Hayden Earle

Case: Nike, Inc.: Cost of Capital

The background of the case study under review concerns the current declines Nike, Inc was witnessing
to its financial position in 2001 and the corresponding decisions management had under consideration to rectify
the downturn. In line with the pending decision on the company’s strategy to arrest its decline is a potential
decision to buy Nike shares by Kimi Ford of Northpoint Group. To understand how Nike’s strategic vision will
affect Ms. Ford’s decision on a share purchase let us first review Nike’s recent corporate performance. Per the
article, starting in 1997 Nike first began to witness a plateau in its annual revenues at $9,000,000,000 with its
net income also dropping from $800 million to $580 million, a 27.5% decline. While Nike had surpassed
Converse as the predominant athletic shoe in the 1980s by the late 1990s its financial position was starting to be
affected even within this market. The company saw a decline in its market share within athletic shoes from
48% in 1997 all the way to 42% in 2000. With these facts in mind, the decisions coming will affect both the
future performance of the Nike Brand as well as the recommendation of Ms. Ford.
In evaluating whether Ms. Ford should proceed with a share purchase of Nike Stock an evaluation of the
weighted average cost of capital (WACC) will be essential. WACC in this case would refer to the cost of the
various types of capital, traditionally equity or debt, that the investors must decide on whether to contribute to
the prospective share purchase. A clear analysis of the WACC by Ms. Ford and her assistant Ms. Cohen will
enlighten her investors as to whether the initial estimation of a 12% discount rate and overvaluation of Nike at
is current share price is in fact accurate. With the weighted average cost of capital in hand Ms. Ford and the
investors will be able to assess the future yield they could anticipate if the share purchase is in fact made.
In analyzing the case and Northpoint Group’s decision on whether to purchase shares the question must
be asked as to whether Ms. Cohen accurately calculated the WACC. Through my review of the data points and
conclusions made I do not have faith Ms. Cohen’s calculations and conclusion. To start, rather than using the
market value Ms. Cohen utilized the book value to calculate the respective weights of equity and debt. The
book value is a less accurate predictor of the long-term value of an asset as it presumes that the initial price paid
for the item (in this case stock shares) will not change for the period in which the asset is held. It was a mistake
for Ms. Cohen to use this standard.
Another error was to rely on historical data versus present metrics in her estimation of the debt cost as
the cost of debt is always changing & subject to current events & factors outside of what happened in the past.
For the Nike case, historical data points do not reflect the company’s future or current cost to secure debt. This
being the case, her debt calculations are in error as she took the total interest expense for 2001relative to the
company’s average existing debt. A stronger analysis and conclusion might have been forthcoming if she had
instead calculated the yield to maturity in a multi-year debt setting with a semiannually paid coupon rate. With
such an analysis it would be easier to track long term returns and the corresponding cost of the capital to
achieve them. An analogous example might be how the cost of capital for new mortgages and refinancing is
always changing based on the FED’s interest rates and the health of the economy. What should have taken
precedence in her calculation was how much capital would cost in the current market environment.
A final mistake made by Ms. Cohen in her calculations was to take the average beta over a period from
1996-2001 of 0.80 versus the current number of 0.69. This decision again reflects a decision by Ms. Cohen to
rely on historical data points versus the current facts as they stand in evaluating the cost of capital. The past
number is less relevant to the current decision at hand in 2001 on whether to invest and doesn’t take into
account the future systemic risk factor that should be considered.
Although I disagree with Ms. Cohen’s evaluation, I believe there is still sufficient information to make a
decision based on the facts at hand as to whether an investment in Nike stock is prudent. Included below you
will find my calculations of the WACC for this scenario and clarification for why I see this analysis as accurate.

Weighted Average Cost of Capital: (for Equity and Debt)

Market value of Equity = (Current Share Price Times Current Shares Outstanding)
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= $42.09 (share price) x 271.5 million (current shares outstanding)
= $11,427.44 million = Market Value of Equity
=11,427.44 million / 11,427.44 million + 1.291 mm) = 89.81%
Therefore, Market Value for Equity is 89.81%

The data provided in this case was not sufficient to calculate the market value so I will instead use the
book value to calculate this:
Market Value of Debt = (Current portion of long-term debt + Notes Payable + Long-Term Debt)
= $5.4 million + $855.3 million + $435.9 million
= $1,296.6 million
Market Value for Debt is 10.19% (1-0.899)

In order to find the cost of debt, I will calculate the YTM (yield to maturity) of Nike’s bonds so that I am
able to show the most recent cost of the debt.

The tax rate taken was the same as what Joanna Cohen took which was computed by adding the National
statutory tax rate with the local state taxes (35%+3% = 38%). Therefore, the tax rate taken is equal to 38%.
The Weighted Average Cost of Capital (WACC)= Wd x Rd x (1-T) + We x Re
=10.19% x 7.16% x (1-38%) + 89.81% x9.811% = 9.264%.
As a part of the analysis it will also be relevant to estimate the cost of equity utilizing alternative pricing
models. For the purposes of this case I will examine the Capital Asset Pricing Model and how it affects the cost
of equity. This model has a number of benefits that serve it well including its ability to adjust for risk, its
suitability for use in actual practice, as well as the simplicity of the model. Although outnumbered by its
benefits, some of the downsides of the Capital Asset Pricing Model include a difficulty in validating the results
and that it is a model that predicts the future based on past events (i.e. – doesn’t factor in current dynamics
and/or economic conditions)

RE = RRF + (RM – RRF) x Beta

RE =5.74% + 5.9% x 0.69 = 9.811%

If you were in Kimi Ford’s shoes what would your decision be as far as an investment in Nike? For this
case the computed WACC comes out to 9.27%. With a present value coming in at approximately $58.13 this
conveys that the PV is about 1.39 times higher than Nikes $42.09 market price. I would therefore conclude
that the share price of Nike is undervalued as of the trading schedule in 2001. In 2001 Nike made a corporate
decision to change their business approach by focusing to a greater degree on the mid-priced customer vertical,
a segment that for a long period was less monopolized. Over time I therefore project that there is an increased
possibility that Nike will see an increase in their total sales volume leading to an increase in its revenues and

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eventual net profit. This was the major impetus during executives in 2001, to increase stalled revenues and
profits.
With these points in hand, it is my recommendation that NorthPoint Large Cap Fund buy Nike Shares.
The share’s current undervaluation and future growth opportunities make it a stock worth owning. A final point
worth consideration by Ms. Ford is hers and the funds recommended strategy for the stock over time. A
decision to buy will have different implications over the course of the period in which it will be help both from
a profit and tax standpoint, but I believe there is significant upside if held long-term. Short term there may be
some volatility due to the changing market for athletic goods and increased competition, but shareholders can
take solace in the fact that Nike is the preeminent name in sports.