Executive Summary

This paper will present the financial importance of the Cost of Capital for Nike and its future
investors. Nike Inc. tries a new strategy to revitalize the company by focusing on top-line growth and
operating performance. As such, the cost of capital is a critical factor in decision-making and in
estimating the weighted average cost of capital (WACC). Our analysis will include how WACC is
calculated using the Capital Asset Pricing Model (CAPM) to find out if NorthPoint Group should
include Nike, Inc. in its portfolio. A firm’s WACC shows the required return on the firm and is used by
the firm’s decision makers to determine which expansionary opportunities and or mergers to take.
Investors also use WACC as the discount rate in stock valuation. The result of our analysis suggests
that it is a sound financial decision to include Nike Inc. to NorthPoint Group’s mutual fund portfolio.

I. Single Cost of Capital

It is sufficient to use the single cost instead of multiple costs of capital to compute WACC to be able
to value the cash flows of the firm. Additionally, Nike Inc.’s business segments relatively have the
same risk. Thus, based on our assumption, a single cost of capital is more appropriate

II. Capital Structure

The weights of the costs, Wd and We, are very important in calculating WACC because these show
the company's capital structure. In calculating the weights, Joanna Cohen, Ford’s assistant, used the
book values of debt and equity. But using the market values provide more accurate results. As book
and market values of debt and equity tends to differ a lot, I used market values of debt and equity to
get a closer estimation of the capital structure.

III. Cost of Debt

Cohen miscalculated the cost of debt by using the historical data. She divided the interest expenses
by the average balance of debt to get 4.3 percent of before tax cost of debt. This may not reflect
Nike’s current or future cost of debt because the cost of debt should be forward-looking.

First, I reexamine the cost of debt (Kd), which in this case is the yield to maturity (YTM) on the bonds.
The YTM is a good estimate for the cost of debt if a company had issued debt in the past and the
bonds are publicly traded just as in Nike's case. My calculations for Nike's yield to maturity based on
the given data showed that Kd is 7.16 percent.
IV. Cost of Equity
For the risk-free rate, Krf, I used the current yield on 10-year US treasury bonds (5.39) instead of the
20-year because the 10-year bond matches the tenor of cash flows for the Nike's investment project
[as seen on Exhibit 2], which is 10 years. Secondly, it is relatively less exposed to unexpected
changes in inflation and liquidity premium when compared to the 20-year bond.

For the market risk premium, Km –Krf, I used the arithmetic mean of 7.5 percent of historic risk
premiums to estimate the current risk premium on the assumption that the future will resemble the
historical behavior. Given that this is a viable assumption, the annual arithmetic average is the
theoretically correct predictor for the next year's risk premium. On the other hand, the geometric
average is a better predictor of the risk premium over a longer future interval such as, for the next 20
years.

For Beta, I used the most recent beta estimate, 0.69. I did not use 0.80 to be the measure of
systematic risk because I need to find a beta that is most representative of future beta. As such, I
believe that the most relevant beta in this respect is 0.69.

I used the Capital Asset Pricing Model (CAPM) in estimating the cost of equity, which is 10.57
percent.
V. Weighted Average Cost of Capital (WACC)
Using the above values, the WACC is computed as follows:

VI. Computing for the Enterprise Value

With WACC at 9.95 percent, I recomputed the enterprise value and equity value per share of Nike.
My computation showed that at 9.95 percent, the value of equity and equity value per share is
$19,135.53 and $65.71 respectively. [See Annex A for details of computation.]

VII. Conclusion
Kimi Ford should recommend to the NorthPoint Group Board that acquiring Nike Inc. shares is a
SOUND INVESTMENT. To discount cash flows in Exhibit 2 with the calculated WACC of 9.95
percent, the present value of Nike is $65.71 per share, which is more than its current market price of
$42.09. I believe that this value is still understated because the current growth rate used—6 to 7
percent is much lower than that estimated by Ford—8 to 10 percent. To conclude, since the data
shows that Nike Inc.’s common stock is undervalued NorthPoint Group should add Nike Inc. to its
Large Cap Fund.