This action might not be possible to undo. Are you sure you want to continue?

: Cost of Capital Case Facts

Prof. R. Ybañez BA 280.2 THW 13 March 2012

North Point Group North Point Group is a mutual fund management firm. Large-Cap Fund is one of the portfolios managed by Kimi Ford. This portfolio is composed of Fortune 500 companies, to include Exxon Mobil, GM, 3M, and large-cap, old economy stocks. The fund earned 20.7% return in 2000 and 6.4% year-to-date returns, end of June 2001. With emphasis on valueinvesting, Kimi Ford is considering buying shares of Nike, Inc. Nike, Inc. An athletic shoe manufacturer, Nike, Inc. had a stagnating revenue of $9 billion from 1997-2001. Net income of the company had also fallen from $800 to $580 million. Nike’s market share in athletic shoes had dropped from 48% (1997) to 42% (2000). To address the current performance, Nike’s management has the following plans: Develop more athletic shoe products in mid-price segment Push its apparel line Exert more effort on cost control Targets: Revenue growth: 8% to 10%; Earnings growth: above 15%

Analysts’ Assessment of Nike, Inc. Analysts have mixed reactions about Nike. Some thought that the company has too aggressive financial targets. Others saw significant growth in apparel and Nike’s international businesses. The Lehman Brothers propose a “buy” while the UBS Warburg and CFSB suggest a “hold”. Joanna Cohen’s Analysis The assistant portfolio manager, Joanna Cohen, computed a single cost of capital for Nike, Inc. since the company is in sports-related business, except for one. Value of Debt and Equity Capital Sources Debt Equity Total Values Book Value Book Value Amount (in million $) 1,296.6 3,494.5 4,791.1 Weights (%) 27 73 100

Joanna Cohen used the book value of both debt and equity to compute for the value of the firm and the weights of debt and equity.

Value of Debt (Vd) Joanna Cohen used the book value of debt. beta: average of Nike’s historic beta from 1996 to 2001. This is computed by taking total interest expense for 2001 divided by the company’s average debt balance (May 2000 and May 2001).9 X 5. It means the future value of total long term debt base on coupon rate should be considered.5 months) = 6.5%. the after tax cost of debt is 2.274. Recommendation The issue of Nike’s case is about the calculation of the cost of capital (WACC) and if the share price of Nike is overvalued or undervalued. it is recommended that the value of long term debt that appears on the balance sheet be discounted. the price of Nike.75% coupon paid.427. Nike.30 + $413. Using the above values.4%. the steps are as follows: From 15 July 2000 until 15 January 2001 = 6. From 15 January 2001 until 31 May 2001 (4. To calculate total value of debt. Share price With the discounted cash flow forecast developed by Kimi Ford. the computed WACC is 8.59 per share.09 X 271. using WACC=8. Inc.75 % x 4.44 .833 Value of Equity The market value of equity should be used in calculating the cost of capital. pre-tax.Cost of Debt The estimated cost of debt of Nike is 4.84 = $1.54 **$435. The cost of capital is the minimum rate of return that a firm must earn on the projects in which it invests. Cost of Equity The estimated cost of equity was 10. Market Value of Equity (Ve) Calculation: Ve = Stock Price X Number of Shares Outstanding = $42. This makes Nike undervalued at the current market price of $42. Using CAPM. risk premium: compound average premium of the market over Treasury bonds. Inc. In calculating value of debt.06% Market Value of Debt (Vd) Calculation: Vd = Current LT + Notes Payable + LT Debt** (discounted) = $5. Cost of Capital Calculation for Nike. Finally.9 – (435.5 = $11. is $49. should be added to the North Point Group’s mutual fund portfolio or not.4%.09.5 months/6 months = 5. Using 38% tax rate (statutory tax plus state tax). the following values were used: risk-free rate: 20-year Treasury bonds.7%.3%. Inc. it is also a question if Nike.40 + $855.06%) = $413.

53 + 11. Cost of Equity The CAPM approach is used to compute the cost of equity. Treasuries was used as the risk free rate because it more approximates the market determined rate being a more active market.72 (Exhibit 2). Using Excel. beta: average of Nike historic betas. Compared to the current share price of Nike at $42. 976.53 + $11. this rate was used to discount the free cash flow of Nike for the 10-year projection. Using the effective tax rate of 38%.97% = 9.97% Cost of Debt The cost of debt was calculated by finding the yield to maturity (YTM) on Nike Inc.17%. the YTM is computed as in Exhibit 1. The calculated value of equity was $13.427.S.45. It is recommended that Nike shares should be added to the portfolio of North Point Group because of the following reasons: • Undervalued: priced below fair price • The IRR or rate of return is greater than the cost of capital • Nike has growth potential • Management plans are laid for the company . for the beta.274.Weights of Debt and Equity The weights of debt and equity using the market values are computed as follows: Wd = $1.09. Finally.274.03% We = $11. unlike the arithmetic mean.44) = 89.54% Nike’s Share Price Having computed the new WACC. The geometric mean was used for the risk premium because it is not biased by the measurement period.5. being a single estimate for the entire time interval is invariant to the choice of time interval. Also. The following values are used: risk free rate: the 10-year Treasury bond rate.427.53 / ($1. The pre-tax cost of debt of Nike is 7.75% coupon semi-annually. The 10-year rate also approximates the duration of the stock market index portfolio.427. Weighted Average Cost of Capital Using the above values. the WACC is computed as follows: WACC = 4.44) = 10. the share price of Nike is valued at $51. the after-tax cost of debt is 4.274.44%. the projection of Nike financial statements is 10-year period.44% x 10. we used the average to account for the large fluctuations in Nike’s historical beta. the share is undervalued.03% + 10. The geometric average. The 10-year yield on U.44 / ($1.11% x 89. debt with a 6. risk premium: geometric mean of 1926-1999 equity risk premiums. Given the current outstanding shares of 271.

90% 0.11% $11.274.Exhibit 1 Cost of Debt Settlement Date Maturity Date Rate Current Price Face Value Frequency Basis Tax rate kd before tax kd after tax Value of Debt Cost of Equity Risk Free Risk Premium Beta ke Ve 5.17% 4.427.44 Vd 7/5/2001 7/15/2021 6.75% $95.44% $ 1.80 10.53 Value of Equity .60 $100 2 2 38% 7.39% 5.

Exhibit 2 .

- Nike INC
- Case Study Nike, Inc. - Cost of Capital
- Analysis Slides-WACC Nike
- NIKE Inc Cost of Capital _ Financial Management
- Nike Inc Cost of Capital Case Analysis
- NIKE,INC COST OF CAPITAL
- Nike Assignment
- Nike Inc. Cost of Capital Case Analysis
- Nike, Inc Cost of Capital Case Study
- Case Study
- Nike Case - Team 5 Windsor - Final
- Nike Case Study
- Nike Case Analysis
- Nike, Inc Cheats Kimi Ford
- Nike, Inc. Cost of Capital
- Nike, Inc
- Nike Cost of Capital
- Investment Detective Case
- The Investment Detective
- Investment Detective
- Nike Cost of Capital
- Case Analysis of Nike, Inc.
- CPK Case
- Worldwide Paper Company
- Clarkson Lumber Case Study_Sol
- The Investment Detective Case Study
- New Heritage Doll - Solution
- The Investment Detective
- fonderia torino
- The Investment Detective
- Final Case 2 Nike Inc.

Are you sure?

This action might not be possible to undo. Are you sure you want to continue?

We've moved you to where you read on your other device.

Get the full title to continue

Get the full title to continue reading from where you left off, or restart the preview.

scribd