Nike Inc:

Cost of
Capital
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 Table of Contents

Background
01 02 Business Problem

Analysis
03 04 Conclusion &
Recommendation
01 Background
 Background (Northpoint Group)

- A mutual fund management firm

- It invests money mostly in Fortune 500 companies
- Its top holdings include Exxon mobile, General Motord, Mc Donald, 3M and other large
cap
- The stock market declined over the last 18 months
- NorthPoint large-cap Fund performed extremely well
- In 2000, the fund earned a return of 20.7%, even as the S&P 500 fell 10.1%
- At the end of June 2001, the fund’s year to date returns stood at 6.4% versus -7.3% for
the S&P 500
 Background (Nike Inc.)

- The athletic- shoe manufacturer

- Since 1997, its revenue had plateaued at around USD 9 billion
- Net income had fallen from almost USD 800 million to USD 580 million
- Market share in US athletic shoes had fallen from 48% in 1997 to 42% in 2000
- Adverse effect of a strong dollar had negatively affected revenue
- The management is concerned about the top line growth and operating performance
- To boost revenue the company would develop more athletic shore products in the mid-
priced segment : a segment that Nike had overlooked in the recent years
- The company has also planned to push its apparel line
- The company has planned to exert more effort on the expense control
- Long term revenue growth target is 8% - 10%
- Earning growth target is 15%
02 Business
Problem
 Business Problem

- Kimi Ford is a portfolio manager for NorthPoint Large Cap Fund

- Ford is concerned whether or not, it’s worth investing in Nike
- Analysts provided confronting evidence
- Lehman Brothers recommended to invest
- UBS Warburg / CFSB recommended not to invest
- If Nike’s discount rate is 12% its stock price is overvalued
- If discount rate is < 11.17%, its stock price is undervalued
- Ford needs to calculate the cost of capital to determine whether the investment in
Nike should be made or ignored
- Whether it use single or multiple cost of capital?
03 Analysis
 Analysis

Cost of Capital Type Cost of Debt

Single or Multiple Interest Expense/Avg Debt Bal,
Tax Rate

Methodology Cost of Equity

Weighted-average cost CAPM, DDM, Earning
of capital (WACC) Capitalization Ratio
Discounted Cash-Flow Analysis
WACC - CAPM (Capital Asset Pricing Model)
Joanna Model
WACC - CAPM (Capital Asset Pricing Model)
Revise Joanna Model

Correction:
- Using 10 year treasury bond (Rf) instead of 20
year since the forecast period is 10 years.
WACC - DDM (Dividend Discount Model)
WACC - Earnings-Capitalization Ratio
Summary Table of Three Model
 www.investopedia.com/terms/w/wacc

WACC (Weighted Average Cost of Capital)

Weighted Average Cost of Capital (WACC) is a
calculation of a firm's cost of capital in which each
category of capital is proportionately weighted.
Composition of WACC is consists of Debt and equity
that constitute a company’s capital funding. Lenders
and equity holders will expect to receive certain
returns on the funds or capital they have provided.
Since the cost of capital is the return that equity
owners (or shareholders) and debt holders will
expect, WACC indicates the return that both kinds of
stakeholders (equity owners and lenders) can expect
to receive
 https://learn.g2.com/cost-of-equity

CAPM (Capital Asset Pricing Model)

Using this model, find the cost of equity (or expected
return of investment) by adding the risk-free rate to
the beta risk of the investment multiplied by the
market risk premium (found by subtracting the risk-
free rate from the expected return on investment). It’s
easier than it sounds—see the graphic below for an
explanation of these variables
This model does not account for the dividends
earned by a particular stock.
It is a little bit more accurate because it accounts for
the risk associated with the particular stock you are
analyzing.
 https://learn.g2.com/cost-of-equity

CAPM (Capital Asset Pricing Model)

Advantages:
1. It considers only systematic risk. Disadvantages:
2. It generates theoretical - derived relationship 1. It is virtually impossible to estimate betas for
between required return and systematic risk which has many projects
been subjected to frequent empirical research and 2. People sometimes focus on market risk to the
Testing exclusion of corporate risk, and this may be a
3. It is explicitly takes into account a company’s level of mistake
systematic risk relative to the stock market as whole 3. The short term parameter used will create
4. It is clearly superior to the WACC in providing
volatility
discount rates for use in investment appraisal
 https://learn.g2.com/cost-of-equity

DDM (Dividend Discount Model) 0r

DCM (Dividend Capitalization Model)
Using this model, find the cost of equity of a
dividend stock by dividing yearly dividends per
share by the current price of one share, then
adding the dividend growth rate

this model does not account for stock appreciation

or risk. It also presumes that the dividend
payment will go up rather than stay the same or
go down

DDM (Dividend Discount Model) 0r
DCM (Dividend Capitalization Model)
Advantages:
1. Allow significant flexibility when estimating future
dividend streams so the investors are able to choose
model.
2. Provide useful value approximations even when the
inputs are overly simplified
3. Can be reversed so the current stock price can be
used to impute market assumption for growth and
expected return
4. Specifying the underlying assumption allows for
sensitivity testing and analyzing market reaction to
change circumstances
https://learn.g2.com/cost-of-equity
Disadvantages:
1. Subjective inputs can result in misspecified models
and bad results
2. Over reliance on a valuation that is at heart estimate
3. High sensitivity to small changes in input
assumptions
4. Flow through of minor data entry or formula errors
when using spreadsheets
 http://web.mnstate.edu/sahin/FINC
_446_FDM/Cost_of_Capital.pdf

ECM (Earning Capitalization Model)

The earnings capitalization model is notoriously

poor in estimating equity costs for growing firms.

Reasonable for only no growth firms.

 https://learn.g2.com/cost-of-equity

ECM (Earning Capitalization Model)

Advantages:
Disadvantages:
Help investors determine the potential
This model does not take into
risks and return of purchasing a company
consideration the growth of the company.
04 Conclusion &
Recommendation
 Conclusion
Using single cost of capital is more appropriate than multiple cost of capital because
1 the type of business segmentation face the same risk factors

2 Joanna Cohan’s calculation need to be corrected

By comparing 3 methods for finding the cost of equity, it is shown that the DDM and
3 earning capitalization Ratio is create a lower cost of equity number compare to Joanna
Cohan CAPM Method, and it makes that 2 methods have a higher share price
CAPM is more accurate because it accounts for the risk associated with the particular
4 stock you are analyzing
ECM model is not suitable to be used for the growing firms but it is appropriate for no-
5 growth firms (mature). Hence not appropriate for Nike Inc. since this company is still
growing.
DDM model can create inaccuracy in cost of equity calculation since it is not consider
6 non-dividend factors
 Recommendation

We may recommend to continue with method suggested by Joanna

Cohan because CAPM calculation is more suitable, by looking at the
1 share trend, all calculated share prices is overvalued and the most
closest to current share price is using CAPM Method
We also recommend to buy the share of Nike because the current
2 shared price is undervalued from the calculated shared price
Thank
you!
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