Unformatted text preview: Nike, Inc.: Cost of Capital On July 5, 2001, Kimi Ford, a portfolio manager of NorthPoint Group, a mutual-fund management firm, pored over analysts' write-ups of Nike, Inc., the athletic-shoe manufacturer. Nike's share price had declined significantly from the beginning of the year. Ford was considering buying some shares for the fund she managed, the NorthPoint Large-Cap Fund, which invested mostly in Fortune 500 companies, with an emphasis on value investing. Its top holdings included ExxonMobil, General Motors, McDonald's, 3M, and other large-cap, generally old-economy stocks. While the stock market had declined over the last 18 months, the NorthPoint Large-Cap Fund had performed extremely well. In 2000, the fund earned a return of 20.7%, even as the .S&P 500 fell 10.1 %. At the end of June 2001, the fund's year-to-date returns stood at 6.4% versus -7.3% for the S&P 500. Only a week earlier, on June 28, 2001, Nike had held an analysts' meeting to disclose its fiscal-year 2001 results.1 The meeting, however, had another purpose: Nike management wanted to communicate a strategy for revitalizing the company. Since 1997, its revenues had plateaued at around $9 billion, while net income had fallen from almost $800 million to $580 million (see Exhibit 1). Nike's market share in U.S. athletic shoes had fallen from 48%, in 1997; to 42% in 2000.2 In addition, recent supply-chain issues and the adverse effect of a strong dollar had negatively affected revenue. At the meeting, management revealed plans to address both top-line growth and operating performance. To boost revenue, the company would develop more athletic shoe products in the mid-priced segment3 – a segment that Nike had overlooked in recent years. Nike also planned to push its apparel line, which, under the recent leadership of industry veteran Mindy Grossman,4 had performed extremely well. On the cost side, Nike would exert more effort on expense control. Finally, company executives reiterated their long-term revenue-growth targets of 8% to 10% and earnings-growth target of above 15%. Analysts' reactions were mixed. Some thought the financial targets were too aggressive; others saw significant growth opportunities in apparel and in Nike's international businesses. Kimi Ford read all the analysts' reports that she could find about the June 28 meeting, but the reports gave her no clear guidance: a Lehman Brothers report recommended a strong buy, while UBS Warburg and CSFB analysts expressed misgivings about the company and recommended a hold. Ford decided instead to develop her own discounted cash flow forecast to come to a clearer conclusion. Her forecast showed that, at a discount rate of 12%, Nike was overvalued at its current share price of $42.09 (Exhibit 2). However, she had done a quick sensitivity analysis that revealed Nike was undervalued at discount rates below 11.17%. Because she was about to go into a meeting, she asked her new assistant, Joanna Cohen, to estimate Nike's cost of capital. Cohen immediately gathered all the data she thought she might need (Exhibits 1 through 4) and began to work on her analysis. At the end of the day, Cohen submitted her cost-of-capital estimate and a memo (Exhibit 5) explaining her assumptions to Ford. 1 Nike's fiscal year ended in May. Douglas Robson, "Just Do ... Something: Nike's insularity and Foot-Dragging Have It Running in Place," BusinessWeek, (2 July 2001). 3 Sneakers in this segment sold for $70-$90 a pair. 4 Mindy Grossman joined Nike in September 2000. She was the former president and chief executive of Jones Apparel Group's Polo Jeans division. 2 Questions: 1. What is the WACC and why is it important to estimate a firm’s cost of capital? Do you agree with Joanna Cohen’s WACC calculation? Why or why not? WACC is the weighted average cost of capital and is a blended measure of a firm’s overall cost of capital and is comprised of all of the firm’s various components’ costs, or the required rate of return on each capital component, such as common stock, preferred stock, and debt. The WACC represents the minimum rate of return that the firm expects to earn on any capital investments they may make and is the correct cost of capital to use when analyzing capital budgeting decisions. The WACC is calculated based on (1) estimates of the component costs of common equity, preferred stock, and debt, (2) the firm’s expected tax rate (both federal and state), and (3) Debt-to-Value and Equity-toValue ratios. After reviewing all of the information available to us regarding the firm and the subsequent calculations presented by Ms. Cohen, we found that we did not agree with the methods she used to reach the WACC results due to the fact that she made several assumptions that we believe to be incorrect, which are: 1. Incorrect Debt – We found that the debt of the firm was calculated improperly when Ms. Cohen added short-term debt and notes payable to the long-term debt. When calculating the WACC the correct method, in the case of Nike, Inc., is to take into account only long-term debt. 2. Incorrect Tax Rate – We found that Ms. Cohen used a tax rate of 38% which is incorrect since we believe that she should have used a tax rate of 36% which is the most recent tax rate paid by Nike in 2001 and is therefore more likely to be the most accurate rate. 3. Incorrect Beta – We found that the beta used by Ms. Cohen is also incorrect. Ms. Cohen used the average of Nike’s historical betas which comes to 0.8 instead of the using the most current year-to-date beta of 0.69 that was just calculated recently. 4. Incorrect Risk Free Rate – We found that Ms.Cohen’s decision to use the 20-year bond rate of 5.74% as the Risk free rate was incorrect and she should have used the short-term rate (12 months or less) instead, which in this case is 3.59%. 5. Incorrect Equity – We found that Ms.Cohen calculated the Equity figure by including all of the shareholders’ equity to arrive at a figure of 3,494,500,000 which was incorrect because when calculating the equity she should have used the current market value should be included which is calculated by multiplying the current stock price by the current number of shares outstanding. 2. If you do not agree with Cohen’s analysis, calculate your own WACC for Nike and be prepared to justify your assumptions. Formulas Used in Calculation: WACC = rd(1-T) x (D/V) + re x (E/V) Re = R + Credit Risk Rate (1-t) D = Long Term Debt E = Current Stock Price x Number of Shares Outstanding rm = Market Risk Rate rf = Risk Free Rate CAPM - Re = rf + β (rm – rf) Value = E + D Case Study Data Factors: Tax Rate = 36% Market Risk Rate = 7.50% Risk Free Rate = 3.59% Beta, β = 0.69 Debt, D = 435.9 Equity, E = 42.09 x 271,500,000 = 11,427.4 Value, V = 435.9 + 11,427.4 = 11863.3 Solving for Rd and Re and Tax Rate Tax Rate = 36% Cost of Debt N = 40 PMT = (6.75/2) = 3.375 PV = -95.60 FV = 100 I/Y = 3.5837 x 2 = 7.1674% Rd = 2 x I/Y = 7.1674% Cost of Equity (via CAPM method) rf = 3.59% β = 0.69 rm = 7.50% Re = rf + β(rm – rf) => 3.59% + (0.69)( 7.5% - 3.59%) => 3.59% + (0.69)(3.91%) => 3.59% + 2.698 => 6.288 Re = 6.288% WACC Calculation: WACC = rd(1-T) x (D/V) + re x (E/V) => 7.1674% (1 – 36%) x (435.9/11,863.3) + 6.288% x (11,427.4/11,863.3) => 7.1674% (64%) x (.0367) + 6.288% x (.9633) => 0.001683 + .06057 = .062253 WACC = 6.23% Justification of Assumptions: a. We believe that short-term debts (listed under current liabilities) should only be used when calculating the WACC for small firms in the U.S. and other international firms that rely upon it on a continuous basis for operations. b. We believe that using the most recent tax rate that the firm has paid more accurately reflects the current tax environment and thus is more likely to represent the actual tax rates the firm will encounter. c. We believe that rather than using the average historical beta it is more prudent to use the current year-to-date beta of the firm will more likely represent the current credit risk that the firm is currently operating under and therefore it will increase the accuracy of the estimated cost of equity and the subsequent WACC. d. We believe that using the current yield on 20-year Treasuries for the risk free rate is incorrect due to the fact that the CAPM is a short-term model that calls for a short-term interest rate such as the current yield on short-term Treasuries (12 months or less). 3. 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? I. Cost of Equity using Capital Asset Pricing Model: CAPM Calculation: Re = rf + β (rm – rf) = 3.59% + .69(7.50% - 3.59%) = 3.59% + 2.70% Re = 6.288% II. Cost of Equity using Dividend Discount Model: Given the following: P0 = $42.09, Div1 = .48, g = 5.50% DDM Calculation: r = Div1/P0 + g = .48/42.09 + .055 = .0114 + .055 = .0664 Re = 6.64% III. Cost of Equity using Earnings Capitalization Ratio: Given an estimated EPS of $2.32 and a current stock price of $42.09 gives us the following estimated cost of equity: $2.32 / $42.09 = 0.0552 Re = 5.52% 4. What should Kimi Ford recommend regarding an investment in Nike? Based upon the information available to us we reached the following conclusions: 1) Since non-Nike brands accounted for only 4.5% of Nike’s total revenue and the only non-sports related business segment was their Cole Haan line it was very likely that all of the various business segments faced the same risk factors. Therefore rather than compute multiple costs of capital we thought that it would be appropriate to use to a single cost of capital for the entire company. 2) Since Nike utilizes two capital components, debt and equity, we calculated their cost of capital using the after-tax WACC method (based upon financial figures available) which gave us the following results: a. Capital Structure i. Debt: 3.67% ii. Equity: 96.33% b. Market Value (in millions) i. Debt: 435.9 ii. Equity: 11,427.4 c. Component Costs of Capital i. Debt: 7.17% ii. Equity: 6.29% 3) Taking these component costs into account, along with all of the additional relevant numbers available to us we calculated Nike’s after-tax WACC to be 6.23%. We would strongly recommend, that based upon the analysis by Ms. Ford in which she concluded that Nike is undervalued at discount rates below 11.17%, Ms. Ford immediately invest a substantial amount of the NorthPoint Large-Cap Fund in Nike, Inc. since it is a definite value investment with its discount rate of 6.23%. ...
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2 |Case analysis: Nike Inc, Cost of Capital
structure. It also helps predict risk would be happen with a company (risk management).
Moreover, estimate a firm’s or projects’ cost of capital help investors
can diversification their investment, reduce risk in invest, maximization profits: -Cost of capital using to Capital Budgeting Decision as the measuring for decision an investment proposal. Normally, the 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 costs of capital invest in that projects. It also helps determine the acceptability of investment opportunities. -Cost of capital also helps for Designing the Corporate Finance Structure. In one side, they always follow the changing of capital market for getting information and choosing the best way for capital structure of company. In the other side, managers can use various methods to minimize
company’s cost of capital, changing the market price, the earning per share, bring out
the benefit to company. -In addition, Cost of capital helps 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 helps managers give out better react and balancing sources of finance when faced with requires additonal finance, which helps mimimize the cost of capital.
Cost of capital represent by WACC
(Weighted Average Cost of Capital). The required return will reflect the risk of the investment and the return of alternatives. WACC is sum of cost of debt (R
) and cost of equity (R
is calculated by using DDM (Dividend Discount Model), Earning Capitalization Model or CAPM (Capital Asset Pricing Model). In many case, many companies does not pay dividend at the end of the period, it might lead to inaccurate calculating R
, that is the reason why CAPM using more popular than DDM. Beside that, CAPM also have advantages and disadvantages. To find the average cost of capital, we weight individual cost of capital by their proportions in
the firm’s capital structure:
WACC = R
x E / (D + E) + R
x (1-T) x D / (D + E)
The WACC is set by investors and not the managers.
WACC set by investors when they calculate and find out the decisions about invest or reject invest into a company/project. Managers just listen the market reply and react by estimate their options in invest in a project or restructure their company, give it all for board of management (investors) who have the final decisions. Besides, it also help managers can adjusted share prices, market value of the firm for fi
III/ Case analysis