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1 |Case analysis: Nike Inc, Cost of Capital

I/ Case background
- Kimi Ford- the manager of the NorthPoint Large-Cap Fund, which invested mostly in Fortune 500 companies, weighing whether to buy Nikes stock. - Nike had experienced a negative year: decline in sales growth, declines in profits and market share due to bad effect of supply-chain issue and the adverse effect of a strong dollar. - A meeting was held in order to look for a strategy, Nike has revealed 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 developed her own discounted cash flow forecast to have a clearer conclusion, and asked her assistant Joanna Cohen to estimate 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. The aim of our analysis is to show the mistakes appeared in estimating process of cost of capital (done by Joana Cohen). This analysis will determine basic and general theory about cost of capital and relations, find out the mistakes of Joanna Cohen, and give the advices for Kimi Ford. Moreover, this analysis also gives some of limitations when using DDM, CAPM, WACC for calculating the cost of capital.

II/ Cost of capital of the firm


1. Why is it important to estimate a firms cost of capital? 2. What does it represent? 3. Is the WACC set by investors or by managers? * What is the Cost of capital? Cost of capital denotes the opportunity cost of using capital for a particular investment as oppose to the alternative investment which has similar systematic risk. This is required return necessary to make a capital budgeting project of the company. Cost of capital includes the cost of debt and the cost of equity. +Cost of debt includes cost of junk bonds, cost of ordinary bonds, cost of bank loan (liabilities). +Cost of equity includes cost of ordinary shares. 1. Estimate a firms cost of capital is a very important mission that must be done while analyze and find out the decision about invest in a project or company. These reasons are considered the effect of capital structure to cost of capital, investment decisions, firm value, and share price of a company, which may affect to the value and cost of capital by changing the capital

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 firms 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 companys 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. 2. 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 (RD) and cost of equity (RE). RE 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 RE, 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 firms capital structure: WACC formula: WACC = RE x E / (D + E) + RD x (1-T) x D / (D + E)

3. 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 firms benefit.

III/ Case analysis


1. Multiple or Single Cost of capital?

3 |Case analysis: Nike Inc, Cost of Capital

2. What was your estimate about WACC? 3. What mistake Joana Cohen make in her analysis? 4. Which method is best for calculating the cost of equity? Using WACC formula: WACC = RE x E / (D + E) + RD x (1-T) x D / (D + E) In which: V = D + E = Total Capital D: Debt E: Equity RD: Cost of Debt RE: Equity T: Tax rate According to case study we have: T = 38% (Exhibit 2) E (Equity 2001) = $3494.5 (Exhibit 3) D (Debt 2001) =Current portion of long-term debt + Notes payable + Long-term debt = $5.4 + $855.3 + $435.9 = $1296.6 E/V = 27% (proportion of equity) D/V = 73% (proportion of debt) 1. Multiple or Single cost of capital? Basing on the understanding about single and multiple cost of capital, we can claim that its a right way to calculate all of the Nikes business segments as a single cost of capital instead of multiple cost of capital. The reasons are as following: -Nike has a multiple business segments. Besides footwear, which is a main segment, contributes about 62% to Nikes revenue; Nikes business segments include: apparel (30% of revenue); sport balls, timepieces, eyewear, skates, bats, and other equipment designed for sport activities (30% of revenue). Moreover, Nike also sells some non-Nike -branded products which gain 4.5% of Nikes revenue. We can see clearly that apparel, equipment products and non - Nikebranded products gained over a haft of footwear, but this is not enough evidence to consider them as a cost of capital distinct from footwear. -The first deficiency is the risk rate. Except the non-Nike-branded products such as Cole Hann have some differences, but they only contributed a tiny part of Nikes revenue. There are not significantly different between the risk rates that every Nikes segments stand because all of these segments are related to sport business.

4 |Case analysis: Nike Inc, Cost of Capital

-The second deficiency is about business activities such as marketing, distribution channel, etc. With the management of Nike, all of these segments are set in the same state. They have the same marketing project, distribution channel, customer services, qualify guarantee, etc. They are displayed in stores with the same design. For these deficiencies, it is necessary to claim that computing all of the segments as only one cost of capital for the whole company, is the true way. 2. Cost of Debt RD * By following Joanna Cohens calculation, she estimated the firms cost of debt based on its historical data. In other words, she used todays figure that is total interest expense for the year 2001 (58.7 millions), and then divided it by the average debt balance of the year 2000 and 2001(Debt balance as of May 31, 2000 and 2001, were $1444.6 million and $1296.6 million, respectively), which eventually showed 4.3% as the predicted cost of debt . It may not reflect Nikes current or future cost of debt. Thus, she made a mistake for estimating the firms cost of debt when taking historical data for calculation, because in terms of academic theory, the WACC is the required return on investments by the firm in the future, so all components of the WACC, of which is the cost of debt that must reflect the future interest rate the firm has obligations to pay upon its new borrowing. * Cost of capital based on market value not book value Cohen is wrong to use book values as the basis for debt and equity weights; the market values should be used instead. The reasoning of using market weights to estimate WACC is that it is how much it will cause the firm to raise capital today. -Market value of equity = Current Share Price x Average Shares Outstanding = $42.09 x 273.3mil = $11,503mil. Thus, Market value weight for equity is = 11,503mil / (11,503mil+1,291mil) = 89.9% The weight for debt is 10.1%. 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. + Current Bond Price = 95.6 with r = discount rate + Face value = 100 +Annual coupon rate = = 0.03375 Coupon = 100 0.03375=3.375

+ Bond issued in 07/15/96, its maturity is 07/15/21 => 25-year bond (or the bond was issued 5 years ago, because now is year 2001). As result, we have n=2(25-5)=40 (paid semiannually)

5 |Case analysis: Nike Inc, Cost of Capital

95.6=3.375 r= 7.16% Cost of debt (after tax) is: 7.16%(1-38%) = 4.44%

3. Cost of Equity RE We estimated the cost of equity using the captital asset pricing model CAPM. Another method, such as the Divident Discount Model DDM can not be used. a.Using DDM(Dividend Discount Model) The assumption made with this model is that the company pays a substantial dividend, but Nike Inc. does not. Therefore, we rejected this model because it does not reflect the true cost of capital. RE = D1/P0 + g D1 = D0(1+g) D0 = 0.48; g = 5.5% D1 = 0.48 x (1+ 0.055)= 0.5064 P0 = 42.09 RE= D1/P0 + g = 0.5064/42.09 + 5.5% = 1.20% + 5.50% = 6.70% *Because Nike did not pay any dividend for share holders since after June 30, 2001, so this model (DDM) can not be used for calculating KE in this case because it does not reflect the true cost of capital. *Using DDM(Dividend Discount Model) also have advantages and disadvantages. -Advantages of using DDM are significant flexibility when estimating future dividend streams, provide useful value approximations even when the inputs are overly simplified, can be reversed so the current stock price can be used to impute market assumptions for growth and expected return, specifying the underlying assumptions allows for sensitivity testing and analyzing market reactions to changing circumstances.

6 |Case analysis: Nike Inc, Cost of Capital

-Disadvantages are subjective inputs can result in unspecified models and bad results, overreliance on a valuation that is at heart an estimate, high sensitivity to small changes in input assumptions. b. Using Earning Capitalization Model Capitalization refers to the return on investment that is expected by an investor. Capitalization methods for valuing a business are based upon return on the new owner's investment. The problem with this model is that it does not take into consideration the growth of the company, it is appropriate for no-growth firms. Therefore we chose to reject this calculation. The earnings capitalization model calculations were found this way: ECM= E1 / P0 = 216 / 42.09 = 5.31% (forecasted) and P0 is the stock price today. where E1 is the earnings for the upcoming year

+ Earnings Predictions: One disadvantage of basing your valuation of a company on future earnings is that the projected future earnings may wrong. Estimates may not be accurate. Unforeseen circumstances could cause earnings to be much less than anticipated. If you purchase such a business, you could not get the income from it that you want. + Current Capitalization Rate Errors: Because capitalization of future earnings depends on the current capitalization rate for its formula, you must make sure that rate is reliable. Sometimes business owners use the most recent year's earnings. Ask for an average over the past three to five years, and you will mitigate the effect of unusual spikes in any given year. c. Using CAPM for calculate RE: RE = RRF + (RM RRF) x Beta -In which: *RRF= risk-free rate (Profitability rate of Government bonds (U.S. Treasury), in Exhibit 4 we have U.S Treasury 20-year RRF= 5.74%) *(RM RRF): Risk market premium.(Exhibit 4:geometric mean = 5.90%, arithmetic mean = 7.50%). Because of arithmetic mean is better for one-year period estimated expected returns, while geometric mean is better for long-term period valuation. So, for long life valuation, we can find stable valuation. *Beta: index of responsiveness of changes in a securitys returns relative to changes in returns on the market, in this case is sport utility industry (Exhibit 4 of Nike Inc., given from 1996 is Average beta = 0.98, beta in 2001 is 0.69). We need to find out a beta that is most representative to future beta (not as beta from 1996 to 2001 is 0.8 according to Cohen). Most recent beta estimate is recent beta at 06 June 2001 is 0.69. Given that RRF=5.74%; RM-RRF=5.9%; Beta=0.69 RE = 5.74% + 5.9% x 0.69 = 9.811%

7 |Case analysis: Nike Inc, Cost of Capital

*CAPM has the advantage of simplicity and can be applied in practice. However, like many other models, CAPM inevitable limitations and criticism. Maybe the attraction of CAPM is simplicity and easy to apply, but may be CAPM too simple to apply, it lead to reflect not really true happen, it is normally just a model. There are some limitatations of the CAPM model. These abnormalities include: + Unrealistic assumptions: CAPM is based on a number of assumptions that are far from the reality. For example it is very difficult to find a risk free security. A short term highly liquid government security is considered as a risk free security. It is unlikely that the government will default, but inflation causes uncertain about the real rate of return. The assumption of the equality of the lending and borrowing rates is also not correct. In practice these rates differ. Further investors may not hold highly diversified portfolios or the market indices may not well diversify. Under these circumstances CAPM may not accurately explain the investment behavior of investors and beta may fail to capture the risk of investment. + Difficult to validity: Most of assumptions may not be very critical for its practical validity. Therefore is the empirical validity of CAPM. Need to establish that the beta is able to measure the risk of a security and that there is a significant correlation between beta and the expected return. The empirical results have given mixed results. The earlier tests showed that there was a positive relation between returns and betas. However the relationship was not as strong as predicted by CAPM. Further these results revealed that returns were also related to other measures of risk, including the firm specific risk. In subsequent research some studies did not find any relationship between betas and returns. On the other hand other factors such as size and the market value and book value ratios were found as significantly related to returns. +Betas do not remain stable over time: Stability of beta, beta is a measure of a securities future risk. But investors do not further data to estimate beta. What they have are past data about the share prices and the market portfolio. Thus, they can only estimate beta based on historical data. Investors can use historical beta as the measure of future risk only if it is stable over time. Most research has shown that the betas of individual securities are not stable over time. This implies that historical betas are poor indicators of the future risk of securities. CAPM is a useful device for understanding the risk return relationship in spite of its limitations. It provides a logical and quantitative approach for estimating risk. It is better than many alternative subjective methods of determining risk and risk premium. One major problem is that many times the risk of an asset is not captured by beta alone. 4. WACC: Putting it all together Apply in to formula WACC: WACC = RE x E / (D + E) + RD x (1-T) x D / (D + E) WACC = 10.1% x 4.44% + 89.9% x 9.81% = 0.45% + 8.82% = 9.27%

8 |Case analysis: Nike Inc, Cost of Capital

IV/ Recommendation:
What should Kimi Ford recommend regarding an investment in Nike? -According to Kimi Fords quick sensitive analysis, Nike was undervalued at discount rate below 11.17%. Kimi Ford used a discount rate of 12 percent to find a share price of $37.27. This makes Nike Inc. share price overvalued by $4.82 as Nike is currently trading at $42.09. We already established that we found this discount rate to not reflect the true market value and solved for a discount rate that would be more accurate. Furthermore, discounting cash flows in Exhibit 2 with the calculated WACC is 9.27%, the present value of Nike is $58.13 much higher than Nikes current market price of $42.09.

We assumpt the terminal value growth rate is 3% So Nike shares price is undervalued. 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 NorthPoint Large-Cap Fund should buy Nike Inc., shares at this time because the stock is undervalued and because it had growth potential that would be beneficial to the fund.

9 |Case analysis: Nike Inc, Cost of Capital

-In conclusion, based on all data including history data, recently 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, other companies in industry and other shares in S&P 500. 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. Beside that, Kimi Ford also dont forget monitor its activities very closely. If North -Point Large-Cap Fund want to invest in Nikes shares in short-term, they should buy Nikes shares at the end of the year, while others not really pay attention to much in market and sell it in the first month of next year. In January, when people have a little overestimate, North-Point Large-Cap Fund can sell for achieve their profit.