Edward C. La VictoriaNovember 18, 2011 MBA – 1WAC Case: Nike, Inc. : Cost of Capital I. Point of View - Kimi Ford, portfolio manager at NorthPoint Group, a mutual-fund management firm. II. Problem Should Kimi Ford proceed to buy shares from Nike, Inc.? Or not? III. Objective This case analysis aims to increase the earnings of NorthPoint Group which, at the end of June 2001 stood at 6. 4%. IV. Areas of Consideration 1. On July 5,2001, Kimi Ford pore over analysts’ write-ups of Nike, Inc.. 2. Nike’s share price had declined significantly from the beginning of the year.
But Ford was considering buying some share for the fund she managed. 3. While the stock market had declined over the last 18 months, the NorthPoint Large-Cap Fund had 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 2011, the fund’s year to date returns stood at 6. 4% versus -7. 3% for the S&P 500. 4. On June 28, 2001, Nike held an analysts’ meeting to disclose its fiscal-year 2001 results and to communicate a strategy for revitalizing the company. 5.
Since 1997, Nike’s revenue had plateaued at around $9 billion, while net income had fallen from almost $800 million to $500 million. Nike;s market share in US athletic shoes had fallen from 48%, in 1997, to 42% in 2000. 6. At the meeting, management revealed plans to address both top-line growth and operating performance. To boost revenue, the company would develop shoe products in midpriced segment. Nike also planned to push its apparel line with the leadership of Mindy Grossman. 7. On the cost side, Nike would exert more effort on expense control. 8.
Company executives reiterated their long-term revenue-growth targets of 8% to 10% and earning-growth targets of above 15%. 9. There were mixed reactions among the analysts. Some thought the financial targets were too aggressive; others saw significant opportunities in apparel and in Nike’s international businesses. 10. Kimi’s own forecast shows that at 12% discount rate, Nike was overvalued at $42. 09. However, it was undervalued as 11. 17% discount rate. 11. Joanna Cohen, the assistant of Kimi, calculated that Nike’s cost of capital is 8. 4%. This is based on the tables provided by Kimi.
V. Alternative Courses of Action Before going to the recommendations, let us first take a look at Joanna Cohen’s calculations of WACC. Cohen used the capital asset pricing model (CAPM) and her WACC is at 8. 4%. The problem with Cohen’s calculations is that she used the book value for both debt and equity. While the book value of debt is accepted as an estimate of market value, book value of equity should not be used when calculating cost of capital. The market value of equity is found by multiplying the stock price of Nike Inc. by the number of shares outstanding. Market Value of Equity | | |E = |Stock Price |# Shares Outstanding | | |$42. 09 |271. 5 | |E = |$11,427. 44 | | This figure is much different than the book value of equity that Joanna Cohen used ($3,494. 50). In addition, for market value of debt, Cohen uses the book value, when in fact she should have discounted the value of long-term debt that appears on the balance sheet.
The market value of debt is found by adding the current portion of long-term debt, notes payable, and long-term debt discounted at Nike’s current coupon. |Market Value of Debt | | | |D = |Current LT |Notes Payable |LT Debt (discounted) | | |$5. 40 |$855. 30 |$416. 72 | |D = |$1,277. 42 | | |
Using these figures, we can now find the market value of Nike Inc. , and the company’s capital structure. |Weight of Debt | | |Weight of Equity | | |W = |D |/D+E | |W = |E |/D+E | |W = |$1,277. 42 |$12,704. 86 | |W = |$11,427. 44 |$12,704. 86 | | |10. 05% | | | |89. 5% | | The next issue at hand is finding the correct costs of debt and equity in order to find an accurate calculation of WACC. Cohen used the 20-year yield on U. S. Treasuries as the risk free rate, which we found to be the correct figure given that Nike Inc. debt was valued over 25 years. Because there is no other given yield that is comparable to a 25-year valuation period, our risk free rate used in calculations is 5. 74 percent. Just as important as choosing a risk free rate is choosing the appropriate market risk premium.
There are two historical equity risk premiums given for a time period from 1926 to 1999: Geometric mean and arithmetic mean. The geometric mean is a better estimate for longer life valuation while the arithmetic mean is better for a one-year estimated expected return. Therefore, we chose to use the geometric mean to coincide with the choice to use the 20-year yield on U. S. Treasuries, which is 5. 9 percent. Next, we had to decide on a beta to use for Nike Inc. for use in the CAPM approach. The logical choice was to use the average (0. 80) to account for the large fluctuations seen in Nike’s historic betas.
We felt that the YTD beta was a reflection of current business practices, but the goal of Nike Inc. was to look forward and gain back market share and increase revenues. Consequently, we felt the average beta reflected the historical business practices of Nike Inc. better. From here, we calculated the cost of debt and equity. Cost of debt was calculated by finding the yield to maturity on 20-year Nike Inc. debt with a 6. 75% coupon semi-annually (See Appendix A). We assumed Nike Inc. to have a single cost of capital since its multiple business segments (shoes, apparel, sports equipment, etc. are not very different and would experience similar risks and betas. The cost of equity was calculated as follows: |Cost of Debt | | | |WACC = |Wd*Kd(1-T) + WeKe | | |Wd*Kd(1-T) |WeKe | | |0. 4682% |9. 4083% | | |9. 8765% | | Thus weighted average cost of capital for Nike Inc. is 9. 8765 percent. Based on the new computed WACC, 9. 765%, below are the recommended courses of action. 1. Kimi Ford should proceed to buy shares of Nike, Inc. At 9. 87% WACC, Nike’s share price is $36. 49 which makes the current trading price, $42. 09, overvalued by $5. 60 per share. The advantage of this action is that Nike has a good growth potential based on the company’s executive meeting. This will be very beneficial for NorthPoint. Even if they will purchase the shares at higher cost, future earnings are of high probability. On the contrary, this purchase will also be very risky for NorthPoint.
Since Ford will purchase the shares at a price which is $5. 60 more than its actual value, this will mean that NorthPoint will lose more money if Nike’s plans fail. 2. Kimi Ford should not buy shares of Nike, Inc.. This action is a conservative one. Since NorthPoint is currently performing better than others in S&P 500, so there is no reason to venture into transactions that are risky like that one of Nike’s. The main advantage of this action is that NorthPoint will maintain its growth rate as long as its shares from other companies continue to perform well.
The only disadvantage I see is that NorthPoint is losing the opportunity to earn more if it does not purchase the shares. Nike’s plans are well presented and they have a concrete direction, which gives Nike a great potential for growth. If this growth is realized, NorthPoint will lose a great deal of opportunity. 3. Kimi Ford should put the purchase on hold and wait until the actual trading price and WACC is closer to each other before making a purchase. Given that the current trading price of Nike’s share is overvalued, purchasing it at present will mean a losing investment for NorthPoint.
But the growth potential of Nike is too hard to resist. The advantage of this action is that if the actual price and WACC do equalize, there is less risk for NorthPoint to loss a lot of money. The value of money invested is the actual value of shares NorthPoint will be getting. But on the other hand, in the event that Nike’s future plans will work, then the actual trading price of Nike’s share will definitely go up as well. Thus delaying the purchase will also make them lose the opportunity to earn more. VI. Recommendation/Conclusion
Based on the facts of the case, the calculations made and the advantages and disadvantages of the alternative courses of action, it is recommended that Kimi Ford should proceed and purchase Nike’s shares (Alternative #1). Nike’s future plans are well laid out and are all directed towards making growth in its finances. Upon learning about the plans, Ford has to immediately purchase shares. Other funds management companies might see the opportunity and grab it, eventually purchasing ahead of NorthPoint. This will also cause the actual trading price to rise making it harder for NorthPoint to capitalize with this opportunity.