Case 15: Cost of Capital: Nike, Inc.

Victoria Soto
Simon Hoang
Michael Vu

Grade: 90/100

In this case, Kimi Ford contemplates whether to invest in Nikes common stock. She is a
portfolio manager at NorthPoint Group, which is a mutual fund management firm that invests

Case 15: Cost of Capital

mostly in Fortune 500 companies that focuses on value investments. In June 2001, Ford faced a
dilemma regarding investment in Nikes stock. In 2001, Nike had underperformed due to
microeconomic factors such as: downtrend in revenue growth, profits, and market share. Key
issues that needed to be addressed was the inadequate effect of supply-chain dissemination and
the detrimental effect of a strong dollar. As a result, managements decision to implement new
strategies which ranges from increase in sales growth by developments in athletic shoe products
in the mid-priced segment, apparel line, and commitment to cost reduction. Nevertheless,
analysts and investors react with mixed indications to Nikes new strategy.
Some believed management was too aggressive and others believed that it was a buying
opportunity. Kimi Ford read the analysts reports available, and she could make a decision based
on mixed opinions. Therefore, Ford decided to develop her own discounted cash flow analysis to
make a decision. Fords analysis showed that using a discount rate of 12% and current price
share of $42.09 Nike was overvalued. Using a sensitivity analysis, Ford found Nikes break-even
discount rate was 11.17%. Using the information obtained in her analysis, Ford decided to ask
her assistant, Joanna Cohen, to estimate Nikes cost of capital. Cohen estimated Nikes cost of
capital to be 8.4% which was below the break-even point and it would result in a buy
recommendation. After carefully reviewing Cohens methodologies and assumptions, we
discovered that the estimation process for the cost of capital was flawed. Our goal is to utilize the
basic fundamentals and general theory about the cost of capital; identify Joanna Cohens
erroneous analysis, and make an accurate recommendation for Kimi Ford.
The weighted cost of capital is one of the best methods available to estimate Nikes cost
of capital. WACC is calculated and set by investors. However, WACC estimation is used by
managers to determine if the firms projects can generate enough returns while investors use
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WACC to make investment decisions. In other words, WACC is a required rate of return that
reflects whether the risk for an investment (for firms) is profitable versus the returns of
alternative investments.
After reviewing Joanna Cohens analysis, we concluded that parts of her analysis were
flawed. She made several technical errors during the estimation process which could have led to
an erroneous decision. Therefore, we decided to estimate cost of capital avoiding the technical
errors Cohens made in order to give an accurate recommendation.
The first key decision Cohen faced was to determine whether to use a single or multiple
cost of capital. Since most of Nikes business segments face approximately the same risk, we
concluded that Cohens decision to use a single cost of capital was very reasonable.
The second step that needed to be address was to determine Nikes debt and equity
values. She opted to use book value to calculate both debt and equity instead of market value.
Since it would be very difficult to calculate an accurate market value of debt, we concluded that
Cohens decision to use book value of debt of $ 1,296,600 (Exhibit 1A) was reasonable.
However, using the book value to calculate Nikes total equity was not the best option because
there were enough information available and methods to calculate an accurate market value of
equity. In order to estimate market value of equity, we decided to discount future cash flows
assuming WACC was 12% and terminal value growth was 3%. Our results showed that Nikes
total enterprise value was $11,415,660 (Exhibit 1B) million and equity value was $10,119,060
(Exhibit 1C) million. Therefore, debt accounted for 11.36% (Exhibit 2A) of Nikes total value
and Equity accounted for 88.64% (Exhibit 2B).

Case 15: Cost of Capital

Cost of debt was another important variable that needed to be estimated to determine
Nikes cost of capital. Cohens decided to use the historical interest rates. Cohens estimated
before-tax cost of debt to be 4.3% which was lower that markets risk free. We concluded that
there was a better method to estimate. Instead of using historical interest rate, we decided to
utilize current market yield-to-maturity on publicly traded Nike debt securities. Our estimation
showed Nikes before-tax cost of debt was 7.17% (Exhibit 2A) and After-tax cost of debt was
calculated to be 4.45% (Exhibit 2B).
Cost of equity was the last variable required to calculate Nikes cost of capital. There are
different methods that can be used to estimate cost of equity: (1) capital asset pricing model
(CAMP), (2) discount dividend model (DDM), and (3) earning capitalization ratio (ECR).
Among these three methods, Cohen opted to use CAMPM. We believed that CAMPM is the best
approach because it is the most widely used model in finance, relatively easy to use, and
accounts for systematic risk, even though estimating its components (risk free, beta and market
risk premium) can be challenging .On the other hand, DDM and ECR are simple to calculate, but
do not take into consideration systematic risk and both models accuracy depend upon firms
maturity and growth. Exhibit 7A shows estimation of cost of equity to be 6.64% and Exhibit 7B
estimates cost of equity to be 5.51% using the DDM and ECR models respectively. Based on the
results obtained, and comparing them to before-tax cost of debt, we concluded that these both
methods are not the best estimators since equity investors usually required a higher rate of return
than debt investors. Therefore, we agreed to use the CAMP method to accurately estimate cost of
capital. Since Nike is a mature firm we decided to utilize two long term risk-free rates, 10-year
U.S. Treasury bill 5.39% and 20-year U.S. Treasury bill of 5.74%. We also utilized geometric
and arithmetic mean from 1926-1999 because we wanted to take a conservative approach. In
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Case 15: Cost of Capital

order to estimate beta, we used weekly returns from 1999-2001 to calculate raw and adjusted
beta (Exhibit 8). However, we agreed to use just the adjusted beta to calculate cost of capital.
Exhibit 4 show the different four combinations used to arrive to a cost of equity of 11.03%
After we had all the estimations needed, we calculated Nikes WACC to be 10.29%
(Exhibit 5). We decided used the four different cost of equity results obtained by using geometric
mean, self-calculated adjusted beta, and a combination of 10-year and 20 year U.S. Treasury
Bills while debt and equity weights and cost of debt remained constant. Based on Fords
sensitivity analysis that showed a break-even cost of capital of 11.17%, we concluded that Nikes
stocks price was undervalued by 15% (Exhibit 6). The price per share at WACC 10.29% should
be $48.46 (Exhibit 6) and currently the price is $42.09 (Fords analysis). Since break-even
WACC 11.17% is greater than our calculated WACC of 10.29%, we recommend Ford to buy
shares of Nikes stock.

Appendix
Formulas
Book Value of Debt = Position of Long-term debt + Notes Payables + LongTerm Debt
Market Value of Equity = Total Enterprise Value Book Value of Debt
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Case 15: Cost of Capital

Total Enterprise Value = NPV of future cash flows discounted at 12%
Weight of Debt = W

debt

Weight of Equity = W

= Book Value of Debt / Total Enterprise Value

equity

= Market Value of Equity / Total Enterprise

Before-Tax Cost of Debt = PV= -$95.60 FV= $100 PMT= (Coupon Rate *
FV)/2 N= Years left to Maturity *2
After-Tax Cost of Equity =Before-Tax Cost of debt * (1- Tax Rate)
CAMP = Rf + Beta(Rm-Rf)
Dividend Discount Model (DDM) = K
Earnings Capitalization Ratio = K

equity

equity

= D1 / P 0 + g

= E1 EPS1 / P0

Exhibits
Exhibit 1: Book Value of Debt, Market value of Equity, and Total Enterprise Value
Exhibit 1A : Debt: $5.4 + $855.3 + $435.9 = $1,296.6
Exhibit 1B: Nikes Total Enterprise Value

Exhibit 1C: Market Value of Equity: $11,415.66 $1,296.6 = $10,119.06

Exhibit 2: Nikes Weight of Debt and Equity

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Exhibit 2A: Weight of Debt: $1,296.6/$11,415.66 = 11.36%

Exhibit 2B: Weight of Equity: $10,119.06/$11,415.66 = 88.64%
Exhibit 3: Cost of Debt
Exhibit 3A: Before-Tax Cost of Debt: 3.58372 * 2 = 7.17%
PV= -$95.60 FV= $100 PMT= (0.0675 *100)/2 N=20*2 =3.5372%
Exhibit 3B: After-Tax Cost of Debt: 7.17% *(1-.36) = 4.59%

Exhibit 4: Cost of Equity (CAMP)

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Exhibit 5: WACC = 10.29%

Exhibit 6: Intrinsic Value per share at calculated WACC of 10.29%: $48.46

Exhibit 7: DDM and ECR

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Exhibit 7A: DDM: $0.48/$42.09 + 0.055 = 6.64%
Exhibit 7B: ECR = $2.32/$42.09 = 5.51
Exhibit 8: Self-Calculated Raw Beta and Adjusted Beta