FIN 340 Case Four - Nike, Inc.: Cost of Capital Case PDF

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Nike, Inc.: Cost of Capital Case...

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Nike, Inc.: Cost of Capital 1.

Nike should use a single cost of capital. Their different products: clothes, shoes, etc., are

not differentiated enough to demand a separate cost of capital calculation. Additionally, Joanna Cohen makes the assumption that because “they are sold through the same marketing and distribution channels”, “they face the same risk factors”. As a result, Nike only requires a single cost of capital, as the company’s cost of debt will not differ significantly across its multiple business segments. If over 92% of the company’s revenue carries the same risk, one cost of capital is sufficient. 2.

We do not agree with Cohen’s WACC calculation. Firstly, we believe she is incorrect in

using a historical average of Nike’s past betas instead of using the most recent beta; the most recent beta, 0.69, provides the best projection looking forward, as it will account for Nike’s recent performance, and yield the most precise cost of equity. However, we agree with the risk free rate and the market risk premium that Cohen chose to use. Furthermore, using a historical value or book value for equity and debt is not a correct assumption. Rather than using the book values of equity and debt for the WACC calculation, she should use the market values in her calculation of weight. However, because there isn’t sufficient information to estimate a market value of debt, we will use the book value of debt in the following WACC calculation. 3.

First, we found the market value for debt and equity. In order to find the market value of

equity, we multiplied the current market share price ($42.09) by the number of outstanding shares (271.5 million) to arrive at a value of $11,427.44 million. The value of debt used was Nike’s current outstanding debt, $1296.6 million. From these values we found the weight of debt to be 10.19% and the weight of equity to be 89.81%.

Using the CAPM model, we estimated Nike’s cost of equity to be 9.811%. To find the cost of debt, we used the information provided regarding publicly traded Nike debt. This information allowed us to calculate the YTM on Nike’s publicly traded debt, equating to the pretax cost of debt we estimated to be 7.12%. We multiplied this value by (1-Tax Rate) to arrive at an effective cost of debt of 4.44%. Applying the cost of capital formula, shown in Exhibit 4, we arrived at a WACC of 9.26%. 4.

Ford should strongly recommend investing in Nike: at the current price per share of

$42.09, the stock is undervalued if one considers the WACC of 9.26%. This WACC predicts a share price of $58.24 (Exhibit 6), thus we believe that the stock should be recommended/purchased as a value stock. One key driver of this valuation is the WACC itself; by using a WACC much lower than 12% (which Ford used in her rough estimate), the present value of Nike’s cash flows increased, resulting in a larger value per share. Another key driver of this valuation is the long term growth rate assumption of 3% given in the valuation spreadsheet. Even though the Nike executives claimed a long term growth rate target of 8-10%, this modest 3% assumption still results in Nike’s stock being undervalued in the market. 5.

By changing the weight of debt to 35% and weight of equity to 65%, we computed the

new WACC for Nike. Assuming the only difference was the change of these weights, we used the same calculation for cost of debt and cost of equity used in Exhibit 4; the new WACC is 7.93% (see Exhibit 5), a significant decrease from a WACC of 9.26% found using Nike’s ~10% debt to ~90% equity capital structure. Inputting this new WACC into the Valuation Spreadsheet yielded the new Equity Value per Share of $77.04 (Exhibit 7), a larger value when compared to the share value found in the previous WACC calculation. Such a share valuation compared to Nike’s current market share price would give Ford an even stronger reason to invest in Nike.

Exhibits: Exhibit 1: Market Value of Equity

Exhibit 2: Cost of Equity

Exhibit 3: Cost of Debt

Exhibit 4: WACC Calculation WACC=[E/(E+D)]*(Cost of Equity)+[D/(E+D)]*(Cost of Debt)*(1 – Tax Rate) WACC = (weight of equity)(cost of equity) + (weight of debt)(effective cost of debt) WACC = (89.81%)(9.811%) + (10.19%)(4.44%) = 9.26% Exhibit 5: WACC Calculation (Question 5) WACC=[E/(E+D)]*(Cost of Equity)+[D/(E+D)]*(Cost of Debt)*(1 – Tax Rate) WACC = (weight of equity)(cost of equity) + (weight of debt)(effective cost of debt) WACC = (65%)(9.811%) + (35%)(4.44%) = 7.93%

Exhibit 6: Equity Value Per Share with Calculated WACC

Exhibit 7: Equity Value Per Share with Question 5 WACC...