FINANCE 470

Nike Inc. Cost of Capital

Finance 470
Hongrui Sun

I had neither gave or received nor had I tolerated others’ used of unauthorized aid.
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EXECUTIVE SUMMARY

This report analyzes Nike’s WACC and Joanna Cohen’s analysis of Nike, Inc.

Weighted Average Cost of Capital

Nike incorporated has requested for an analysis of the company’s cost of capital. The best way
to calculate the cost of capital is by using the weighted average cost of capital. The WACC
allows the company to see the cost of capital proportionally distributed across common stock,
preferred stock, bonds, and other long-term debt. There are three sources with which the WACC
can be valuated. These sources are the book value, market value, and the optimal values.

Corrections to Joanna Cohen’s Analysis

Joanna Cohen, an assistant to a portfolio manager with Northpoint Group, was chosen to
calculate cost of capital for Nike by her manager. She made a few mistakes when calculating
this value. Firstly, Cohen used the book value instead of the market value for the basis of debt
and equity weights. Cohen also miscalculated the cost of debt and the cost of equity. In this
situation, she should have the current data should be used and not the historical data. Cohen
used the historical data.

CAPM, ECM, and DDM

The report displays the advantages and disadvantages of the Capital Asset Pricing Model,
Earnings Capitalization Model, and the Dividend Discount Model. The results that were found
are that the cost of equity is 9.811% for the CAPM, 5.5% for the ECM, and 6.7% for the DDM.

WACC Calculations

After looking into the models, the WACC was solved for. The results were that the WACC is
about 9.27%, which results in a stock price of $58.77. This shows that the current stock price of
$42.09 is undervalued.

INTRODUCTION
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The goal of this report is to decide whether NorthPoint Group should build Nike’s stock

into their portfolio. To decide whether to buy the stop, this report will examine Nike’s WACC,

CAPM, ECM, DDM and Joanna Cohen’s observation of the Nike stock. After looking into these

equations, NorthPoint Group will be able to decide whether the stock should be bought. If the

value per share is higher than the current share price, the stock is undervalued, and NorthPoint

Group should purchase the stock.

WEIGHTED AVERAGE COST OF CAPITAL

“WACC” is short for “Weighted Average Cost of Capital.” WACC is used to determine a

company’s cost of capital. It is a calculation of the firm’s cost of capital in which common stock,

preferred stock, bonds and other long-term debt are proportionately weighted. The WACC is

used to show investors what the opportunity cost of their risk is. This simply means that for how

much risk that is taken, the WACC shows what the possible profits will be from taking this risk.

The calculation of WACC is important to the organizations as well. It defines the cost of

acquiring additional sources of capital. This also allows the company to negotiate the cost of

capital with stakeholders. Also, the WACC is a component in the determination of the valuation

of the organization.

When calculating the WACC of the firm, there are three values that can be used in the

valuation of the contribution of the various sources of capital. The first value is the book value

that Cohen used, which refers to the value of capital on acquisition or formation of the

organization. The book value can also be described as the par value of the capital. This use of

the book value in the calculation of the WACC is not popular as it does not reflect current market

conditions upon which the firm can raise new funds.

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Secondly, an organization can value contribution of the capital sources based on their

market value. The use of this method is favored as it reflects the most current conditions under

which the firm can maybe raise new funds. The values are determined as a result of forces of

demand and supply, and therefore they are seen as more realistic values in WACC calculation.

The third method of valuation of sources is capital target values or optimal values. These

are values that the firm intends to maintain in the future. The problem with this is that it requires

estimation of valuation which is subjective. Valuation is an estimate of how much an asset or

assets of the company are worth.

CORRECTIONS TO JOANNA COHEN’S ANALYSIS

WACC is a crucial element to determine the value of a company. Joanna Cohen

miscalculated the WACC, which has a big impact on their future decision. Joanna Cohen’s

calculation of WACC should not be followed. She forgot to consider a few specifics that would

significantly change the results of her findings. The biggest error found in her calculation is she

used book value instead of market value as the basis for debt and equity weights. The market

value should be used to calculate weights since Nike is concerned with how much it will cost to

raise the capital today. To calculate the value of the equity, simply use the current share price

times the current shares outstanding. The equation for this is $42.09*271.5M=11,427.435M. To

calculate the debt, EXHIBIT 2 should be observed. From EXHIBIT 2, the current outstanding

debt is known to be 1296.6M. Therefore, the weights for debt and equity are 10.2% and 89.8%

respectively.

The second mistake she made is how she miscalculated the cost of debt and the cost of

equity. In this case, the current data should be used instead of the historical information. To

calculate the cost of debt, calculate the yield to maturity. Based on information given in
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EXHIBIT 4, the Present Value is $95.6, the Future Value is $1000, Number of Periods is 42, and

the Payment is $3.375. When these values are inputted into a financial calculator, one can

calculate that the yield to maturity is 7.31%. Joanna took an average of the historical betas in

order to calculate her beta. Although this is not necessarily wrong, the better idea would be to

use the latest beta of 0.69. Nike has started to veer away from the S&P 500 over the course of

the years. Joanna took an average of previous years which tend to significantly decrease. Since

the more recent years are lower, it seems as though the early years she used are irrelevant to how

Nike is currently operating. This is why the beta of 0.69 should be used.

CAPM, ECM, and DDM

Using the Capital Asset Pricing Model, one can calculate the cost of equity is 5.74%

+0.69*5.9%=9.811%. The advantages of CAPM are that it is easy to use and it accounts for

systematic risk, while decreasing unsystematic risk if a portfolio is diverse. A disadvantage of

the CAPM is that the yield for the risk-free rate changes daily. This causes volatility in the

model.

Earnings Capitalization Model

In this scenario, the cost of equity is equal to the EPS for the future year (2002) is divided

by the current share price (2001). Therefore, Ke= $2.32/$42.09 = 5.5%. An advantage of the
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earnings capitalization model is that it is very simple, and easy to calculate. A disadvantage is

that this model will not work for growth companies.

Dividend Discount Model

Ke= ((.12)+(.12)+(.12*1.055)+(.12*1.055*1.055)/$42.09 * 100%)+5.5%

Ke= 6.7%

The advantage of the Dividend Discount Model is that it is better for companies with a

predictable growth rate in dividends. This is potentially a disadvantage because it limits what

kinds of companies it can be used for. Nike for instance is quite as predictable as a company

needs to be able to use the DDM effectively.

WACC CALCULATIONS

Based on this analysis, the weighted-average cost of capital is as follows:

WACC = Kd(1 − t) × D/(D + E) + Ke × E/(D + E)

WACC = 7.31% (1-38%) * 10.2% +9.8% * 89.8% = 9.2627%.

When the WACC is 9.27%, the equity value will be $58.77, and the stock price is

significantly undervalued. Since the stock price is undervalued, the recommendation found from

this case is that the stock is a Strong Buy. Although this stock is a strong buy, this might be seen

as being too optimistic. It is optimistic because the equity value is estimated at $58.77 which is

significantly higher than the current share price of $42.09. Stock prices are not usually seen to
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have increases as large as $16.68. Although this is largely optimistic, it is still expected that this

stock should have a stock price increase. The calculated results might be a bit too extensive.

CONCLUSIONS AND RECOMMENDATIONS

It would be wise to buy Nike, Inc.stock. This is because the Nike, Inc. manager’s

estimates were higher than the current growth rate. This in turn makes the calculated WACC

value to be high. The overly high WACC value leads to present value of the share becoming

higher than the current market price.

WORKS CITED

Besley, Scott, and Eugene F. Brigham. Principles of Finance. , 2014. Print.