ent irq ==} ] 3 Nike, Inc.: Cost of Capital On July 5, 2001, Kimi Ford, a portfolio manager at NorthPoint Group, a mutual fund ‘management firm, pored over analyst write-ups of Nike, Ine., the athletic shoe man- ufacturer. Nike's share price had declined significantly from the start of the year. Ford ‘was considering buying some shares for the fund she managed, the NorthPoint Large- Cap Fund, which invested mostly in Fortune $00 companies with an emphasis on value investing, Its top holdings included ExxonMobil, General Movors, McDonald’, 3M and other large-cap, generally old-economy stocks, While the stock market declined over the last 18 months, NorthPoint Large-Cap had performed extremely well, In 2000, the fund esrned a return of 20.7 percent even as the S&P 500 fell 10.1 percent, The fund's yeartowdate returns at the end of June, 2001 stood at 6.4 percent versus the S&P 500’s minus 7.3 percent, Only a week ago, on June 28, 2001, Nike held an analysts’ meeting to disclose its fiscal year 2001 resuts.' However, the meeting had another purpose: Nike man- agement wanted to comnunicate a strategy for revitalizing the company. Since 1997, [Nike's revenues had plateaued at around $9 billion, while net income had fallen from almost $800 million to $580 million (see Exhibit 1). Nike’s market share in U.S, ath- letic shoes had fallen frem 48 percent in 1997 to 42 percent in 2000? In addition, recent supply-chain issues and the adverse effect of a strong dollar had negatively affected revenue, At the meeting, management revealed plans to address both top-line growth and ‘operating performance, ‘To boost revenue, the company would develop more athletic shoe products in the midpriced segment’ —a segment that it had overlooked in recent years. Nike also planned to push its apparel line, which, under the recent leadership ‘ike’ eal yea ended in May, Robson, Dovglas, “Jest Do... Something: Nike insular an fot dragging have it runing in place Busnesivek Sal 2, 2001, "Sneakers in his segment Sold fr $70-890 poi. “This case was prepared from pully avallale information by Teeica Chan unde the supervision of Profesor Rober F. Bruner. The nancial supe of te Baten ste egal acknowledged, This case was writen asa bass fr css dscusion rather thant laste effective or ineffective handling of an aminsativ sation. Copyright © 2001 by she Uvversity of Virgina Darden School Foundation, Castes, VA. Allsighs reserved. To order copie. send an email a slew@cardenpubishing com. No port ofthis publication ey be reproduced, stored Ina rereval mer, selina spreaishet, or renzmted ‘nan form or by any means-eectrani, mechoico,pheccopyig,reconing, o otherwse—without the eran ofthe Darden Schoo, Fouetion. Rew. 1,196 Part Thee Estimating the Cost of Capital of industry veteran Mindy Grossman,* had performed extremely well. On the cost side, Nike would exert more effort on expense control. Finally, company executives reiterated their long-term revenue growth targets of 8-10 percent, and earnings growth targets of above 15 percent, ‘Analyst reactions wore mixed. Some thought the financial targets to be 100 aggressive; others saw significant growth opportunities in apparel and in Nike’s inter- national businesses. ‘Kimi Ford read all the analyst reports that she could find about the June 28 meet- i, but the reports gave her no clear guidance: a Lehman Brothers report recom- mended a ‘Strong Buy’ while UBS Warburg and CSFB analysts expressed misgivings about the company and recommended a ‘Hold’. Ford decided instead to develop her ‘own discounted-cash-flow forecast to come to a clearer conclusion, Her forecast showed that at @ discount rate of 12 percent, Nike was overvalued at its current share price of $42.09 (see Exhibit 2). However, she had done a quick sensitivity analysis that revealed Nike was undervalued at discount rates below 11.2 percent, Since she was about to go into a meeting, she requested her new assis- tant, Joanna Cohen, to estimate Nike's cost of capital. ‘Cohen immediately gathered all the data she thought she might need (Exhibits 1 through 4) and set out to work on her analysis. At the end of the day, she sub- mitted her cost of capital estimate and a memo (Exhibit 5) explaining her assump- tions to Ford. q “indy Grossman joined Nike in September 2000, She nas the former president an chief executive of “Jones Apparel Group's Plo Jeans division,cue 13. Nike, Ie: Cost of Capital 197 the cost EXHIBIT 1 1 Consolidated Income Siatements Year Ended May 31 (in millions except ershare data) 190519051907 10981999 20002001 venues 47608 $54706 $9,186 $9.553.1 $8769 $0,995.1 $9,4888 Cost of goods sold 28653 3.0087 55030 60655 54005 5,409.8 5,704.9 Gross profit 1095.6 2.5639 9.5035 94876 32834 3,501.9 3,709) Soling andacminitatve «1,208.8 115886 2.9037 26238 24066 2.6064 2,609.7 Operating income 6858 9753 19798 0698 0568 9049 1,014.2 Interest expense 22 «90562360015 (thor expense, nat 11786. 3 209021582 Fectructuring charge, net por etton = 199 45.4 25) = , Income before incometaxes 649.9 8901 1.2052 6530 748.1 «9192214 Income taxes 2502 345.9 ‘4904 2534 2047 gwod__aNT ' Net income $3907 § 5532 $ 7058 $ 9996 $ 4514 § S721 _$ 5897 Dittes earnings por ‘comman share S196 $188 $288 S195 «StST $207 «$18 ‘Average shares { ‘outstanding (cited) 2940 2938 07.2060 BTS BTOB (27S Growth (4) rovers so 20040) 55 (Operating income 2 415 Gra) (08) 180. 30 Net income sea 88488) 180 28.8 18 Margins () Gross maigin m6 401 88S # 89890 ‘Operating margin Bt 150,80, 98 109107 Net margin e874 51 ea 52 iectve trate (6) ms 96 a8 sO “Tne US. sary te rao was 35%, Te sae tax ved ‘euros: Companys 10K SEO fling, UBS Warburg ay tom 25% 19 35%, veo198 Pat Three Estimating the Cost of Capital EXHIBIT 2.1 Discounted Cash Flow Analysis ee ee ‘avemptons Pveue o 7 03 as 02 00 eo ao eo ao wo | cossiate td © cho sos sos sao 690 aes sas cto s00 i ‘Salsas (%) m0 75 «270 285 (BOSS HO KO 280 250 i Tennale wo Sho 990 oma] msm Ciroamansen) «dds } Gwestonecaett) Ns odo HS ONS OMS Ns MS NS Ne | Yea econ se Caoocen nhee cater io Termine wth aa “ | Deceit can Few i Operatingicome S$ 12184 $1951 SISSES $1717 Stes00 s2j959 $24102 25548 $2700 $2057 Toe ‘oo sige sos 28 eno atl aise ora ‘oso tious ovat THA” eno wR VeE4S 12000 aNd La OKO E80 "18887 : Capon nettcapacaton "Se SE NOSE TAN IRN TO tem tome Coorg ne Sars) (es) (08s) (08) GOK aw WH wed corn f Frveutton Wear eeut 778 etka too vate tara 98.7 a8? 18727 | romoa ae naar | Tea tows eat teat 78 etna jou wave Vaiea asi? aa? wars | Povomiabeclfowe = cand S080 6 GA 8 Suns 8 eras S'uoe Fares oaNGa 8/5050 eons fitemieo wus SH87 i ‘debt $.1,2966 | Equity value s10,1198.4 Cure Ss canara ms iy sae ati Current share price: [§ 42.08 Senay of egy veo dicount te ete Toma! ves tae wg be crt Dict rat ay wae owt ot Bee oe qy ~ FoF io8 (t+ Terminal vatue growth rate) con eras - ae oar ras susrer (08) oon se e405 socoe ore jase wat sei ez ham ‘am sia08 ‘ar ‘2008 na60 250 330 ns seasrs 11239 1087 es10) 15727 wears 53015 Case 13. Nike, ie: Cow of Cait EXHIBIT 3 | Consolidated Balance Shoots ial 199) ‘As of May 31, (omitions) 2000) 200% Assets Current assets: Cash and equivaents 8 2543 8 3040 ‘Accounts recsivablo 1.5604 1e2t.4 Irventores 1446.0 14241 Deferred income taxes ‘its 1133 Propaid expences 2152 1625 “otal curent assots 3.8084 36253 Property, plant and equpment, nat 1,583.4 16188 ‘entifabie intangible assets and goodwi, not ‘109 ‘397.3 Deferred income taxes and other assets 2862, __782 Total assets 35.56.9 S5st05 Liabilities and shareholders’ equity Current iabiitiae: Current portion of long-term debt 8 sat 8 54 Notes payable 242 8553 ‘Accounts payable 5438 492.0 ‘Accrued lanes e219 4724 Income taxes payable 219 Total curtent labios 21400 1,788.7 Long-term debt ama 4359 Dolerrod income tsxes and other Hable 1103 1022 Redeemable proteed stock 03 03 ‘sharenoisere’ oguly: ‘Common stock, par 28 28 Capital in excess of sated value 3690 450.4 Unearned stock compensation 47) 9) ‘Accumulated other crmprehensive income (it) (821) Felained earnings 28070 ‘otal shareholders’ equiy 3.1380 ‘Total lablitios and sharcholders' equity 5.956. ‘Source: Company 10 SEC tng,EXHIBIT 4 | Capital Markot and Financial Information On or Around July 5, 2001 Ccurront yields on U.S. Treasuries Nike Share Price Performance Relatve 10 $8500: Seonth 3.55% January 2000 ty 5 2008 month 350% : year 350% e Syear 308% {oryoar 5.50% 1” 2o3ear 874% e Historical Equity Risk Premiums (1926-1998) - Geometric mean 53.90% ‘hnatic mean 750% i ‘Current Yield on Publicly Traded Nike Debt ‘Coupon 16.75% pad semi-annually bad Issued o7it5i96 Maturity onset 7 Curent Price $95.60, ‘Nike Historic Betas 1998 0.98 Peete Het a = Sok oe we ea PESEPPP ERLE ER ER ER TF vows Ba ws ea 880 ‘Average 9.80 S-Mar 30Jun 30-Sop 31-Dec ‘Total cx tie (esters SS kee eee a ote OA a2 042 048, Value Line Forecast of Dividend Growth from '98-00 to 0406: 5.50% “Data have been modi fr toching purpores, Sources of daa: Bloomberg Fan Services, sbetton Assocs Yearbook 1890, Valo Line Investment SU, IBES.‘Source of dat: Bcerberg Faria Series, inbatson Assocates Vestbock 1990, Vai Line Ivesent Survey BES. “Data nave been modi for eachng purposes (Case 13. Nike, ne: Cost of Capit 2 5 Joanna's Analysis _—_—<——S Ee TO: Kini Ford FROM: Jeanna Cohen DATE: ‘bay 6, 2001 SUBLECT: Nike's Cost of Capital, Based on the following assumptions, my estinate of Nike's cost of capital is 8.4 percent Single or Multiple Costs of Capital? ‘The frst question | considered was whether fo use single oc multiple costs of capital given that Nike has multiple ‘businoss sogmenis. Aside rom footwear, which mkes up 62 percent of revenve, Nae also sels apparel (80 percent ‘of revenue) that complement is footwear procucts. In adton, Nike ea sport balls, timepieces. eyewvar, skates, ‘ats, and other equipment designed for sports acvites. Equipment products account for 3.6 percent of revenue. Final, Nike elso sells some non-Nike branded products such as Cole-Haan cress and casual footwear, ard ice skatos, skate biases, hockey seks, hockey jerseys and other products under tha Bauer wademars, Non-Nike brands account for 45 percent of revenue, | asked mysolf whether Nike's businass sogments had cflerent enough risks from each other to warrant ‘dfioront costs of capital Wore tor profes relly ctferent? | concluded that it was only the Cole-Haan line tt was somewhat diferent the rest were al sports-elated businesses. However, since Cole-Hean makes up only & tin fraction of revenues, | didnot thnk it necessary to computa a separate cost of capital. As fo" the apparel ad footwear ines, they are sod through the same marketing and distribution channels and are often marketed in “cotactons"ofsimlar design. | botove they face the same risk factors, as such, I decided to compute only one ost of capital forthe whole company, Methodology for Calculating the Cost of Capital: WAC Since Nike is funded with both dabt and equi, | used tho Weighted Average Cost of Capital (WAC) method. Based on the latest availabe balance sheet, cab as a proporton of otal capital makes Up 27.0 percent and ‘equly accounts for 73.0 percent: Capital Sources. Book Values Date Saar Current portion ef opgtorm dabt BB Notes payable 3853 - Long-torm debt _ 4859 $2966 > 27.0% of otal coptal Equiy $4945 9.78.0% of total captal Cost of Debt [My estimate of Nike's cost of dabt is 4.3 perce arrived at this estimato by taking otal intorest expan forthe year 2001 and dvising i bythe company’s everage debt balance.’ The rate slower than Treasury vols but that i because Nike raised a portion oft funcing noeds through Japanese yen notes, which cary rates between 2.0 percent to 4.3 percent ‘After ajusting or tax, the cost of debt comes cut to 2.7 percent. used a tx rate of 38 percent, which! obtained by adding state taxes of 8 percent fo he U.S. statutory tax rat. Mistrial, Nike's slate taxes have ranged from 2.5 percent to 3. percent ‘Debtbalance as of May 31. 200 end 2001 were $141.6 andS1 296.6 especie,202 Pa Thuce Estimating the Cost of Capital EXHIBIT 5 | (continued) EXHIBIT 6 | (continved) ‘Cost of Equity "estimated the cost of equity using the Capital Asset Pricing Modal (CAPM), Other methods such as he Dividend Discount Model (DDM) and the Earrings Capltalzaion Ratio can be used to estimate the cost of equity, Homever, in my opinion, CAPM is the superior method. My estimate of Nike's cost of equiy i 10.5 percent. | used the cuent yield on 20-year Treasury bonds 28 in isk foo rat, ar tha compound average premium ofthe market over Treasury bonds (5.9 percent) a5 my nis premium. For bel | took the average of Nike's bela from 1996 othe present. Putting it AllTogether Inputtng all my assumptions into the WACC formula, my estimate of Nik's cost of caplal is 84 percent. WAC = Ky(1—)*D(D+E)+K, EAD +E) 27% + 27.0% + 10.5% 873.0% = 84%