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Case 6a
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  • 1. I. INTRODUCTION 1.1. SUMMARY Kimi Ford, a portfolio manager at NorthPoint Group, a mutual-fund management firm, analyzed thestock of Nike Inc., whether she would add Nike stock in his portfolio or not. Nike’s share price haddeclined significantly from the beginning of the year. Since 1997, its revenues had plateaued at around$9 billion, while net income had fallen from almost $800 million to $580 million. Nike’s market share inU.S. athletic shoes had fallen from 48%, in 1997, to 42% in 2000. Finally, company executive reiteratedtheir long-term revenue-growth targets of 8% to 1-5 and earnings-growth targets of above 15%. Ford decided instead to develop her own discounted cash flow forecast to come to a clearerconclusion. Her forecast showed that at the discount rate at 12%, Nike was overvalued at its currentshare price of $42.09. On her analysis, Nike was undervalued at discount rate below 11.17%. Becauseshe was about to go into a meeting, she asked her new assistant, Joanna Cohen, to estimate Nike’s costof capital. In this case, we suppose to analyze whether her calculation is right or not. 1.2. OBJECTIVE - To explain the importance of WACC and to clarify the Cohen’s calculation. - To calculate the costs of equity using CAPM, the dividend discount model, the earnings capitalization ratio and the advantages and disadvantages of each method - To give a good recommendation for Kimi Ford whether to buy the stock or notII. ANALYSIS 2.1 Weighted Average Cost of Capital (WACC) The weighted average cost of capital (WACC) is the rate that a company is expected to pay onaverage to all its security holders (debt holders and shareholders) to finance its assets. Companies raisemoney from a number of sources: common equity, preferred equity, straight debt, convertible debt,exchangeable debt, warrants, options, pension liabilities, executive stock options, governmentalsubsidies, and etc. Different securities are expected to generate different returns. WACC is calculatedtaking into account the relative weights of each component of the capital structure-debt and equity, andis used to see if the investment is worthwhile to undertake. A calculation of a firms cost of capital inwhich each category of capital is proportionately weighted. All capital sources - common stock,
  • 2. preferred stock, bonds and any other long-term debt - are included in a WACC calculation. All else equal,the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACCnotes a decrease in valuation and a higher risk. The WACC equation is: Where,Wd: weight of debtWe: weight of equityKd: cost of capitalKe: cost of equityT: tax rate The advantages of WACC: - To help company when make decision for capital budgeting. The company will choose the projects that have a good return, which is bigger than the cost of capital. - To help when the company designing corporate financial structure. The cost of capital is significant in designing the firms capital structure. The cost of capital is influenced by the chances in capital structure. - To measure the performance of top management. The evaluation for top management can be measure by the difference between actual and forecast profit of the project and by the overall cost of the project. - To help company when make a decision for dividend policy. - To determine a strong estimate if not an exact cost of capital leveraging. Ideally, the lower the WACC percent is the better for the company. 2.2 Calculation for WACC We don’t agree with Cohen’s calculation because Cohen used book value in her calculation wherewe consider market value. a. Value of equity
  • 3. Book value of equity should not be used when calculating cost of capital. The market value ofequity is found by multiplying the stock price of Nike Inc. by the number of shares outstanding. Market Value of Equity (E) E = Stock Price × Shares Outstanding b. Value of debt We should consider the value of long-term debt on balance sheet. This long-term debt is related tothe Nike’s bond yield and coupon rate. So, Joanna Cohen should discount the value of long-term debt. Here is the way we calculate the market value of debt: Market Value of Debt (D) D = current portion of long-term debt + notes payable + long term-debt c. The weight of equity and debt Then, we calculate the weight of each equity and debt. Weight of Debt Wd = D/ (D+E) Weight of Equity We = E/(D+E) d. Cost of debt and cost of capital The next step is calculating the Cost of Debt and Cost of Capital Cost of Debt To calculate the cost of debt, we use YTM on 20 years of Nike’s bond. From exhibit 4: Coupon rate = 6.75% paid semi-annually  3.375% per 6 months 15 July – 15 January = 3.375% (6 months) Current Price = $95.6 Par value = $100 Coupon rate = 3.375% Maturity time = 20 years paid semi-annually (40 times paid)
  • 4. As it pays semiannually, the YTM per year would be 7.13% (3.56%x2) for 20 years. So, the cost of debt is (Kd) Cost of Equity To calculate the cost of equity, we use geometric mean for the historical risk premium rather than arithmetic mean because it is more applicable for long-term estimation. The arithmetic mean is better to analyze the year to year condition. From exhibit 4 Risk free rate (20-year) = 5.74% Risk Premium = 5.90% Beta = 0.8 (the average beta represents the historical business condition) Tax Rate = 38% (35% corporate tax+3% state taxes) So, the cost of equity (Ke) is calculated as below: Ke = CAPM = Risk free + (β x Risk Premium) e. Weighted average cost of capital 2.3 Calculation Another Method for Cost of Equity a. CAPMThe capital asset pricing model (CAPM) is used to determine a theoretically appropriate required rateof return of an asset, if that asset is to be added to an already well-diversified portfolio, given that assetsnon-diversifiable risk.Recall the calculation from 2.2 ,Ke = CAPM = Risk free + (β x Risk Premium) b. Dividend Discount Model From exhibit 4:
  • 5. D0 =$0.48 P0 =$42.09 Forecast of Dividend growth (g) = 5.50% D0 = Current Dividend (year 0) P0 = Current share price g = Dividend growth c. Earning Capitalization Model - From the case, Nike targeted its earnings-growth of above 15% - Current diluted earnings per share is $2.16 - Current market share is $42.09So, we calculate the cost of capital based on earnings capitalization model as follow: Ke = E1 / P 0 E1 = Forecasted earning P0 = Current share price