5th Case: NIKE, INC; COST OF CAPITAL

FINANCIAL
MANAGEMENT
& POLICY
Sofie Ratna Artanti (29123194)
Fawaz Irfan Mubarok (29123003)
Denisa Naura (29123145)
Yohanes Vito Perdana Sujudi (29123094)
 Fawaz Irfan Sofie Ratna

Team
Mubarok Artanti

Member
Yohanes Vito
Perdana Sujudi Denisa Naura
1. What is WACC and why is it important to estimate a
firm’s cost of capital?
The Weighted Average Cost of Capital (WACC) is a key financial metric that calculates a firm's cost of capital, where each
category of capital (debt and equity) is proportionately weighted. WACC is crucial because it represents the minimum
return a firm must earn on its existing assets to satisfy its investors—those who provide debt (creditors) and equity
(shareholders).

Importance of WACC:
1. Investment Decision-Making: WACC serves as a hurdle rate against which the firm's investment projects are evaluated.
For example, if a company has a WACC of 5% and undertakes a project that generates a return of 15%, the project
yields a net gain of 10% over the cost of capital, indicating it is a profitable venture.
2. Performance Evaluation: By comparing a project or firm's return against the WACC, stakeholders can assess whether
the entity is generating value. A project returning more than the WACC adds value to the company, enhancing
shareholder wealth.
3. Strategic Financial Planning: Firms aim to optimize their capital structure—the mix of debt and equity—in a way that
minimizes the WACC. Lowering the WACC can increase the firm's value and potentially reduce the cost associated with
raising new funds.
4. Risk Management: The WACC incorporates the costs associated with both debt and equity, reflecting the overall risk of
the firm. A higher WACC indicates higher risk and vice versa. It is a comprehensive measure that helps in assessing the
risk-return profile of the firm's investments.
1. What is WACC and why is it important to estimate a
firm’s cost of capital?

Components of WACC:
1. Cost of Debt (COD): This is the interest rate a company pays on its borrowings, adjusted for tax benefits since interest expenses are tax-deductible.
For instance, if a firm's interest rate on its debt is 7% and the corporate tax rate is 30%, the after-tax COD is 4.9% (7% * (1-0.3)).
2. Cost of Equity (COE): This represents the returns required by the firm's equity investors. It can be estimated using models like the Capital Asset
Pricing Model (CAPM), which considers the risk-free rate, the equity beta (risk measure relative to the market), and the market risk premium.
Suppose the risk-free rate is 3%, the market risk premium is 5%, and the company's beta is 1.2. The COE would be 9% (3% + 1.2 * 5%).

Calculating WACC:
Assuming a firm is financed by 40% debt and 60% equity, with an after-tax cost of debt of 4.9% and a cost of equity of 9%:
WACC = (0.4×4.9%) + (0.6×9%)
= 1.96%+5.4%
= 7.36%
This means the firm must generate at least a 7.36% return on its investments to meet its cost of capital.

Strategic Implications for Investors:

While WACC is primarily a tool for corporate finance decisions, it indirectly aids investors by highlighting the risk and return expectations of a company.
A lower WACC suggests a company is able to generate returns at a lower cost, potentially making it a more attractive investment. Conversely, a high
WACC indicates higher risk and may necessitate higher returns to attract investors.
2. Do you agree with Joanna Cohen’s WACC calculation?
why or why not?
Those are reasons why a firm’s cost of capital is important. Joanna calculated weighted average
cost of capital (WACC) as 8.4% using CAPM model and we do not agree with her calculations as
below reasons:
Use of Book Value for Debt and Equity: The critique highlights Joanna's use of book values rather than market values for both
debt and equity in her calculation. This approach can lead to inaccuracies because book values often differ significantly from
market values. Specifically, it's mentioned that she should have used the market value of equity, calculated by multiplying Nike
Inc.'s stock price by the number of shares outstanding, and the market value of debt for calculating the cost of debt. Instead,
she used the book value, leading to incorrect weights for the cost of equity and cost of debt.

Cost of Debt Calculation Using Current Market Rates: Joanna should have used the current market rate to determine the cost
of debt, rather than relying on book values or historical interest rates. This is because the current market rate more accurately
reflects the rate Nike Inc. would pay on new debts issued today. The critique specifically mentions that she should have
discounted the value of long-term debt that appears on the balance sheet ($435.9 million) at Nike's current coupon rate,
which she did not do.

Use of Historical Beta vs. Current Beta: Joanna's decision to use the historical average of Nike's beta from 1996 to the present
is criticized because it may not accurately reflect the company's current risk profile. The critique points out the difference
between the historical average beta (0.8) and the latest beta (0.69), emphasizing that the use of a historical beta may not
accurately predict the future cost of equity. The suggestion is that using the current beta is more appropriate for reflecting
the company's current risk level.
 3. If you do not agree with Joanna’s analysis, calculate
your own WACC for Nike and be ready to justify your
assumptions.
To compute the WACC we have to calculate separately the financial return expected by the cost of equity (KE) and the
financial return expected by the providers of the cost of debt(KD), so as to compute a weighted average of the two expected
returns according to their respective proportion in the capital structure of the company. The WACC is obtained by using the
following formula:

Cost of Debt
We think Cohen mistakenly uses the historical data in estimating the cost of debt by dividing it in the average balance of debt
to get 4.3% of before tax cost of debt. The rate is lower than Treasury yields and may not reflect Nike’s current or future cost of
debt. We calculate the appropriate cost of debt by using data provided:

As data above, we can calculate interest as 3.58% (semiannual) or 7.16% (annual), thus after tax cost of debt = 7.16%(1-38%) =
4.44%
3. If you do not agree with Joanna’s analysis, calculate
your own WACC for Nike and be ready to justify your
assumptions.

Weights of Capital Components:

Market value of equity = current share price* current shares outstanding
= 42.09* 271.5
= 11,427.44

Book value of debt = 1296.6

The market value weight for equity is:

= 11,427.44 / (11,427.44 +1,296.6)
= 89.8%

The weight for debt is 10.2%. Based on the assumptions above, our calculation of the WACC is as follow:
= 4.44%*0.102 + 9.81%*0.898
= 9.26%
4. 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?

Capital Asset Pricing Model (CAPM)

Advantages:
The model is simple to use and generate a range of possible outcomes around the required rate of return.
Only systematic risk is being considered as it can be assumed that the investors would have a well-diversified portfolio and the unsystematic risks has
been diversified away.
Can be used when exploring business opportunities when the business mix and the financing differ from the current business.
Takes into account the company’s level of systematic risk relative to the market as a whole.

Disadvantage:
Risk-free rate yield change daily and can create volatility
Market return (capital gains and dividends) can be negative at any given time and must be utilized to even this out. Moreover, it is not a true
representative of future market returns as it focuses more on backward-looking
Unfair assumption is made that individual investor can borrow at the same rate as the government (risk-free rate), which means the actual model is
more steep than what we might expect in reality
It is extremely difficult to estimate betas for many projects
Corporate risk is sometimes overlooked as market risk becomes the main focus.
4. 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?

Capital Asset Pricing Model (CAPM)

Advantages:
Most commonly used and easiest to understand
Value company’s stock without taking into account the market condition (can specified sensitivity testing and changing circumstances)
Flexibility for investor when estimating future dividend earnings
Allow for calculating the desire stock price by matching the market assumptions for growth and expected return.

Disadvantage:
Does not take into account non-dividend factors such as: brand loyalty, customer retention and intangible assets ownership. All of which impact
company’s value
Sensitive to small changes in the input assumptions
Overreliance on valuation that is from data estimations
4. 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?

Earning Capitalization Ratio

Advantages:
An income-based method that is commonly used to value small companies or no-growth firms
Reflects the investor’s risk-adjusted required rate of return and includes a factor reflecting future growth.

Disadvantage:
Projected future earning may be wrong and resulted in high deviations from the expected rate of return
Model does not match the size and growth potential of Nike Inc. so would be inappropriate for the situation.
Does not factor company’s assets in calculation

This model does not take into account the growth of the company, therefore we agreed that it will not
be a good representation of the company’s cost of capital.
5. What should Kimi Ford recommend regarding an
investment in Nike?
To discount cash flows in Exhibit 2 with the calculated WACC is 9.26%, the present value of Nike approximately
$57.05 per share, which is much higher (1.36 times) than Nike’s current market price of $42.09. So Nike shares price is
underestimate and undervalued by $14.09 as Nike is currently trading in 2001. Some might think this value is still
understated, due to that current growth rate (6% to 7%) is much lower than that estimated by manager is 9.27% (8%
to 10%). Moreover, Nike also changed their business strategy by more concentrate in mid-priced segment, which is
Nike less concentrate for a long time before. That’s mean their total of sales might increase, lead to avenue increase,
lead to profit increase, of course, Nike’s share prices and dividend will be increase in long-term.

Using this data, we found that North Point Large-Cap Fund should buy Nike Inc., shares at this time because the stock
is undervalued because it has growth potential that would be beneficial to the fund. Along with this fact, management
has goals for the near future that could provide a great deal of profit for Nike Inc. As we know that in conference, Nike
was showed that the company is heading on the recovery path with new strategy and there is potential for abnormal
profits given the growth capacity and the set targets by the management are easily achieved if they stay focused
since they have the capacity. Technical analysis also supports a buy decision, because looking on the past
performance of the Nike Inc., share against the market index. It has shown that Nike can outperform the market
returns and now that it had gown down, it is left with the upside given plans that are being put in place.
5. What should Kimi Ford recommend regarding an
investment in Nike?

Conclusion:
Kimi Ford should recommend buying Nike Inc. shares. The calculated present value of Nike indicating the stock is
undervalued. This discrepancy suggests a strong potential for growth, especially considering Nike's strategic shift towards
the mid-priced segment, which could increase sales, revenue, and ultimately, share price and dividends. Despite some
concerns about short-term volatility in the industry and Nike's position within it, the long-term investment in Nike appears
promising due to its underestimated market value and potential for significant growth relative to its historical performance.
First of all, Nike’s shares long-term always is wonderful investment, but short-time buying also should be careful because of
the changing fast of industry, the changing of Nike, the changing of trend in footwear industry and so on.
Thank You