Case Study Analysis

of
Nike, Inc. : Cost of Capital


EPGDIM 2013-15

by
ANURAG SUKHIJA
MANDEEP SINGH
MAYANK PORWAL
VIKRAM JOSHI








Case Background:
NorthPoint Large Cap Fund weighing whether to buy Nikes stock.
Nike has experienced sales growth decline, declines in profits and
market share.
Nike has revealed 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 Nikes changes. Kimi Ford
has done a cash flow estimation, and ask her assistant, Joanna
Cohen to estimate cost of capital.


Question 1: What is the WACC and why is it important to estimate a firms cost of
capital? Do you agree with Joanna Cohens WACC calculation? Why or why not?
Answer:
The Weighted Average Cost of Capital is the average of the costs of a company's sources of
financing-debt and equity, each of which is weighted by its respective use in the given situation.
By taking a weighted average, it shows how much interest the company has to pay for every
marginal dollar it finances. A firm's WACC is the overall required return on the firm as a whole
and, it is often used internally by company directors to determine the economic feasibility of
expansionary opportunities and mergers. Also, WACC is the appropriate discount rate to use in
stock valuation.
Estimate a firms cost of capital is a very important mission must be done while analyze and
find out the decision about invest in a project or company. These reasons are considered the
effect of capital structure to cost of capital, investment decisions, firm value, share price of a
company, which may affect to the value and cost of capital by changing the capital structure. It
also help predict risk would be happen with a company (risk management). Moreover, estimate
a firms or projects cost of capital help investors can diversification their invest, reduce risk in
invest, maximization profits:
First of all, cost of capital using to Capital Budgeting Decision as the measuring for decision
an investment proposal. Normally, the company/investors will choose the project (compare with
many other projects) which give a higher return and lower risk on investment. If company must
decide the individual project, company will choose the project which give satisfactory return on
investment. Of course, all of the projects which are chosen must be get higher return than the
cost of capital invest in that projects. It also help determine the acceptability of investment
opportunities.
Secondly, cost of capital also help for Designing the Corporate Finance Structure. In one
side, they always follow the changing of capital market for get information and choose the best
way for capital structure of company. In the other side, managers can use various methods to
minimize companys cost of capital, changing the market price, the earning per share, bring out
the benefit to company. Many companies before designing their corporate finance structure,
they try to figures their information such as accounting reports, their cost of capital to market.
After that, they listen carefully the market before decide their corporate finance structure. Even
they get positive or negative reply from market, they will have their decisions in designing their
corporate finance structure: cancel or invest in project.
Moreover, cost of capital help managers Decide the Method of Financing. Understanding
about financial situations and the rate of interest on loan, normal dividend rate in the market is
need conditions of financial managers. It help managers can give out better react and balancing
sources of finance when faced with requires additonal finance, which help mimimize the cost of
capital. Moreover, it also very important when using it for considerations of control relate factors
and reduce the risk for company.

In addition, cost of capital can also help board of management/investors estimate the
Performance of top Managers. The cost of capital can used to estimate, compare managing
ability of financial managers (CEOs, CFOs), which base on evaluation between profit of projects
(company) and cost of capital. As mention above that a company might listen the market reply
by present their accounting report, their cost of capital, a better manager is a manager can get
sensitivity reply from market, reduce the risk, increase the profit for company. That means we
can use calculating cost of capital for estimate the work ability of managers by assessment
managers ability to earn profit, reduce risk and errors, manage debt including bad debt.
Moreover, it also helps estimate, manage the actual cost incurred in rising funds when manager
require rising funds for project.
We dont agree with Joanna Cohens WACC calculation. 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 Nikes current or future cost of
debt. I dont 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.

Question 2: If you do not agree with Cohens analysis, calculate your own WACC for Nike
and be prepared to justify your assumptions.
Answer:
We analyzed the process of Johanna Cohens calculation, and found some flaws which we
believe caused computational mistakes as follows:
When using the WACC method, the book value of bond is available as the market value
since bonds are not quite active in the market, but the book value of equity isnt. Instead of
Johannas using equitys book value, we should multiply the current price of Nikes stock
price by the numbers of shares outstanding. i.e. Market value of Equity.
When calculating the YTM of the firms bond, Johanna only used the interest expense of the
year divided by the average debt balance, which fully ignored the discounted cash flow of
the cost of debt. She should have divided the total interest expense by the long term debt of
the company.
The tax rate that she used was the state tax of 3% to the US statutory tax rate of 35%. She
should have divided the income tax paid by the taxable income.
Cost of debt
The WACC is used for discounting cash flows in the future, thus all components of cost must
reflect firms 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 Nikes 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 Nikes bond to represent Nikes 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%

The risk 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.
Market risk premium
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 is negatively serial
correlated.
The market risk, beta
I dont 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.
Therefore, our estimate of cost of equity will be:
5.74% + (5.9%)* 0.69 = 9.81%

Our WACC Calculation
For market value of equity, $42.09 x 273.3 million shares = 11,503 mn.
Due to the lack of information of the market value of debt, book value of debt, 1,296 mn, is used
to calculate weights.
Thus, the market value weight for equity is 11,503 / (11,503+1,296) = 89.9%; the weight for debt
is 10.1%.
Thus, our calculation of the WACC is as follow:
4.44%*0.101 + 9.81%*0.899 = 9.27%

Question3: Calculate the costs of equity using CAPM, the dividend discount model, and
the earnings capitalization ratio. What are the advantages and disadvantages of each method?
Answer:
The cost of equity is the rate of return required to persuade an investor to make a given equity
investment.

Calculation using CAPM model
Cost of Equity (K
E
)
K
E
= R
F
+ (R
m
- R
F
) *
j

Where R
F
= 5.74% 20 Year Yield on US Treasuries
R
m
- R
F
= 5.90%
Beta = 0.8 (Average Nike Beta)

It yields K
E
= 10.46%

Advantages of CAPM model
It considers only systematic risk, reflecting a reality in which most investors have diversified
portfolios from which unsystematic risk has been essentially eliminated.
It generates a theoretically-derived relationship between required return and systematic risk
which has been subject to frequent empirical research and testing.
It is generally seen as a much better method of calculating the cost of equity than the
dividend growth model (DGM) in that it explicitly takes into account a companys level of
systematic risk relative to the stock market as a whole.
It is clearly superior to the WACC in providing discount rates for use in investment appraisal

Disadvantages of CAPM
It is virtually impossible to estimate betas for many projects.
People sometimes focus on market risk to the exclusion of corporate risk, and this may be a
mistake.

Calculation using Dividend Growth Model (DGM)
The assumption made with this model is that the company pays a substantial dividend, but Nike
Inc. does not. Therefore, we rejected this model because it does not reflect the true cost of
capital. The calculation is as follows
DDM = [Do (1+g)/Po] + g
= [0.48(1+.055)/42.09] + .055
= 6.70%

Advantages:
Allow significant flexibility when estimating future dividend streams
Provide useful value approximations even when the inputs are overly simplified
Can be reversed so the current stock price can be used to impute market assumptions for
growth and expected return
Investors are able to suit their model to their expectations rather than force-fitassumptions
into the model
Specifying the underlying assumptions allows for sensitivity testing and analyzing market
reactions to changing circumstances

Disadvantages
Subjective inputs can result in misspecified models and bad results
Over-reliance on a valuation that is at heart an estimate
High sensitivity to small changes in input assumptions
Flow-through of minor data entry or formula errors when using spreadsheets

Calculation using Earnings Capitalization Model
The final model used to compute the cost of capital was the earning capitalization model.. The
earnings capitalization model calculations were found this way
ECM = E1/Po
= 232/42.09
= 5.51%
Disadvantages
The problem with this model is that it does not take into consideration the growth of the
company. Therefore we chose to reject this calculation

Question4: What should Kimi Ford recommend regarding an investment in Nike?
Answer:
Kimi Ford should definitely recommend investing in Nike.
As per the above calculation, considering WACC 9.27%, present value per share comes out to
be $58.13 per share which is much more than the current price per share of $42.09.
This clearly indicates that at the current condition also, Niki shares are understated and
underestimated.
Moreover, this value of share is assuming current growth rate 6% to 8%. Whereas the estimated
growth rate by the managers after the executive meeting is 8% to 10% which is more than the
6% to 8%.
In addition to it, outcome of the meeting which is communicated to the outside world would
create the positive sentiments in investors mind for the Nike and its growth path. This would
again help the company to regain a strong position in the market.
Considering all above factors, growth in the Nike shares would be definitely more than the cost
of capital or opportunity cost which they need to pay back to debtors and equity holders.
Therefore, Kimi Ford recommend North-point group to invest in Nike.