Nike case study solution

1. Nike, Inc.:
Cost of Capital

2.  Case Background:
 NorthPoint Large Cap Fund weighing whether to
buy Nike’s stock.
 Nike has experienced sales growth decline,
declines in profits and market share.
 Nike has reveal that it would increase exposure
in mid-price footwear and apparel lines. It also
commits to cut down expenses.
 The market responded mixed signals to Nike’s
changes. Kimi Ford has done a cash flow
estimation, and ask her assistant, Joanna Cohen
to estimate cost of capital.
Nike, Inc.:

3. What is WACC? and why is it important to
estimate a firm’s cost of capital?
 The cost of capital is the rate of return
required by a capital provider in exchange
for foregoing an investment in another
project or business with similar risk. Thus, it
is also known as an opportunity cost.
 Since WACC is the minimum return required
by capital providers, managers should
invest only in projects that generate returns
in excess of WACC.

4. What is WACC? and why is it important to
estimate a firm’s cost of capital?
 The WACC is set by the investors (or
markets), not by managers. Therefore, we
cannot observe the true WACC, we can only
estimate it.

5. Do you agree with Joanna Cohen’s
WACC estimations? Why or why not?
 Issues
 Single cost or Multiple Cost?
 Cost of debt
 Cost of equity
 Weights of capital components

6. Single cost or Multiple Cost?
 Should Cohen estimate different cost of
capital for footwear and apparel divisions?
 I agree with the use of the single cost
instead of multiple costs of capital. The
reason of estimating WACC is to value the
cash flows for the entire firm, that is
provided by Kimi Ford. Plus, the business
segments of Nike basically have about the
same risk; thus, a single cost is sufficient
for this analysis.

7. Cost of debt
 The WACC is used for discounting cash flows in
the future, thus all components of cost must
reflect firm’s concurrent or future abilities in
raising capital.
 Cohen mistakenly uses the historical data in
estimating the cost of debt. She divided the
interest expenses by the average balance of debt
to get 4.3% of before tax cost of debt. It may not
reflect Nike’s current or future cost of debt.

8.  The cost of debt, if it is intent to be forwarding looking,
should be estimated by 1. yield to maturity of bond, or 2.
according to credit rating.
 The more appropriate cost of debt can be calculated by
using data provided in Exhibit 4. We can calculate the
current yield to maturity of the Nike’s bond to represent
Nike’s current cost of debt.
 PV= 95.60
 N=40
 Pmt=-3.375
 FV=-100
 Comp I = 3.58% (semiannual) 7.16% (annual)
 After tax cost of debt = 7.16%(1-38%) = 4.44%

9. Cost of equity
 Joanna Cohen seems to use CAPM to
estimate cost of equity. Her number comes
from following:
 10.5% = 5.74% +(5.9%)*0.80
 Her risk free rate comes from 20-year T-bond rate
 Cohen uses average beta from 1996 to July 2001,
0.80.
 Cohen uses a geometric mean of market risk
premium 5.9%

10. Comments on cost of equity –
The risk-free rate
 It is no problem to use 20-year T-bond rate to
represent risk-free rate. The cost of equity
and the WACC are used to discount cash
flows of very long run, thus rate of return a T-
bond with 20 years maturity, 5.74%, is the
longest rate that are available.

11.  To use a geometric mean of market risk premium
5.9% is also correct. Using arithmetic mean to
represent true market risk premium, we have to
have independently distributed market risk
premium. It is often found that market risk
premium are negatively serial correlated.
Comments on cost of equity –
The market risk premium

12.  I don’t agree that Cohen uses average beta from 1996
to July 2001, 0.80 to be the measure of systematic risk,
because we need to find a beta that is most
representative to future beta. As such, most recent beta
will most relevant in this respect. So I suggest using the
most recent beta estimate, 0.69.
Comments on cost of equity –
The market risk, beta

13. Cost of equity
Therefore, my estimate of cost of equity will be:
5.74% + (5.9%)* 0.69 = 9.81%

14. Weights of capital components
 Cohen is wrong to use book values as the basis
for debt and equity weights; the market values
should be used in calculating weights.
 The reasoning of using market weights to
estimate WACC is that it is how much it will
cause the firm to raise capital today. That cost
is approximated by the market value of capital,
not by the book value of capital.

15.  For market value of equity, $42.09*273.3 mn
shares = 11,503 mn.
 Due to the lack of information of the market value
of debt, book value of debt, 1,291 mn, is used to
calculate weights.
 Thus, the market value weight for equity is 11,503
/ (11,503+1,291) = 89.9%; the weight for debt is
10.1%.
Weights of capital components

16. The WACC
 Thus, my calculation of the WACC is as follow:
 4.44%*0.101 + 9.81%*0.899 = 9.27%

17. What should Kimi Ford recommend
regarding an investment in Nike?
 To discount cash flows in Exhibit 2 with the
calculated WACC 9.27%, the present value equals
$58.13 per share, which is more than current
market price of $42.09.
 Some might think this value is still understated,
due to that current growth rate used (6% to 7%) is
much lower than that estimated by manager (8% to
10%). So the recommendation is to BUY!

18. 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
FreeCahFlows toFirm 764.1 663.1 777.6 866.2 1014 1117.6 1275.1 1351.7 1483.7 1572.7
TerminalValue 25835.42
Cashflows 764.1 663.1 777.6 866.2 1014 1117.6 1275.1 1351.7 1483.7 27408.12
TheFirmValue $17,079
Less:Current debt 1296.6
EquityValue $15,782
SharesNumber 271.5
EquityValuepershare 58.13052
TerminalValue 25835.42
2012CashFlow 1619.881
PermanentGrowth 0.03
WACC 0.0927

19. Stock split: 03-Apr-07 [2:1]