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Case Study: Nike, Inc. : Cost of Capital
Transcript of Case Study: Nike, Inc. : Cost of Capital
NorthPoint Large-Cap Fund manager Kimi Ford considering whether to buy Nike’s stock
Nike has experienced decline in sales growth, profits and market share
Nike has revealed that it would increase exposure in mid-price footwear and apparel lines. It also commits to cut down expenses
The market responded mixed signals to Nike’s changes. Kimi Ford has done a cash flow estimation, and asked her assistant, Joanna Cohen to estimate the firms cost of capital
Cost of Capital
Weight of Capital Components
In the case, Cohen also makes a mistake by using the book values as the basis for the debt and equity weights. Instead, we used the market value to calculate weights.
Cost of Capital
Why is it important to calculate the Cost of Capital?
What does it signify?
Is WACC determined by investors or managers?
Cost of Capital
The rate of return that is required by investors to forego another project with similar risk
dependant on the mode of financing that is used by firm
Cost of Debt
The WACC is used to discount future cash flows, therefore must be a reflection of the company's future ability in raising capital
Cohen makes a mistake by using historical data in estimating the cost of debt for Nike, Inc.
May not reflect Nike's current or future cost of debt
The cost of debt should be estimated by YTM of bond or by credit rating
Using 20 year bond in Exhibit 4, our after tax cost of debt = 7.16%(1-38%) = 4.44%
Cost of Equity
Cohen seems to use CAPM to estimate cost of equity.
10.5% = 5.74% +(5.9%)*0.80
Her risk free rate comes from 20-year T-bond rate
Cohen uses average beta from 1996 to July 2001, 0.80.
Cohen uses a geometric mean of market risk premium 5.9%
There is no problem with using 20-year T-bond rate, however Cohen uses an average beta from 1996-2001. Instead, we used most recent beta rate, which is 0.69 because that is more representative to its future volatility. Therefore our cost of equity is:
5.74% + (5.9%)* 0.69 = 9.81%
Weighted Average Cost of Capital (WACC)
Most companies use a combination of both debt and equity financing
cost of capital can be derived using the WACC by calculating the weighted average of all its capital sources
WACC = rD (1- Tc )*( D / V )+ rE *( E / V )
Single vs. Multiple Cost?
We agree that the single cost of capital is the best way to value the cash flows for the entire firm
Other segments have similar risk, therefore single cost is sufficient
Nike has multiple segments that contribute to revenue
Sports balls, apparel, skates, bats etc.
Therefore our calculation =
4.44%*0.101 + 9.81%*0.899 = 9.27%
After discounting cash flows provided in Exhibit 2 with the calculated WACC of 9.27%, the PV equals $58.13 per share, which is more than current market price of $42.09 and it is in our opinion that Kimi Ford buy stock in Nike, Inc. because it is undervalued.