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Case Analysis of Nike, Inc.

: Cost of
Capital
Apparently, the issue of Nikes 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
Groups Mutual Fund Portfolio or not.
Now, let me approve Kimi Fords 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 Equitys 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 shortterm 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, Cohens 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 firms 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 Debts 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 companys 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 Debt
There 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, I
calculated the interest rate in accordance with Exhibit 1(Income
Statement) for 2001 year as follows:
Interest rate = Interest payment / Operating income
Cost 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 was calculated by finding the yield to
maturity on 20-year Nike Inc. debt with a 6.75% coupon semiannually. I assumed Nike Inc. to have a single cost of capital since
its multiple business segments (shoes, apparel, sports equipment,
etc.) are not very different and would experience similar risks and
betas.
Before-Tax Cost of Debt
I used three (3) methods as follows:
-Method (1): Using Cost Quotations Based on Coupon Interest
Rate and Yield to Maturity (YTM)

Cost of Debt = 14.14%

-Method (2): Based on calculating the IRR


Cost of Debt = 14.15%
-Method (3): Approximating the Cost Based on the Value Bond and
Coupon Rate
Cost of Debt = 14%
All of the calculations have been included in my spreadsheet.

Note: The students, which are interested in


having my spreadsheet (One Excel file
included one sheet) of this case analysis as a
template for further practice, do not hesitate
to ask me by sending an email
to: soleimani_gh@hotmail.com. It is free of
charge only for students. Please be informed
this material is for non-commercial

As we can see, all three methods present us


approximately the same amount of the cost of debt. I
have chosen 14.15% for the cost of debt.
It is important to find the relationship between the required
return and the coupon interest rate. When the required return is
greater than the coupon interest rate, the bond value will be less
than its par value. We choose cost of debt as 14.15% because it
is rational (coupon value annually is 13.50%). When current
value of bond is less than par, required return will be more 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 of Debt. I calculated the weight
average for Cost of debt as follows:
Total debt type 1 = $5.40 + $855.30 + 0.3 = $861
Total debt type 2 = $435.9
Total debt = $1296.9
W (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 Debt
Cost of financing must be stated on an after-tax basis. Because
interest on debt is tax deductible, it reduces the firms taxable
income.

ri =rd x (1 T)
=8.6% x (1 38%)
=5.33%

Cost of Equity