Nike, Inc.:Cost of Capital

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.:

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.

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.

Do you agree with Joanna Cohen’s WACC estimations? Why or why not?

IssuesSingle cost or Multiple Cost?Cost of debtCost of equityWeights of capital components

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.

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.

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%

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%

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.

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

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

Cost of equity

Therefore, my estimate of cost of equity will be:

5.74% + (5.9%)* 0.69 = 9.81%

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.

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

The WACC

Thus, my calculation of the WACC is as follow:

4.44%*0.101 + 9.81%*0.899 = 9.27%

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!

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011Free Cah Flows to Firm 764.1 663.1 777.6 866.2 1014 1117.6 1275.1 1351.7 1483.7 1572.7Terminal Value 25835.42Cash flows 764.1 663.1 777.6 866.2 1014 1117.6 1275.1 1351.7 1483.7 27408.12The Firm Value $17,079Less: Current debt 1296.6Equity Value $15,782Shares Number 271.5Equity Value per share 58.13052

Terminal Value 25835.422012 Cash Flow 1619.881Permanent Growth 0.03WACC 0.0927

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