet, Gebs as a proportion of total capital makes up 27.0 perceat ancequity accounts fr 730 percent caine’ asa: Cepicel sources " Eee ‘Notes payadic. en ee . 2 Long-term debt . + 270% of total capital : + Equity 83,4945 + 72.0% of total capital “1 - Ui. Cost of Debt : My estiorace of Nike's cost of debt is 43 percent, arrived at this estimate by taking tot interes pense forthe year 2001 and dividirg itby the company’s average debtbalance.' The rte i iower than Treasury “Debi balances as of May 37, 2000, and 2001, were $1,¢44.6 and 51,291 2, respectivelyea : ee Ty Coe 13. ike, tae Cost of Capital 185 which eniry yells bat that is because Nike exis « portion of its Fonding needs through Japanese ye 1 rates between 2.0 percent 1043 percent. a ‘After adjusting foc ax, the cos of debt comes ual to 2.7 perven. used tax eale oF 38 percent, whet | bjained by adding state axes of 3 percent to the US. sakuly tax rae. Histrially, Mike's state taxes have fanged from 2.5 percent to 35 percent IV, Cost of Equity Lesimatd te cos equity using the Capital Asc Picing Mel (CAPM, therein sch ate Dividend Discount Mods (DDB) ad the Ersing Copal Rati can be ed 0 etnte e600 However n my opie tie CAPM is the spc method My estimate of Nike's cost of equity is 10.5 percent. | used the curtent yield on 20-year Treasury bonds a ny irate ant cmpound average pum of te marke over Tey bonds (3.3) perce) sty Sak premium, Forbes, Ito the erage oF Nike's ben 198 oth rset V. Putting it All Togeshe Inutting all my assumpticns into the WACK Formula, my etme of Nike's cost of capitals 8 3 percent. WACC = Ky(1 —t)*D/(D + E)+K, *E/(D +'E) 21% — * 210% «+ + 105% 72.0% 83%