Nike Case Study

1. WACC is the weighted average cost of capital and it is the required rate of return or discount rate
average of the costs of a company's sources of financing-debt and equity, each of which is
weighted by its respective use in the given situation.
a. It is what the firm needs to make collectively on all investments in order for them to be
considered good investments
b. By taking a weighted average, we can see how much interest the company has to pay for
every marginal dollar it finances.
c. A firm's WACC is the overall required return on the firm as a whole and, as such, it is often
used internally by company directors to determine the economic feasibility of expansionary
opportunities and mergers. Also, WACC is the appropriate discount rate to use in stock
valuation
d. Since WACC is the minimum return required by capital providers, managers should invest
only in projects that generate returns in excess of WACC
e. The WACC is set by the investors (or markets), not by managers. Therefore, we cannot
observe the true WACC, we can only estimate it
2. Calculations
a. Single or multiple
i. 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.
b. Cost of debt
i. 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.
ii. 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.
iii. The cost of debt, if its intention is to be forwarding looking, should be estimated by
1. Yield to maturity of bond
2. According to credit rating.
iv. 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
N=40 (20 years paid semi annually)
Pmt=-3.375
FV=-100
Comp I = 3.58% (semiannual) 7.16% (annual)
After tax cost of debt = 7.16%(1-38%) = 4.44%
c. Cost of equity
i. Cohen seems to use CAPM to estimate cost of equity. Her number comes from
following:
1. 10.5% = 5.74% +(5.9%)*0.80
a. Her risk free rate comes from 20-year T-bond rate
b. Cohen uses average beta from 1996 to July 2001, 0.80.
c. Cohen uses a geometric mean of market risk premium 5.9%
ii. Risk free rate
1. 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.
iii. Market risk premium
1. 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.
iv. Beta
1. 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.
v. Recalculated Cost of Equity
vi. 5.74% + (5.9%)* 0.69 = 9.81%
d. Weights of capital components
i. Cohen is wrong to use book values as the basis for debt and equity weights; the
market values should be used in calculating weights.
ii. 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.
iii. For market value of equity, $42.09*273.3 m shares = 11,503 m.
iv. Due to the lack of information of the market value of debt, book value of debt, 1,291
m, is used to calculate weights.
v. Thus, the market value weight for equity is 11,503 / (11,503+1,291) = 89.9%; the
weight for debt is 10.1%.
3. Calculation of the WACC is as follow:
a. 4.44%*0.101 + 9.81%*0.899 = 9.27%
4. See above
5. 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.
a. 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!


Class Answer
1. WACC
What is WACC?
Required rate of return
Why is it important?
Used to:
Value a capital project
Perform valuations of the whole firm (FCF)
Who sets WACC?
Set by the investors of the firm
Could argue that it is a combination as the managers determine the weighting of debt to
equity in the firm and the investors only determine the required rate of return on equity
2.
2.1 Single or Multiple costs of capital
She argues that although there are multiple businesses, they are very similar in terms of their risk. Even
though they were located in different places. She also used one rate because she was valuing the whole
company.
2.2 Calculation of WACC:
Capital Structure Jos Assumptions
She used the book value (straight from the balance sheet) as opposed to the market value
Traditional view: if you have a target structure, use that. If not, market values. Thereafter, market value.
Cost of Debt Jos assumptions
She took total interest for the year divided by the companys average debt balance
Can actually calculate what the yield is on their securities
Her argument re borrowing in Japan at lower rate is not bad but not great either
She has use Nikes effective tax rate (use this because it is specific to the company)
Cost of Equity Jos assumptions
She used the CAPM model says its more superior. This model is used 65% yet hugely controversial. 100s
of people saying CAPM doesnt work. But it does help us do a valuation which is never exact science
anyway.
She used a 20 year treasury bond as her risk free (most ofteb used). Could have used the 10 year too. She
used the geometric average for the equity risk premium which is superior to the arithmetic mean. For
Beta, she took the average from 1996 to 2001 (present). She could have taken something like the current
YTD beta as it is forward looking which is what we require.
3. CAPM calculation

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This gives us a range of 9.46% to 10.46% using different risk free rates (10 year or 20 year) and different
betas (average since 96 or YTD)
None of them are incorrect just have to justify
CAPM advantages and disadvantages
DDM Calculation
She used the value line forecast for dividend growth of 5.5%. Last dividend was 48c

This rate is too low to use
DDM Advantages and disadvantages
Earnings capitalization method calculation

Taking the diluted EPS from the AFS, growing it by the growth rate and then dividing by the current share
price
Earnings capitalization method advantages and disadvantages
4.
Capital Structure
Cost of debt
PV= 95.60
N=40 (20 years paid semi annually)
Pmt=-3.375
FV=-100
Comp I = 3.58% (semiannual) 7.16% (annual) (market related yield to maturity)
After tax cost of debt = 7.16%(1-38%) = 4.44%
Many people would take the YTM and put it into a formula with the par value of the notes.
Going to do the shortcut method and take the amount on the balance sheet

The sum of current portion of long term debt (5.4), long term debt(435.9) and notes payable (855.3) x
(calculated cost of debt)/(coupon rate of debt)
Value of Equity: 271.5 (number of shares outstanding) x 42.09 = 11427
Thus weightings 10.75% (debt), 89.25% (equity)
Cost of equity
WACC
5. Buy or sell?