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Nike Inc.: Cost of Capital
Transcript of Nike Inc.: Cost of Capital
Cost of Capital Methods
Joanna Cohen's Analysis
Nike, Inc: Incorporated in 1968
largest seller of athletic footwear
design, development, market and sell athletic footwear, apparel, equipment, accessories, and services.
Emphasis on high-quality construction and innovation in products
Other brands owned by NIKE:
NIKE struggles with demand of changing design trends.
Must respond to shifts in consumer preferences by adjusting existing product offerings, styles and categories.
Failure to respond timely could have adverse effects on sales and productivity
Plateaued at $9B while net income had fallen from ~$800 M to $580 M.
Market share in U.S. athletic shoes had fallen from 48% in 1997 to 42% in 2000.
Recent supply chain issues and strong dollar had negatively affected revenue.
NIKE decides to hold an analysts meeting to disclose 2001 results.
Alternative meeting purpose: NIKE management wants to communicate strategy to revitalize company.
NIKE reveals plan to address top-line growth and operating performance.
Develop mid priced shoe segment
Push apparel line, which has done well
Kimi Ford, a portfolio manager at NorthPoint Group a mutual-fund management firm, considering buying funds for NorthPoint
NorthPoint historical investments have consisted of fortune 500 companies with an emphasis on value.
While stock market had declined in recent past, NorthPoint performed well.
Analysts reactions mixed
Ford decides to develop own discounted cash flow forecast.
Forecast showed Nike was overvalued at current share price of $42.09.
Sensitivity analysis showed NIKE was undervalued.
Asked her assistant Joanna Cohen to estimate NIKE's cost of capital.
Utilizes the WACC method to calculate the cost of capital.
WACC = (Ke x E)/(D + E) + [Kd x (1-Ct) x D]/(D + E)
apital: The rate of return required by a capital provider in exchange for foregoing an investment in another project or business with similar risk.
Refers to the cost of a company's funds (both debt and equity).
Used as a discounted rate to determine present value of specific investments.
Since WACC is the minimum return required by capital providers, managers should invest only in projects that generate returns in excess of WACC.
Includes the cost of debt (bonds, bank loans) and cost of equity
WACC is essential to make a capital budgeting project/company decision.
Helps managers predict risk and maximize profits (choose projects with greater returns than the cost of capital to invest in them).
Helps determine the acceptability of investment opportunities
Set by investors or markets not managers, therefore can only estimate it.
Joanna analysis based on book values
Joanna Cohen’s Analysis
Cost of equity – CAPM model (Capital asset pricing model) = 10.5%
Used the average beta of 0.80 with a 5.90% risk premium,
Nike capital sources (debt + equity)
Capital Source for equity – data from the balance sheet ($3,494.5).
Joanna’s Analysis (cont)
Cost of equity – CAPM model (Capital asset pricing model) =
New assistant to Kimi Ford
Completes analysis base on book values
Buy shares, net present value will increase.
WACC = Kd (1- t) x D/(D+E) + Ke x E/(D+E)
WACC: Weighted Average Cost of Capital
Kd: Cost of Debt
Ke: Cost of Equity
Wd: Weight of Debt
We: Weight of Equity
Coupon rate 6.75%
Present value 95.60
Future value 100.00
Number of pmt 40 (=20x2)
Semi-annual Interest 3.58%
Annual Interest 7.16%
or Cost of Debt (Kd)
(1- t) x
↓ ↓ ↓
Cost of Debt
Yield To Maturity rate (YTM) for the long term bonds issued by Nike Inc
After tax Cost of Debt = Cost of Debt x (1 - tax)
7.16% x (1 - 38%)
Ke or Re = rf + (rm – rf) * β
5.74% + (5.90%) * 0.69
Kd (1- t)
↓ ↓ ↓
Cost of Equity
rf = the risk free rate: 20-year rate on yield rate on US Treasuries (consistent with the life of the asset being valued)
rm – rf = the market risk premium: use Geometric mean instead of Arithmetic mean for long term investment
β = unsystematic risk: most recent beta of Nike in 2001 because it reflects the most trend of Nike’s lower market risk
CORRECT WEIGHTED AVERAGE COST OF CAPITAL
Kd (1- t) x D/(D+E) + Ke x E/(D+E)
↓ ↓ ↓
or = after-tax Kd x Wd + Ke x Wd
= 4.44% x 10.19% + 9.81% x 10.19%
Cost of Debt
2.7% pulled from using the income statement and 38% state tax rate.
One at a Time Please
WE ARE BUYING.....
Market Value of Equity = Current Outstanding Share x Current Stock Price
= 271.5 x $42.09
Based on Market Value
Weight of Debt (Wd) = D(D+E)
Weight of Equity (We) = 100 - weight of Debt
WEIGHTS OF DEBT AND EQUITY