Brian Dean

John Ekelund
Lauren Finkenbeiner
James Toomarian

Nike, Inc.
Kimi Ford, a portfolio manager for NorthPoint Group, is looking for value opportunities.
Specifically, Nike has caught Fords attention in its recent drop in share price, and she would like
to know as to whether this would be a good company to add to the NorthPoint Large-Cap Fund,
which Ms. Ford manages. After finding significantly conflicting conclusions from reputable
analyst reports across the board, Ford decides her own independent research and forecasting will
clear the air. Through a sensitivity analysis of a discounted cash flow forecast, Ms. Ford feels
Nike would be a value opportunity at discount rates below 11.17%. Ford decides to delegate the
task of calculating Nikes weighted average cost of capital to Joanna Cohen, her assistant.

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?
WACC, or weighted average cost of capital, is a calculation of a companys cost of
financing proportionate to its degree of leverage. It is important to estimate a firms cost of
capital as it serves as a type of benchmark when deciding where it would be most effective or
worthwhile to deploy a companys capital. We disagree with Joanna Cohens WACC calculation
of 8.4% for Nike. This is due to her use of book values instead of market values in her
calculation. Using a market value approach will more accurately reflect the most current
opportunity cost to the company.
Moreover, we noticed Joanna calculated Nikes cost of debt by dividing the interest
expense by the debt balance. We feel this calculation does not provide any meaningful
information, and this approach would not be possible using only the information provided in the
case study. Instead, we approach cost of debt by calculating the yield to maturity of Nikes
outstanding corporate bonds.

If you do not agree with Cohens analysis, calculate your own WACC
for Nike and be prepared to justify your assumptions.
We calculate Nikes weighted average cost of capital to be 7.54% based on the following
assumptions:

Capital Structure:
We started by verifying Nikes capital structure weights. We used market values for both
debt and equity. Preferred stock is given, however there is not enough information to calculate
the cost of preferred stock, and its final weight is negligible regardless. Regarding debt, we used
the sum of Current Portion of Long-term Debt, Notes Payable, and Market Value of long-term
debt. We found MV of L.T. Debt by adjusting the book value of L.T. Debt against its current
trading price of .956 of par. Regarding equity, we simply multiplied shares outstanding by the
most current price of Nike publicly traded common stock.
Cost of Debt (7.17%)
We calculated Nikes cost of debt by finding the YTM of Nikes corporate bonds. The
information given includes the coupon rate of the bond, the maturity date, and the current price
of the bonds. We then used the RATE function in excel while adjusting for semi-annual payments
to arrive at a cost of debt of 7.17%.
Cost of Equity (7.89%)
We calculated Nikes cost of equity by using the CAPM model. For the risk-free rate, we
used 10-year U.S. Treasuries, as these more liquid than the also provided 10-year U.S.
Treasuries. Regarding the equity risk premium, we decided to use the 2001 Implied Equity Risk
Premium calculated by Aswath Damodaran of NYU Stern. We do not feel comfortable using the
given 5.9% geometric mean or the arithmetic mean of 7.5% going back to 1926. Averages going
back that far run the risk of being contaminated by noise, or variability cause by no longer
relevant market environments. An example of the sensitivity of geometric mean of equity
premiums can be found on page 4 of this report, and Damodarans risk premiums can be found
here. Finally, we used the most recent market beta for Nike which is given at 0.69.

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?
CAPM (7.54%)
CAPM is one of the most widely used models to estimate return on equity. It is very
elegant in the way that it ties risk to return. This elegance comes at a cost. The degree to which
the CAPM model is reliable is directly tied to the assumptions that are put into CAPM; in a
sense, this is a second way in which CAPM ties risk to return.

DDM (6.70%)
The Dividend Discount model is also a popular tool when measuring return on equity.
However, it does not account for risk in the way that beta does. In addition, DDM only uses two
data points for dividends and then extrapolates the growth of those dividends at a constant rate.
This type of assumption will degrade quickly over time periods of scale unless used on
companies that have a very consistent track record of dividend payments as well as a solidified
dividend policy.

Earnings Capitalization Ratio (5.13%)

We recently learned about the Earnings Capitalization Ratio and its uses. This model
also does not account for risk, and it utilizes a given companys P/E ratio and is simply [1 /
(PE)]. The obvious downside to this model is the sharp variability of a companys P/E ratio. P/E
ratios are not easily forecasted, and are often most affected by investor sentiment more than
fundamentals.

What should Kimi Ford recommend regarding an investment in Nike?

Kimi Ford, a portfolio manager for NorthPoint Group, is looking for value opportunities.
Through a sensitivity analysis of a discounted cash flow forecast, Ms. Ford feels Nike would be a
value opportunity at discount rates below 11.17%. We calculated Nikes current weighted
average cost of capital to be 7.54%, which is well below the threshold required to flag this
company as undervalued. Along with this value opportunity comes the financial state of the
company. Ratio analysis for 200 and 2001 shows Liquidity metrics improving across the board
year over year. Regarding Asset Management, metrics have overall remained constant at
favorable levels, with the only change coming in Payables Turnover, which increased slightly. All
of Nikes Debt Ratios have fallen year over year, which is our most promising sign that the
company will succeed in its plans to restructure in response to changing market environments.

WACC, or weighted average cost of capital, is a calculation of a companys cost of

financing proportionate to its degree of leverage. It is important in estimating a firms cost of
capital as it serves as a type of benchmark when deciding where it would be most effective or
worthwhile to deploy a companys capital. WACC is a powerful concept that is centrally
significant to measuring a companys value. One example of its application is for value investors
such as NorthPoint in determining at what level of capital costs a company would be worth
investing in or staying away from. Investors can then calculate what they believe the actual cost
is, and compare these figures to make an investment decision. In this case, Ms. Fords decision
should be to add Nike, Inc. to her portfolio, and to replace her assistant Joanna with an alumnus
of Professor Sarmass FRL 440 class, who would make a more diligent and consistent analyst.