Nike, Inc.: Cost of Capital

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Nike, Inc.Cost of Capital
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Nike, Inc.

• 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 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 Nikes
  changes. Kimi Ford has done a cash flow
  estimation, and ask her assistant, Joanna Cohen
  to estimate cost of capital.

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What is WACC? and why is it important to estimate
a firms 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.

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What is WACC? and why is it important to estimate
a firms 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.

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Do you agree with Joanna Cohens WACC
estimations? Why or why not?

• Issues
• Single cost or Multiple Cost?
• Cost of debt
• Cost of equity
• Weights of capital components

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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.

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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.

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• 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
• N40
• Pmt-3.375
• FV-100
• Comp I 3.58 (semiannual) 7.16 (annual)
• After tax cost of debt 7.16(1-38) 4.44

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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

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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.

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Comments on cost of equity The 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 are negatively serial correlated.

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Comments on cost of equity 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.

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Cost of equity

• Therefore, my estimate of cost of equity will
  be
• 5.74 (5.9) 0.69 9.81

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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.

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Weights of capital components

• For market value of equity, 42.09273.3 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 / (11,5031,291) 89.9 the weight for
  debt is 10.1.

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The WACC

• Thus, my calculation of the WACC is as follow
• 4.440.101 9.810.899 9.27

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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!

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