Nike, Inc. : Cost of CapitalBackgroundNorthPoint Large-Cap Fund adalah salah satu perusahaan manajemen pendanaan yangberada dibawah NorthPoint Group yang mengalokasikan dananya untuk berinvestasi diperusahaan-perusahaan besar. NorthPoint Large-Cap Fund sudah banyak menginvestasikandananya dalam perusahaan-perusahaan Fortune 500, yang menekankan pada nilai investasi.Top holdingsnya mencakup ExxonMobil, General Motors, McDonald’s, 3M, dan modal besaryang lainnya. Walaupun bursa saham telah menurun sejak 18 bulan terakhir, NorthPointLarge-Cap telah menunjukkan performanya yang cukup bagus. Pada tahun 2000, dana-danatersebut menghasilkan return sebesar 20.7% walaupun S&P 500 turun 7.3%.Kimi Ford, Portfolio manajer dari NorthPoint Large-Cap sedang memutuskan untukberinvestasi dalam salah satu perusahaan besar di Amerika Serikat, yaitu Nike, Inc., sebuahperusahaan yang memproduksi sepatu olahraga, tapi dia belum membuat kepastianmengenai keputusan ini, ditambah dengan harga saham Nike, Inc. yang telah menurunsecara signifikan sejak awal tahun.Nike Inc, sebuah perusahaan manufaktur yang berdiri sejak tahun 1964 di Portland. Awalnyaperusahaan ini telah memproduksi sepatu atletis, yang kemudian berkembang sehinggapada akhirnya memproduksi berbagai macam produk olahraga. Produk-produk yangdiproduksi oleh Nike secara umum dibagi 2 yaitu produk dengan merek Nike serta mereknon-Nike. Khusus produk bermerek Nike adalah sepatu, aparel sebagai pelengkap produksepatu, bola olahraga, perelatan waktu, kacamata, skates, bats. Produk bermerek Non-Nikeyang diproduksi adalah Cole-Haan line dress dan casual footwear, ice skates, skate blades,hockey sticks, hockey jerseys, dan produk-produk lain di bawah Bauer trademark.Nike adalah market leader untuk sepatu atletis. Pangsa pasarnya sampai tahun 2000 adalah42%. Dengan pendapatan yang stabil yaitu sekitar 9 milliar tiap tahunnya.Tetapi ternyata ada masalah pada bidang keuangan dari Nike. Inc,. Menurut financialstatementnya, Net income Nike menurun dari hampir $800 juta pada tahun 1997, menjadi$589,7 juta di tahun 2001. Selain itu, sekalipun tetap menjadi market leader, namun marketsharenya di sepatu atletik di US sebesar 42% pada tahun 2000 ternyata turun dari 48%sebelumnya.
Nike telah mengadakan meeting dengan analis-analis untuk memperlihatkan hasil fiscal year2001-nya. Nike menargetkan revenue growth sebesar 8-10% dan earnings-growth diatas15%. Melihat optimisme dari Nike, ternyata para analis memiliki respon yang berbeda-beda.Hal inilah yang membingungkan Kimi Ford apakah akan melakukan investasi di Nike atautidak.Lehman Brothers menyarankan Kimi Ford untuk melakukan investasi di Nike karenamenurutnya Nike memiliki kesempatan berkembang di apparel line dan di bisnisinternasional. Di lain pihak, UBS Warburg dasn analis CSFB sama sekali tidak mendukunginvestasi di Nike, dengan alasan target mereka terlalu agresif.SWOT AnalysisStrengths· Nke, Inc. pemimpin pasar di produk sepatu olahraga.· Pendapatan yang cukup stabil dari tahun 1997.· Citra merek yang sudah kuat di pasar dunia.WeaknessPangsa pasar untuk sepatu atletik di Amerika menurun dari 48% di tahun 1997 menjadi 42%di tahun 2000.Harga saham yang terus menurun dari awal tahun 2001.Opportunity· Mengembangkan produk sepatu di segmen harga menengah yang sedang bertumbuh.· Mendorong pendapatan melalui segmen produk apparel.
Threats · Harga saham yang terus menurun akan terus berkelanjutan. Statement of the problem Keputusan apakah yang akan dikeluarkan oleh Kimi Ford dalam investasi NorthPoint Large Cap Fund di Nike, Inc.? Alternative Course of Actions 1. Membuat keputusan untuk investasi di Nike, Inc. dengan menggunakan perhitungan Weighted Average Cost of Capital yang dibuat oleh Joanna Cohen. 2. Menahan investasi yang akan dilakukan pada Nike, Inc.dengan mempertimbangkan keadaan perusahaan yang sedang menurun. Recommendation Kami merekomendasikan alternatif pertama, dimana Kimi Ford harus mengeluarkan investasi untuk Nike, Inc. Case Analysis of Nike, Inc.: Cost of Capital Apparently, the issue of Nike’s case is to control and check the calculation cost of capital done by Joanna Cohen who is the assistant of a portfolio manager at NorthPoint Group. But I am willing to tell you that it can be a complex case in which we can doubt about sensitivity analysis done by Kimi Ford (portfolio manager) because her assumptions such as Revenue Growth Rate, COGS / Sales, S &A / Sales, Current Assets / Sales, and Current Liability / Sales have been adopted from previous income statements and balance sheets from 1995 to 2001. Perhaps, we can take new assumptions. Generally, the case issue is to examine if the share price of Nike is undervalue or overvalue and the common stock of Nike Inc should be added to the North Point Group’s Mutual Fund Portfolio or not. Now, let me approve Kimi Ford’s analysis and tell you only the mistakes of Joanna Cohen. What is the cost of capital? The cost of capital is the rate of return that a firm must earn on the projects in which it invests to maintain the market value of its stock. Cohen calculated a weighted average cost of capital (WACC) of 8.4 percent by using the Capital Asset Pricing Model (CAPM) for Nike Inc. I do not agree with Joanna Cohen because of below mentioned: -In the field of Equity’s Cost: She should use current yields on US Treasuries 3 to 12 months at 3.59% because the yield curve is upward sloping. Upward sloping yield curve means that North Point Group should rely to short-term financing instead of long term financing. In fact, by short term financing, the manager can use cheaper cost of equity. It means that North Point Group should sell the purchased shares of Nike during the period of one year. In the case of value of equity, Cohen’s should use liquidation value in calculating value of equity. Liquidation value per share is more realistic than book value because it is based on the current market value of the firm’s assets by using of balance sheet data.
Market Value of Equity (E) Calculation: E = Stock Price x Number of Shares Outstanding = $42.09 X 271.5 = $11,427.44 This figure is should be used for market value of equity (E) rather than Joanna Cohen figure ($3,494.50). -In the field of Debt’s Cost: In calculating value of debt, Cohen should have discounted the value of long-term debt that appears on the balance sheet. It means she should also consider the future value of total long term debt base on coupon rate. To calculate total value of debt, the steps are as follows: Market Value of Debt (D) Calculation: I considered the total amount of Debt for all items which are included by a interest rate as follows: -Current portion of long -term debt -Notes payable -Long - term debt -Redeemable preferred stock D = Current LT + Notes Payable + LT Debt (discounted) = $5.40 + $855.30 + $435.9 + 0.3 = $1296.9 Using these figures, we can now find the market value of Nike Inc., and the company’s capital structure. The Calculation of Weighs: The weights of debt and equity are calculated using the market values of debt and equity as follows: Weight of Debt (WD) D + E = 1296.9 + 11,427.44 = 12724.34 WD = D/ D+E WD = $ 1296.9 /$12724.34 = 10.2% Weight of Equity (WE) WE = E/ D +E WE = 11,427.44/ 12724.34 =89.8%
Cost of DebtThere are two types of interest rate for Nike, Inc. as follows:1) For Notes payable, Current portion of long - term debt and Redeemable preferred stock,all these debts should be cleared during the period of maximum 12 months. Therefore, Icalculated the interest rate in accordance with Exhibit 1(Income Statement) for 2001 year asfollows:Interest rate = Interest payment / Operating incomeCost of Debt = Interest rate = (58.7 / 1014.2) * 100 = 5.78%You can see this interest rate is approximately equal to 20 year yields on U.S Treasuries(Exhibit 4).2) For Long - term debt, Nike, Inc. had issued the Bonds in which the Cost of debt wascalculated by finding the yield to maturity on 20-year Nike Inc. debt with a 6.75% couponsemi-annually. I assumed Nike Inc. to have a single cost of capital since its multiple businesssegments (shoes, apparel, sports equipment, etc.) are not very different and would experiencesimilar risks and betas.Before-Tax Cost of DebtI used three (3) methods as follows:-Method (1): Using Cost Quotations Based on Coupon Interest Rate and Yield toMaturity (YTM)Cost of Debt = 14.14%-Method (2): Based on calculating the IRRCost of Debt = 14.15%-Method (3): Approximating the Cost Based on the Value Bond and Coupon RateCost of Debt = 14%All of the calculations have been included in my spreadsheet.As we can see, all three methods present us approximately the same amount of the cost ofdebt. I have chosen 14.15% for the cost of debt.It is important to find the relationship between the required return and the coupon interestrate. When the required return is greater than the coupon interest rate, the bond value will beless than its par value. We choose cost of debt as 14.15% because it is rational (coupon valueannually is 13.50%). When current value of bond is less than par, required return will bemore than coupon rate.Weight Average of Cost of Debt:
As I mentioned, there are two types of debt and consequently we have two types of Cost ofDebt. I calculated the weight average for Cost of debt as follows:Total debt type 1 = $5.40 + $855.30 + 0.3 = $861Total debt type 2 = $435.9Total debt = $1296.9W (type 1) = (861 / 1296.9) * 100 = 66.4% , Cost of Debt (type 1) = 5.78%W (type 2) = (435.9 / 1296.9) * 100 = 33.6% , Cost of debt (type 2) = 14.15%Weight Average of Cost of Debt = (66.4% * 5.78) + (33.6% * 14.15) =3.84 + 4.75 = 8.59%Therefore, the Cost of Debt is equal 8.6%After-Tax Cost of DebtCost of financing must be stated on an after-tax basis. Because interest on debt is taxdeductible, it reduces the firm’s taxable income.ri =rd x (1 –T) =8.6% x (1 – 38%) =5.33%Nike CaseSummaryWe recommend a buy for Nikes stock on July 6, 2001. Our analysis consists of adiscounted cash flows model. We projected unlevered free cash flows over the next10 years and discounted them according to our derivation of Nikes weightedaverage cost of capital. Our analysis suggests the stock is significantly undervalued,given our expectation it will deliver earnings in the future.
Below we have analyzed Joanna Cohens WACC calculation and her projection ofcash flows. We then calculate our own WACC, discuss the results of our own modelfor cash flow projections, and conclude with our valuation and notes regarding ourrecommendation.Evaluation of Joanna Cohens WACC CalculationCohens WACC calculation is decent, but has a few issues, and a number of errors,as described below.Weighting the capital structure. She weights the capital structure using the bookvalue of equity. Nike is a public company, and its market capitalization is a morerelevant metric for equity than the book value of equity.Cost of debt. To calculate the cost of debt, Cohen simply divides the interestexpense by the average balance of the interest-bearing debt. This is anapproximation for the true cost of the debt, but is too inaccurate. The interestexpense line may include expenses not directly related to the debt of the company(unlikely, but perhaps non-cash payment-in-kind expenses for the preferred stock, orsimply interest expense recognized under GAAP, but not necessarily indicative ofreal costs of debt).The cost of debt should include the current market yield on Nikes publicly tradeddebt, as this is a more pertinent metric.Furthermore, Cohen uses the 20 year yield on treasury bonds to approximate therisk free rate. We feel that the 3-month yield on treasuries is appropriate.Market premium. Cohen uses a market premium of 5.9%, which is surprisingly low.She claims it is the market performance in excess of the treasury rate, but fails todefend this assertion. Perhaps using the arithmetic mean is a better approximationthan the geometric mean for the market risk premium.Decision to use only one WACC. She divided each division by revenue. Indeciding whether to use an overall WACC, or to assign a WACC to each division,she should have weighted each division by cash flows, and not by revenue. It isreasonable to ignore the other sports division, as it is such a small fraction, butperhaps it would have been wise to calculate different WACCs for the footwear andapparel divisions. However, her evaluation of risk related to each division is a
defensible one in using a single WACC for the entire company, and we view this as apotential issue, but not as an error per se.Cost of Japanese debt. The risk related to Japanese debt comes not only frominterest rate risk, but also more significantly from foreign currency exposure. This riskhas not been accounted for and is actually a more potent risk to the debt thanfluctuations in the yield to maturity.Tax benefit of interest expense related to Japanese debt. Under U.S. tax law,interest expense on non-dollar-denominated debt is not a tax-deductible expense,and thus these notes should not be tax-effected (our analysis, however, remainswithin the scope of this class and tax-effects the yield to maturity).Evaluation of Joanna Cohens Cash Flow ProjectionsOverall, her projections seem fairly sound. She keeps margins fairly consistent, withonly slight variations. Revenue growth projections are modest, and the firm seemsdecent cash requirements. However, there are a few issues with her projections.Revenue growth projections. Company executives indicated a long-term revenuegrowth target of 8% to 10% and earnings growth targets of above 15%. Why has shecut her projections? We do not consider her move unreasonable, but we areinterested to hear why she did this.Capital expenditures and depreciation. She projects depreciation and capitalexpenditures as equal in the future. It is unlikely, considering the projected growthrates, that Nike could grow without increasing capital expenditures. Looking at theirhistoric financial statements, capital expenditures far outweighed depreciation andamortization, and so Cohen has made the mistake of understating cashrequirements related to fixed costs. (See appendix 1 for our projection of capitalexpenditures and depreciation.)Positive cash requirement for net working capital. In her first years projection,she shows a cash inflow of $8.8 million related to working capital. Where does thiscome from, and why does it occur? Historically, her working capital requirementshave been consistently negative, and since she projects the company to grow, weexpect the company to use cash in working capital.
Equity value calculation. The calculation of enterprise value to equity value onlyremoves total debt. It should remove net debt and preferred stock, and so hasunderstated equity value.Shares outstanding. Her figure for shares outstanding does not match the dilutedshare count on the income statement, nor does it match the common sharesoutstanding (when net income is divided by common EPS).Cash flow recognition method. She assumes an end-point method for recognizingcash flows. While this is not uncommon, it is also probably not appropriate, as Nikereceives cash flows throughout each period, and thus should recognize the cashflows using a mid-point method.WACC CalculationSee appendix 4 for full details of our WACC calculation. We calculated the cost ofdebt using the yield to maturity, considering an upcoming coupon payment is aboutto be made. Our cost of equity followed the capital asset pricing model, and the twocosts were weighted by their levels within the capital structure, using marketvaluations in weighting the equity value.RecommendationIn the attached appendices, we calculated our own WACC and projected cash flows,duplicating Cohens analysis but with corrections as we saw fit (described above). Inthe appendix, we projected future capital expenditures and depreciation, as we didnot agree with Cohens assertion that capital expenditures will equal depreciation.We then discount the new cash flows subject to new, but similar, criteria, and arriveat an enterprise value. Finally, we calculate an equity value and produce a similarsensitivity chart as shown before.The model in the appendices employs methods that correct those used by Cohen.We re-projected capital expenditures and depreciation to be more accurate (asappendix 1 demonstrates) and tweaked the discounting methods, as described in theabove sections.Our analysis, in appendix 3, shows equity prices per share at various discount rates.Most values are above the current share price of $42.09. Our chosen discount rateof 9.09% yields a share price of $61.44, or a current under-valuation of the stock of$19.35 (46%) per share. The discount rate that yields no over- or under-valuation
(the current price per share) is 11.41% – significantly higher than our discount rate of9.09%.Since the date of the case, Nikes stock rose sharply in the following 9 months,proceeded to drop back down to similar levels after 1 year, and continued to growsignificantly thereafter. However, in recent months (2008), it has come down. Theshort run (after the case) validates our analysis somewhat, however, it isextraordinarily difficult to identify a time period that represents the point at which weagree whether a valuation was "correct" or incorrect" (and of course, it is also verydifficult to identify what constitutes a correct valuation in the first place).Appendix - http://www.filedropper.com/appendix1to4Executive summaryIn this report we focus on Nikes Inc. Cost of Capital andits financialimportance for the company and future investors. The management ofNikeInc. addresses issues both on top-line growth and operating performance. Thecompanys cost of capital is a critical element in such decisions and it isimportant toestimate precisely the weighted average cost of capital (WACC).In our analysis, weexamine why WACC is important in decision making andwe show how WACC forNike Inc. is calculated correctly. Also, we calculatethe companys cost of equity usingthree different models: the Capital AssetPricing Model (CAPM), the DividendDiscount Model (DDM) and the EarningsCapitalization Model (EPS/ Price), weanalyze their advantages anddisadvantages and finally we conclude whether or notan investment in Nikeis recommended.Our analysis suggests that NikeInc.s common stock should be added to theNorth Point Groups Mutual FundPortfolio.I. The Weighted Average Cost of Capital and its Importance for NikeInc. The Weighted Average Cost of Capital (WACC) is the average of the costs of acompanys sources of financing-debt and equity, each of which is weightedby itsrespective use in the given situation. By taking a weighted average,we can see howmuch interest the company has to pay for every marginaldollar it finances. A firmsWACC is the overall required return on the firm asa whole and, as such, it is oftenused internally by company directors todetermine the economic feasibility ofexpansionary opportunities andmergers. Also, WACC is the appropriate discountrate to use in stockvaluation.II. Calculation of Nikes WACC The calculatingmethodology for Nikes Inc. WACC seems to be inconsistentwith the principles1 thatshould be followed when estimating this measure. These are our points ofdisagreement with the calculations in Exhibit 5:- Calculation of the cost of debtby taking the total interest expense for theyear 2001 dividing it by the companysaverage debt balance, which is notappropriate for the WACC estimation- Use as taxrate the sum of state and statutory taxes instead of the firmsmarginal tax rate- Useof the Book Value of equity rather than the market value which issuggested as itgives more precise results- Calculation of the cost of equity using long time periodfor risk free rate andrisk premiumIn order to make our justifications more comprehensive we need theformulafor estimating WACC:WACC= Wd*Kd(1-T) + We*KeFirst, we reexamine thecost of debt (Kd) which in this case is the yield tomaturity (YTM) on the bonds. The
YTM is a good estimate for the cost of debtif a company had issued debt in the pastand the bonds are publicly traded just as in Nikes case. Our calculations for Nikesyield to maturity based onthe given data showed that Kd= 7.16%.c1 (See Appendixfor detailedcalculations) The second variable that should be noted is T or the taxrate. In hercalculations, Joanna Cohen added the 3% state taxes to the 35%statutorytax where in WACC calculation the marginal rate should beused. Themarginal tax rate generally refers to the "federal income tax that isleviedonto the additional dollar earned" and usually is about 40%. The weights of thecosts, Wd and We, are very important in calculatingWACC as they show thecompanys capital structure. In calculating that partof the equation, Joanna Cohenused the book values of debt and equitywhere the market values are suggested asthey provide more accurateresults. As book and market values of debt and equitymay differ a lot,market values of debt and equity give a closer estimation of thecapitalstructure2. We calculate the enterprise value (P0*#shares outstanding=$11,427.4357m). For debt, the book value gives a close estimation for thecurrentvalue, whereas the same doesnt hold for the value of equity. Thus,debt is equal to$1,296.6m (current portion of L-T debt + notes payable + L- T debt). In finding theweights, the previous explanation shows that equity is88.65% whereas debt is11.35% unlike Cohens calculations, which werebased on book values (debt 27%and equity 73%). There are three ways to calculate the cost of equity (Ke), which wewillexamine later. In our calculations of WACC we use the Capital AssetPricingModel (CAPM), as it is considered to be the most complete modelforestimating the cost of equity.CAPM Equation is: Ke=Krf+ β(Km-Krf)c2,whereKe is the cost of equity, β is beta that measures the tendency of a stock tomove up and down with the market, Km is the required return of the market, Krf isthe risk free rate and (Km - Krf) is equal to the market riskpremium.For the Krf (riskfree rate), we used the current yield on 10yr bond (5.39) U.S.treasuries, instead of the 20yr, as the 10yr matches the duration of cashflows for theNikes investment project (Exhibit 2) and because it is relativelyless exposed tounexpected changes in inflation and the liquidity premiumwhen compared to thelonger 20 yr bond3. For the market risk premium, Km- Krf, we used the arithmeticmean (7.5%). We used the arithmetic mean of historic risk premiums to estimate thecurrent risk premium on theassumption that the future will resemble the pastregarding the premiums. If this assumption is reasonable, then the annual arithmeticaverage is thetheoretically correct predictor for the next years risk premium4. Ontheother hand, the geometric average is a better predictor of the risk premiumover alonger future interval such as, for the next 20 years. For β weused the historicaverage of the past 6 years (0.8). After we calculate thecost of equity with CAPM(Ke= 11.39%), we plug our results in the givenformula of WACC and we getWACC=10.59c3.III. Alternative Methods of Calculating the Cost of EquityAlthough,CAPM approach is considered to be an accurate and preciseestimate of Ke, thereare two other models used by those analysts who donot have complete confidencein CAPM. These approaches are the DividendDiscount Model (DDM), whichcompares dividends forecasted for the nextperiod with the current share price for thefirm and then adds the growthrate of the firm and the Earnings Capitalization Model(ECM), whichcompares forecasted earnings for the next period over the currentshareprice. Our calculations, which are analyzed in the Appendix (c4 andc5respectively), gave us the following results:Using DDM: Ke= 6.7%Using ECM: Ke=9.88%We can see that the three different methods of calculating the cost
of equityproduced widely varied estimates. In such situations the financial analysthasto use his/her judgement as to relative merits of each estimate and thenchoosethe estimate which seemed more reasonable under thecircumstances.Comparingthe already discussed methods, we found that the mainadvantage of CAPMapproach is that it takes into consideration a companysmarket risk as the mostrelevant risk to stockholders, hence to determine theeffect of the new activities andprojects of the company on stock price. Thismethod can be applied to firms that donot pay dividends as well as newfirms, by using betas for similar firms (e.g., otherfirms in the industry).However, with CAPM all our projections are based on historicaldata onto thefuture, because of the estimate of Beta we use. Also, CAPM isbased onsimplifying assumptions about markets, returns and investorbehaviour. The dividend discount model (DDM) is a simple model for valuing equity.It is