Nike, Inc.: Cost of Capital

Case Facts

North Point Group
North Point Group is a mutual fund management firm. Large-Cap Fund is one of the portfolios managed by Kimi Ford. This portfolio is composed of Fortune 500 companies, to include Exxon Mobil, GM, 3M, and large-cap, old economy stocks. The fund earned 20.7% return in 2000 and 6.4% year-to-date returns, end of June 2001. With emphasis on value-investing, Kimi Ford is considering buying shares of Nike, Inc.

Nike, Inc. An athletic shoe manufacturer, Nike, Inc. had a stagnating revenue of $9 billion from 1997-2001. Net income of the company had also fallen from $800 to $580 million. Nike’s market share in athletic shoes had dropped from 48% (1997) to 42% (2000).

To address the current performance, Nike’s management has the following plans:
Develop more athletic shoe products in mid-price segment
Push its apparel line
Exert more effort on cost control
Targets: Revenue growth: 8% to 10%; Earnings growth: above 15%

Analysts’ Assessment of Nike, Inc. Analysts have mixed reactions about Nike. Some thought that the company has too aggressive financial targets. Others saw significant growth in apparel and Nike’s international businesses. The Lehman Brothers propose a “buy” while the UBS Warburg and CFSB suggest a “hold”.

Joanna Cohen’s Analysis

The assistant portfolio manager, Joanna Cohen, computed a single cost of capital for Nike, Inc. since the company is in sports-related business, except for one.

Value of Debt and Equity Capital Sources
Values
Amount (in million $)
Weights (%)
Debt
Book Value
1,296.6
27
Equity
Book Value
3,494.5
73
Total

4,791.1
100

Joanna Cohen used the book value of both debt and equity to compute for the value of the firm and the weights of debt and equity.

Cost of Debt The estimated cost of debt of Nike is 4.3%, pre-tax. This is computed by taking total interest expense for 2001 divided by the company’s average debt balance (May 2000 and May 2001). Using 38% tax rate (statutory tax plus state tax), the after tax cost of debt is 2.7%.

Cost of Equity The estimated cost of equity was 10.5%. Using CAPM, the following values were used: risk-free rate: 20-year Treasury bonds; risk premium: compound average premium of the market over Treasury bonds; beta: average of Nike’s historic beta from 1996 to 2001.

Using the above values, the computed WACC is 8.4%. Nike, Inc. Share price With the discounted cash flow forecast developed by Kimi Ford, the price of Nike, using WACC=8.4%, is $49.59 per share. This makes Nike undervalued at the current market price of $42.09.

Recommendation

The issue of Nike’s case is about the calculation of the cost of capital (WACC) and if the share price of Nike is overvalued or undervalued. Finally, it is also a question if Nike, Inc. should be added to the North Point Group’s mutual fund portfolio or not.

Cost of Capital Calculation for Nike, Inc.

The cost of capital is the minimum rate of return that a firm must earn on the projects in which it invests.

Value of Debt (Vd)
Joanna Cohen used the book value of debt. In calculating value of debt, it is recommended that the value of long term debt that appears on the balance sheet be discounted. It means the future value of total long term debt base on coupon rate should be considered.

To calculate total value of debt, the steps are as follows:
From 15 July 2000 until 15 January 2001 = 6.75% coupon paid. From 15 January 2001 until 31 May 2001 (4.5 months) = 6.75 % x 4.5 months/6 months = 5.06%

Market Value of Debt (Vd) Calculation:
Vd = Current LT + Notes Payable + LT Debt** (discounted) = $5.40 + $855.30 + $413.84 = $1,274.54 **$435.9 – (435.9 X 5.06%) = $413.833

Value of Equity The market value of equity should be used in calculating the cost of capital.

Market Value of Equity (Ve) Calculation:
Ve = Stock Price X Number of Shares Outstanding = $42.09 X 271.5 = $11,427.44

Weights of Debt and Equity The weights