# Nike Inc.: Cost of Capital Essay Sample

## A limited time offer!

Get a custom sample essay written according to your requirements urgent 3h delivery guaranteed

Order Now## Nike Inc.: Cost of Capital Essay Sample

In this report we focus on Nike’s Inc. Cost of Capital and its financial importance for the company and future investors. The management of Nike Inc. addresses issues both on top-line growth and operating performance. The company’s cost of capital is a critical element in such decisions and it is important to estimate precisely the weighted average cost of capital (WACC).

In our analysis, we examine why WACC is important in decision making and we show how WACC for Nike Inc. is calculated correctly. Also, we calculate the company’s cost of equity using three different models: the Capital Asset Pricing Model (CAPM), the Dividend Discount Model (DDM) and the Earnings Capitalization Model (EPS/ Price), we analyze their advantages and disadvantages and finally we conclude whether or not an investment in Nike is recommended.

Our analysis suggests that Nike Inc.’s common stock should be added to the North Point Group’s Mutual Fund Portfolio.

I. The Weighted Average Cost of Capital and its Importance for Nike Inc.

The Weighted Average Cost of Capital (WACC) is the 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. By taking a weighted average, we can see how much interest the company has to pay for every marginal dollar it finances. 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.

II. Calculation of Nike’s WACC

The calculating methodology for Nike’s Inc. WACC seems to be inconsistent with the principles1 that should be followed when estimating this measure. These are our points of disagreement with the calculations in Exhibit 5:

– Calculation of the cost of debt by taking the total interest expense for the year 2001 dividing it by the company’s average debt balance, which is not appropriate for the WACC estimation

– Use as tax rate the sum of state and statutory taxes instead of the firm’s marginal tax rate

– Use of the Book Value of equity rather than the market value which is suggested as it gives more precise results

– Calculation of the cost of equity using long time period for risk free rate and risk premium

In order to make our justifications more comprehensive we need the formula for estimating WACC:

WACC= Wd*Kd(1-T) + We*Ke

First, we reexamine the cost of debt (Kd) which in this case is the yield to maturity (YTM) on the bonds. The YTM is a good estimate for the cost of debt if a company had issued debt in the past and the bonds are publicly traded just as in Nike’s case. Our calculations for Nike’s yield to maturity based on the given data showed that Kd= 7.16%.c1 (See Appendix for detailed calculations)

The second variable that should be noted is T or the tax rate. In her calculations, Joanna Cohen added the 3% state taxes to the 35% statutory tax where in WACC calculation the marginal rate should be used. The marginal tax rate generally refers to the “federal income tax that is levied onto the additional dollar earned” and usually is about 40%.

The weights of the costs, Wd and We, are very important in calculating WACC as they show the company’s capital structure. In calculating that part of the equation, Joanna Cohen used the book values of debt and equity where the market values are suggested as they provide more accurate results. As book and market values of debt and equity may differ a lot, market values of debt and equity give a closer estimation of the capital structure2. We calculate the enterprise value (P0*#shares outstanding = $11,427.4357m). For debt, the book value gives a close estimation for the current value, whereas the same doesn’t hold for the value of equity. Thus, debt is equal to $1,296.6m (current portion of L-T debt + notes payable + L-T debt). In finding the weights, the previous explanation shows that equity is 88.65% whereas debt is 11.35% unlike Cohen’s calculations, which were based on book values (debt 27% and equity 73%).

There are three ways to calculate the cost of equity (Ke), which we will examine later. In our calculations of WACC we use the Capital Asset Pricing Model (CAPM), as it is considered to be the most complete model for estimating the cost of equity.

CAPM Equation is: Ke=Krf+ β(Km-Krf)c2,

where Ke is the cost of equity, β is beta that measures the tendency of a stock to move up and down with the market, Km is the required return of the market, Krf is the risk free rate and (Km – Krf) is equal to the market risk premium.

For the Krf (risk free rate), we used the current yield on 10yr bond (5.39) U.S. treasuries, instead of the 20yr, as the 10yr matches the duration of cash flows for the Nike’s investment project (Exhibit 2) and because it is relatively less exposed to unexpected changes in inflation and the liquidity premium when compared to the longer 20 yr bond3. For the market risk premium, Km – Krf, we used the arithmetic mean (7.5%). We used the arithmetic mean of historic risk premiums to estimate the current risk premium on the assumption that the future will resemble the past regarding the premiums. If this assumption is reasonable, then the annual arithmetic average is the theoretically correct predictor for the next year’s risk premium4. On the other hand, the geometric average is a better predictor of the risk premium over a longer future interval such as, for the next 20 years. For β we used the historic average of the past 6 years (0.8). After we calculate the cost of equity with CAPM (Ke= 11.39%), we plug our results in the given formula of WACC and we get WACC=10.59c3.

III. Alternative Methods of Calculating the Cost of Equity

Although, CAPM approach is considered to be an accurate and precise estimate of Ke, there are two other models used by those analysts who do not have complete confidence in CAPM. These approaches are the Dividend Discount Model (DDM), which compares dividends forecasted for the next period with the current share price for the firm and then adds the growth rate of the firm and the Earnings Capitalization Model (ECM), which compares forecasted earnings for the next period over the current share price. Our calculations, which are analyzed in the Appendix (c4 and c5 respectively), gave us the following results:

Using DDM: Ke= 6.7%

Using ECM: Ke= 9.88%

We can see that the three different methods of calculating the cost of equity produced widely varied estimates. In such situations the financial analyst has to use his/her judgement as to relative merits of each estimate and then choose the estimate which seemed more reasonable under the circumstances.

Comparing the already discussed methods, we found that the main advantage of CAPM approach is that it takes into consideration a company’s market risk as the most relevant risk to stockholders, hence to determine the effect of the new activities and projects of the company on stock price. This method can be applied to firms that do not pay dividends as well as new firms, by using betas for similar firms (e.g., other firms in the industry). However, with CAPM all our projections are based on historical data onto the future, because of the estimate of Beta we use. Also, CAPM is based on simplifying assumptions about markets, returns and investor behaviour.

The dividend discount model (DDM) is a simple model for valuing equity. It is considered to be a good thinking exercise as it forces the investors to begin thinking about different scenarios in relation to how the market is pricing the stock. On the other hand, dividend discount model requires an enormous amount of speculation in trying to forecast future dividends. Meaning that a model is only as good as the assumptions it is based upon. Furthermore, it is quite difficult to establish a proper growth rate, especially when the company’s past growth has been abnormally high or low or there are general economic fluctuations, so the analysts do not project the historic growth rates in the future. Finally there are no direct adjustments for risk in this method.

The earnings capitalization model (ECM) is a simple model and easy to understand. However, it is considered poor in estimating equity costs for growing firms, so it is used as reasonable only for no growth firms.

IV. Is Nike a Good Investment for the time being?

The Discounted Cash Flow Analysis (Exhibit 2) showed that at the discount rate of 12%, Nike was overvalued at its current share price of $42.09. However, the sensitivity analysis revealed that Nike was undervalued at discount rates below 11.2%. We estimated WACC, the appropriate discount rate, at 10.59% which is less than 11.2%. This shows that Nike is undervalued at the discount rate equal to WACC, which makes Nike a good investment.

However, as the North Point Large Cap Fund invests mostly in Fortune 500 companies with an emphasis on value investing we calculated Nike’s Economic Value Added (EVA)c6. Our results give a positive EVA for Nike at $304.5 which means that the company adds to its shareholders’ value.

As Nike’s common stock is undervalued and the company has a positive EVA, it should be added to the North Point Large Cap Fund.

Appendix

1. Mistakes to Avoid when Calculating WACC

Use of the current cost of debt. The relevant pre-tax cost of debt is the interest rate the firm would pay if it issued debt today.

Use of historical average return on stocks with the current risk free rate. A case could be made either using the historical risk premium or the current one, but it is wrong to subtract the current risk free rate from the historical rate of return on the market.

Use of book values of debt and equity to estimate their weights in WACC. Although debt may have close market and book value, the market value of equity may differ significantly.

2. Adjusting the Cost of Capital for Risk

Nike is planning to focus mainly on two projects in the next year: To develop more athletic-show products in mid-priced segment and to push its apparel line which has already done extremely well. It seems that these two projects have different risks: mid-priced athletic shoes could be treated as a “new” product for Nike while apparel is already successful and both projects are in different business segments. Also, Nike provides plenty of other products. We can say that the use of multiple costs of capital, especially for the new project, is reasonable. However, we do not have enough data to support such approach.

3. Estimating the Market Risk Premium for CAPM

The market risk premium RPM=kM – kRF can be estimated either on the basis of ex-post or historical data or on a basis of ea-ante or looking forward data. Although, historic risk premiums are results of a very complete and accurate study (available from Ibbotson Associates) are usually treated with low confidence from the investors.

Ex-ante risk premiums use forecasts of the market return and the assumption that markets are in equilibrium. Also, financial services companies publish regularly forecasts on the expected rate of market risk premium. However, there are potential problems as well. Many consider these forecasts the analysts and not the investors’ expectations-although this probably is not a major problem as many studies have shown-and that there are many financial companies that give different forecasts, so a potential investor needs to take the average from several forecasts.

4. Use of Historical Arithmetic Mean of Risk Premiums

Although we did extended research to find Value Line’s forecasts for the rate of return on the market or the risk premium for 2001, we did not find anything due to limited access on relevant data. We decided to use the arithmetic mean based on the reasons we gave above but we still believe that the use of current values is better when estimating CAPM.

5. Calculations

c1. Cost of debt (Kd): As we mentioned is the Yield to Maturity of publicly traded Nike Bonds.

(Values inserted in financial calculator)

PV: -95.6

FV: 100

n: 40

Pmt: 6.75/2= 3.375 (as it pays semiannually) → i* = 3.5813 semiannually, so, I/Y=(i*) * 2 →

i: 7.1627% = YTM= Kd= 7.16%

c2. CAPM for Nike’s cost of equity

Ke = Krf+β(Km-Krf)

= 5.39+0.8(7.5)

= 11.39%

c3. WACC = Wd*Kd(1-T) + We*Ke

= 0.1135 * 7.16% (1-.4) + 0.8865 * 11.39%

= 10.59%

c4. Dividend Discount Model (DDM) for Nike’s cost of equity (Ke)

Ke = D1/P0 +g

g = 5.5% (Value Line’s estimation)

P0 = 42.09

D1 = D0(1+g)

= 0.48(1+.055)

= 0.5064

So, Ke = 0.564/ 42.09 + .055= 6.7%

c5. Earnings Capitalization Model (ECM) for Nike’s cost of equity (Ke)

Ke = E1 / P0

Where, E1 = (1+g) * E0 / # of share outstanding

and g = Retention ratio * ROE

We used this estimation for g, instead of the Value Line’s forecast (5.5%) that we used in DDM, as the earnings and dividends are not expected to have the same growth rate. Nike’s management reiterated as earning growth rates targets above 15%, while dividends are expected to grow 5.5%

From the available data we have,

Retention Ratio = Retained Earnings / Net Income = 3194.3/ 589.7 = 5.42

ROE = Net Income / Total Shareholders’ Equity = 589.7/ 3494.5= 16.88%

That gives: g=5.42*0.1688=0.914

E1 = (1+g) * E0 / # of share outstanding = [(1+ 0.914)* 589.7 / 271.5] =4.1572

So,

Ke = E1 / P0= 9.88%

c6. EVA = NOPAT – (Operating Capital*WACC)

NOPAT = Operating Income (1 – Tax) = 1,014.2 (1-0.35) = 659.2

Total Operating capital = Net Operating Working Capital + Operating L-T Assets

NOWC = (Cash + Acc. Receivables + Inventories) – (Acc. Payables + Accruals) =

(304 + 1,621.4 + 1,424.1) – (432 + 472.1) = $2,445.4

Operating L-T Assets = $1,618.8

Operating capital = 2,445.4 + 1,618.8 = $3,349.5

So, EVA= 659.2 – (3,349.5*0.1059)= 304.488 ~ 304.5