Pierre Cattoni

Michelle Maayo
Kyoungsook Park
Joviel Teves

Prof. R. Ybaez
BA 280.2 THW
13 March 2012
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 valueinvesting, 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. Nikes market
share in athletic shoes had dropped from 48% (1997) to 42% (2000).

To address the current performance, Nikes 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 Nikes international
businesses. The Lehman Brothers propose a buy while the UBS Warburg and CFSB suggest
a hold.
Joanna Cohens 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

Debt
Equity
Total

Book Value
Book Value

Amount (in
million $)
1,296.6
3,494.5
4,791.1

Weights (%)
27
73
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 companys 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 Nikes 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 Nikes 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 Groups 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 of debt and equity using the market values are computed as follows:
Wd = $1,274.53 / ($1,274.53 + $11,427.44) = 10.03%
We = $11,427.44 / ($1,274.53 + 11,427.44) = 89.97%
Cost of Debt
The cost of debt was calculated by finding the yield to maturity (YTM) on Nike Inc. debt with
a 6.75% coupon semi-annually. Using Excel, the YTM is computed as in Exhibit 1. The pre-tax
cost of debt of Nike is 7.17%. Using the effective tax rate of 38%, the after-tax cost of debt is
4.44%.
Cost of Equity
The CAPM approach is used to compute the cost of equity. The following values are used:
risk free rate: the 10-year Treasury bond rate; risk premium: geometric mean of 1926-1999
equity risk premiums; beta: average of Nike historic betas.
The 10-year yield on U.S. Treasuries was used as the risk free rate because it more
approximates the market determined rate being a more active market. Also, the projection of
Nike financial statements is 10-year period. The 10-year rate also approximates the duration of
the stock market index portfolio. The geometric mean was used for the risk premium because it
is not biased by the measurement period, unlike the arithmetic mean. The geometric average,
being a single estimate for the entire time interval is invariant to the choice of time interval.
Finally, for the beta, we used the average to account for the large fluctuations in Nikes historical
beta.
Weighted Average Cost of Capital
Using the above values, the WACC is computed as follows:
WACC = 4.44% x 10.03% + 10.11% x 89.97% = 9.54%
Nikes Share Price
Having computed the new WACC, this rate was used to discount the free cash flow of Nike
for the 10-year projection. The calculated value of equity was $13, 976.72 (Exhibit 2). Given the
current outstanding shares of 271.5, the share price of Nike is valued at $51.45. Compared to
the current share price of Nike at $42.09, the share is undervalued.
It is recommended that Nike shares should be added to the portfolio of North Point Group
because of the following reasons:
Undervalued: priced below fair price
The IRR or rate of return is greater than the cost of capital
Nike has growth potential
Management plans are laid for the company

Exhibit 1

Cost of Debt
Settlement Date
Maturity Date
Rate
Current Price
Face Value
Frequency
Basis
Tax rate
kd before tax
kd after tax
Value of Debt

Vd

7/5/2001
7/15/2021
6.75%
$95.60
$100
2
2
38%
7.17%
4.44%
$
1,274.53

Cost of Equity
Risk Free
Risk Premium
Beta

Value of Equity

ke
Ve

5.39%
5.90%
0.80
10.11%
$11,427.44

Exhibit 2