CASE 15

NIKE, INC.: COST OF CAPITAL

This case is intended to serve as an introduction to the calculation of the weighted-average cost
of capital (WACC) of the firm. The case provides a WACC calculation that contains errors based
on conceptual misunderstandings. The task of the student is to identify and explain the mistakes
in the analysis. The case assumes that students have been exposed to the WACC, CAPM, the
dividend discount model, and the earnings capitalization model.
This case is about selecting and choosing weather or not Kimi Ford, a portfolio manager
at NorthPoint Group, a mutual-fund management firm, should to invest in Nike, Inc. based
on past performances of Nike, Inc., future plans and evaluation of Nike, Inc. The NorthPoint
Large-Cap Fund invested mostly in Fortune 500 companies, with an emphasis on value
investing, for examples, ExxonMobil, and General Motors. The NorthPoint had performed
very well in the past according to the firms past return performances compared to the
markets returns.
On June 28, 2001, Nike had held an analysts meeting to disclose its fiscal-year 2001
results (Year Ended May 31). Kimi Ford had been given the following data which are
consisted of Consolidated Income Statements (exhibit 1), its gross profit and net income of
all the years shown are pretty much the same. The Discounted Cash Flow Analysis (exhibit
2), assumptions were assumed from year 2002 to year 2011 and they were approximately the
same. Its free cash flows increased respectively along the timeline. The Consolidated Balance
Sheets (exhibit 3). The Capital-Market and Financial Information On or Around July 5, 2001
(exhibit 4), and the Joanna Cohens Analysis, Kimi Fords new assistant (exhibit 5). In
addition, Nikes market shares in U.S. athletic shoes had fallen from 48%, in 1997, to 42% in
2000 and had the adverse negative effect of a recent strong dollar to affect the revenue.
According to Joanna Cohens Analysis to Kimi Ford, she discussed about four
assumptions, single o multiple costs of capital, methodology for calculating the cost of

capital, cost of debt, and cost of equity; while the estimation of cost of capital was 8.4% by
using CAPM (capital-asset-pricing-model). Cohen concluded to compute only one cost of
capital for the whole company although Nike, Inc. is composed of selling variety of
categories. She came up with 27.0% debt and 73.0% equity of total capital by using the
WACC method based on the latest balance sheet, May 31, 2001. The estimation for cost of
debt is 4.3%, and declines to 2.7% after adjusting for tax, and the tax rate used was 38%.

Assigned Questions
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?
Sources of capital of a firm come from 2 main sources which are debts and equity while a
firm has costs on those sources of funds. Cost of debt is an interest and cost of equity is
returns to equity owners. Weighted Average Cost of Capital (WACC) is a calculation of a
firms costs of capital in which each category of capital is proportionately weighted.
When a firm doing business, it needs funds and those funds require returns from a firm.
Thus WACC represents minimum required rate of return of a firm. If a firm generates
15% of returns while WACC is 5%, a firm will gain 10% after costs of capitals. It also
helps predict risk would be happening with a company (risk management). Moreover,
estimate a firms or projects cost of capital help investors can diversification their
investment, reduce risk in invest, maximization profits. Those are reasons why a firms
cost of capital is important.
Joanna calculated weighted average cost of capital (WACC) as 8.4% using CAPM model
and we do not agree with her calculations as below reasons;

Joannas calculation uses the book value for both debt and equity. To determine
the costs of debt, she should use the current market rate that a firm is paying on its
debts. As the book value of debt is as an estimate of market value and the book
value of equity should not be used when calculating cost of capital. The market
value of equity should be calculated by multiplying the stock price of Nike Inc. by
the number of shares outstanding. Also, the market value of debt should be used
in the calculation of the cost of debt instead of the book value used by Joanna.
She should have discounted the value of long-term debt that appears on the
balance sheet ($ 435.9) at Nikes current coupon. Hence, this led to incorrect
weights for the cost of equity and cost of debt.
Joanna took the average of Nikes betas from 1996 to present, it means that she
used historical average beta which may not reflect current risks. So we think using

current beta is more appropriate. As we can see from exhibit 4 that average beta is
0.8 while latest beta is 0.69, those two betas are quite different so using historical
beta may not reflect the correct cost of equity in the future.
2. If you do not agree with Cohens analysis, calculate your own WACC for Nike and be
prepared to justify your assumptions.
To compute the WACC we have to calculate separately the financial return expected by
the cost of equity (KE) and the financial return expected by the providers of the cost of
debt(KD), so as to compute a weighted average of the two expected returns according to
their respective proportion in the capital structure of the company. The WACC is obtained
by using the following formula:

Cost of debt
We think Cohen mistakenly uses the historical data in estimating the cost of debt by
dividing it in the average balance of debt to get 4.3% of before tax cost of debt. The rate
is lower than Treasury yields and may not reflect Nikes current or future cost of debt. We
calculate the appropriate cost of debt by using data provided in Exhibit 4 as below;
Current Yield on Publicly Traded Nike Debt:
Item
Current Price (PV)
Period in semi-annually (N)
Coupon paid semi-annually
(Pmt)
Future Price (FV)

Amount
95.60
40
-3.375
-100

As data above, we can calculate interest as 3.58% (semiannual) or 7.16% (annual), thus
after tax cost of debt = 7.16%(1-38%) = 4.44%
Cost of equity
Cohen estimates the cost of equity using the CAPM as following:
10.5% = 5.74% + (5.9%)*0.80
Her assumption is risk free rate comes from 20-year T-bond rate, average beta from 1996
to July 2001, 0.80, and market risk premium 5.9% from Geometric mean. We think that
risk free rate and market risk premium are reasonable. However, we dont agree that
Cohen uses average beta from 1996 to July 2001, 0.80 to be the measure of systematic
risk because the appropriate beta should be most representative to future beta. Therefore,

we recommend using the most recent beta estimate, 0.69. Our estimate of cost of equity
will be:
5.74% + (5.9%)* 0.69 = 9.81%
In addition, based on the data in exhibit2, Cohen is wrong to use book values as the basis
for equity weights. She should calculate weights by using the market values to reflect
current capital of the firm. For book value of debt, 1,296.6, is reasonable to calculate
weights due to lack of information of the market value of debt.
Weights of capital components:
Market value of equity = current share price* current shares outstanding = 42.09* 271.5
= 11,427.44
Book value of debt = 1296.6
The market value weight for equity is 11,427.44 / (11,427.44 +1,296.6) = 89.8%; the
weight for debt is 10.2%.
Based on the assumptions above, our calculation of the WACC is as follow:
4.44%*0.102 + 9.81%*0.898 = 9.26%
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?
Capital Asset Pricing Model (CAPM)
Risk Free Rate
Market Risk
Premium
Beta
CAPM

5.74%
5.90%
0.69
9.81%

Advantages:

The model is simple to use and generate a range of possible outcomes around the
required rate of return.

Only systematic risk is being considered as it can be assumed that the investors would
have a well-diversified portfolio and the unsystematic risks has been diversified away.

Can be used when exploring business opportunities when the business mix and the
financing differ from the current business.

Takes into account the companys level of systematic risk relative to the market as a
whole.

Disadvantage:

Risk-free rate yield change daily and can create volatility

Market return (capital gains and dividends) can be negative at any given time and must
be utilized to even this out. Moreover, it is not a true representative of future market
returns as it focuses more on backward-looking

Unfair assumption is made that individual investor can borrow at the same rate as the
government (risk-free rate), which means the actual model is more steep than what we
might expect in reality

It is extremely difficult to estimate betas for many projects

Corporate risk is sometimes overlooked as market risk becomes the main focus

Dividend Discount Model

Dividend (2001)
Growth Rate
Price of Stock
(2001)
DDM

0.48
5.50%
42.09
6.70%

It should be noted that Nike Inc. does not payout dividend after June 30, 2001 to justify
using this model as it will not be a good representative of the cost of capital.
Advantage:

Most commonly used and easiest to understand

Value companys stock without taking into account the market condition (can specified
sensitivity testing and changing circumstances)

Flexibility for investor when estimating future dividend earnings

Allow for calculating the desire stock price by matching the market assumptions for
growth and expected return.

Disadvantage:

Does not take into account non-dividend factors such as: brand loyalty, customer
retention and intangible assets ownership. All of which impact companys value

Sensitive to small changes in the input assumptions

Overreliance on valuation that is from data estimations

Earning Capitalization Ratio

EPS FY2002
Price of Stock (2001)
Earning
Capitalization Ratio

2.32
42.09
5.51%

This model does not take into account the growth of the company, therefore we agreed
that it will not be a good representation of the companys cost of capital.
Advantages:

An income-based method that is commonly used to value small companies or no-growth

firms

Reflects the investors risk-adjusted required rate of return and includes a factor
reflecting future growth.

Disadvantages:

Projected future earning may be wrong and resulted in high deviations from the expected
rate of return

Model does not match the size and growth potential of Nike Inc. so would be
inappropriate for the situation.

Does not factor companys assets in calculation

4. What should Kimi Ford recommend regarding an investment in Nike?

To discount cash flows in Exhibit 2 with the calculated WACC is 9.26%, the present
value of Nike approximately $57.05 per share, which is much higher (1.36 times) than Nikes
current market price of $42.09. So Nike shares price is underestimate and undervalued by
$14.09 as Nike is currently trading in 2001. Some might think this value is still understated,
due to that current growth rate (6% to 7%) is much lower than that estimated by manager is
9.27% (8% to 10%). Moreover, Nike also changed their business strategy by more
concentrate in mid-priced segment, which is Nike less concentrate for a long time before.
Thats mean their total of sales might increase, lead to avenue increase, lead to profit
increase, of course, Nikes share prices and dividend will be increase in long-term.
Using this data, we found that North Point Large-Cap Fund should buy Nike Inc.,
shares at this time because the stock is undervalued because it has growth potential that
would be beneficial to the fund. Along with this fact, management has goals for the near

future that could provide a great deal of profit for Nike Inc. As we know that in conference,
Nike was showed that the company is heading on the recovery path with new strategy
and there is potential for abnormal profits given the growth capacity and the set targets by
the management are easily achieved if they stay focused since they have the capacity.
Technical analysis also supports a buy decision, because looking on the past performance of
the Nike Inc., share against the market index. It has shown that Nike can outperform the
market returns and now that it had gown down, it is left with the upside given plans that are
being put in place.
In conclusion, based on all data including history data and future data, it is clearly
that decision is Kimi Ford should buy Nikes shares because it quite safe, underestimate of
market and growth dramatically compare with its history. Overall, Nikes shares are very
potential. In details, Kimi Ford also should consider before buy Nikes shares depend on
some of reasons. First of all, Nikes shares long-term always is wonderful investment, but
short-time buying also should be careful because of the changing fast of industry, the
changing of Nike, the changing of trend in footwear industry and so on.
Discount cash flow analysis