Nike Cost of Capital solution free essay sample

Kimi Ford, a portfolio manager for the mutual-fund management group NorthPoint, was reviewing the financials of Nike Inc. to consider buying shares for the NorthPoint Large-Cap Fund that she managed. A week prior, Nike Inc. held an analysts’ meeting to share their 2001 fiscal results and develop a strategy to revitalize the company. II. Background of Firm Nike’s revenues since 1997 had grown from $9 billion, while net income had fallen $220 million. A study written by Douglas Robson printed in Business Week revealed that Nike’s market share in the U. S. athletic shoe industry had fallen from 48 percent to 42 percent since 1997. In addition, supply-chain issues and the effects of a strong dollar negatively affected revenues. In the meeting, management planned to increase revenues by developing athletic-shoe products in ranges varying between $70-$90 and push their apparel line. Nike’s executives expressed that the company would still continue with a long-term revenue growth target of 8-10 percent and earnings-growth target above 15 percent. III. Statement of Situation After reading all the analysts’ reports, Kimi Ford decided to develop her own discounted-cash-flow forecast to achieve the investment decision for her mutual fund. The forecast showed that at a 12 percent discount rate, Nike’s stock price was overvalued at $4. 82 per share. She created a sensitivity analysis, which revealed that Nike’s stock was undervalued at discount rates of less than 11. 7 percent. The results concluded from the sensitivity analysis made Kimi Ford unsure of her decision on Nike stock; she proceeded to ask Joanna Cohen to estimate Nike’s weighted average cost of capital. IV. Constraints on Solution Cohen calculated a weighted average cost of capital of 8. 4 percent by using the capital asset pricing model for Nike Inc. Cohen’s calculations are incorrect because she used the book value for both debt and equity. When calculating cost of capital, the market value of debt and equity must be used. The market value of equity is found by multiplying the stock price of Nike Inc. by the number of shares outstanding. V. Possible Solutions The analyst team calculated Nike Inc. cost of capital by using two different models and approaches and then choosing the best one based on confidence in the data. Market Value of Equity = (Stock Price * # Shares Outstanding) E = ($42. 09 * 271. 5) E = ($11,427. 44) The above calculation of market value of equity is much higher than the book value of equity that Cohen used of $3,494. 50. In addition, for market value of debt, Cohen uses the book value instead of using the discounted value of long-term debt. The market value of debt is calculated by adding the present portion of long-term debt, notes payable, and long-term debt discounted at Nike’s accepted coupon rate. Market Value of Debt = (Present LT Debt + Notes Payable + LT Debt) D = ($5. 40 + $855. 30 + $435. 9) D = ($1,296. 60) With these calculations, the weight of debt and equity of Nike and the company can be calculated. Once these weights are calculated, the company’s capital structure can be concluded. Weight of Debt = (Debt / Debt + Equity) W = ($1,296. 60 / $1,296. 60 + $11,427. 44) W = (10. 19%) Weight of Equity = (Equity / Debt + Equity) E = ($11,427. 44 / $1,296. 60 + $11,427. 44) E = (89. 80%) In addition, another issue is finding the correct costs of debt and equity in order to find the correct calculation of WACC. Cohen used the 20-year yield on U. S. Treasuries of 5. 74% as the risk free rate, which is correct given the debt was valued over 25 years and there is no given yield for that amount of time. Calculating the market risk premium requires using the two historical equity risk premiums given for a time period from 1926 to 1999: Geometric mean and arithmetic mean. The arithmetic mean is better for a one-year estimated expected return. Considering the 20-year yield on U. S. Treasuries of 5. 9, using the geometric mean is the best choice because it is for a longer time. To use the CAPM approach, a beta for Nike Inc. had to be decided on. To account for significant beta changes, using the average beta of . 80 was the best choice. This was decided on because using the YTD beta of . 69 was showing the past and not a good reflection of potential revenues. In addition, the average beta of . 80 will better show increases in market share. Cost of debt was calculated by the yield to maturity on 20-year Nike Inc. debt with a 6. 75 percent coupon semi-annually. The cost of debt was calculated as follows: PV = -937. 61 N = 40 Pmt = 33. 75 FV = 1000 I/Y = 3. 67% semi-annually (YTM) = 3. 67% * 2 = 7. 34% After-tax cost of debt = . 0734 x (1-. 38) = . 0455 or 4. 55% The cost of equity was calculated as follows: K(e) = Rf + Beta * (MRP) K(e) = 5. 74% + . 8 * 5. 90% K(e) = 10. 46% Using the values from calculating the weight and cost of both debt and equity, the cost of capital is determined to be 9. 86 percent. Using the WACC formula, the analysts’ team came to a different conclusion than Ms. Cohen. WACC = Wd*Kd (1-T) + WeKe = . 1019*. 0734 (1-. 38) + . 8980*. 1046 = 9. 86% The next model that the analysts’ team used to calculate the cost of capital was the dividend discount model. This model assumes that the company pays a substantial dividend. This model was rejected because Nike Inc. does not pay a substantial dividend. DDM = [Do (1+g)/Po] + g DDM = [. 48(1+.055)/42. 09] + . 055 DDM = 6. 70% . The final model used to compute the cost of capital was the earning capitalization model. The analysts’ team chose to reject this model because it does not take growth into account. ECM = E1/Po ECM = 216/42. 09 ECM = 5. 31% VI. Recommendation The analysts’ team found the weighted average cost of capital by using CAPM, finding a discount rate of 9. 86 percent. The WACC calculation difference of 1. 46 percent was higher than what Ms. Cohen calculated ofat 8. 40 percent. At a discount rate of 12 percent, Ms. Ford calculated Nike’s equity value per share at $37. Which is undervalued from the present market share of $42. 09. Using the discount rate of 9. 86 percent the analysts’ team estimated an equity value higher than Ms. Ford’s. The estimate of $44. 11 equity value per share overvalued(? ) the present value by $2. 02. This data concluded that Nike Inc. should not be added to the NorthPoint Large-Cap Fund at this time because the stock is overvalued. She should watch the company closely because Nike Inc. has growth potential that would be beneficial to her fund. Nike Inc’s. management has plans for the future that if successful could provide the company with abundant revenues.