The text focuses on Kimi Ford, a portfolio manager at NorthPoint Group, a firm that manages mutual funds. In July 2001, Ford was in charge of managing the NorthPoint Large-Cap Fund and contemplating investing in Nike for the fund. Despite experiencing a notable drop in their stock value the previous year, Nike appeared to present an appealing opportunity for investment.
Nike had previously held an analysts’ meeting to announce their fiscal results for 2001. However, the purpose of this meeting went beyond just sharing financial information. The management also wanted to outline a plan to rejuvenate the company. Despite experiencing stagnant revenues since 1997 and a decrease in net income, Nike had lost 6% of its market share. Additionally, they faced challenges in their supply chain and were affected by the strengthening U.S. dollar.
During the analysts’ meeting, Nike announced its strategy to address the issue of limited revenue growth and improve operating performance. The company intends to achieve revenue growth by expanding its range of mid-priced athletic shoe products and by emphasizing its apparel line. Nike also mentioned its commitment to controlling expenses. Additionally, the company’s executives reiterated their long-term targets of 8% to 10% revenue growth and earnings growth exceeding 15%. The analysts had varied responses to these announcements.
Despite differing opinions on Nike’s growth targets, some believed there were untapped prospects in apparel and international markets. Ms. Ford thoroughly reviewed all reports from the analysts’ meeting but found no unanimous agreement. Consequently, she took it upon herself to devise a discounted cash flow forecast, which revealed that Nike was overestimated at $42.09 with a discount rate of 12%. Additionally, Ms. Ford discovered that the company was undervalued if the discount rate fell below 11.17%.
Ms. Ford requested her assistant to estimate Nike’s cost of capital in order to gain more confidence in her forecast. The assistant estimated that Nike’s cost of capital is 8.4%, based on four main assumptions. The first assumption is that a single cost of capital for all of Nike’s different business segments will suffice, instead of using a cost of capital specific to each business segment. The assistant believed that since footwear accounted for 62% of revenues and all significant segments were sport-related, the risk factors were likely similar across all business segments.
The first step involved using the WACC to determine Nike’s cost of capital, as the company was financed through debt and equity. The cost of debt, estimated at 4.3%, was calculated by dividing the interest expense for the entire year of 2001 by Nike’s average debt balance. Considering taxes, the adjusted cost of debt is 2.7%, using a tax rate of 38% based on a state tax of 3% and the U.S. statutory tax rate. Finally, the cost of equity was estimated using the CAPM approach.
The estimated cost of equity for Nike is 10.5%, based on the current yield of the 20-year Treasury bond as the risk-free rate, the compound average premium of the market over Treasury bonds as the risk premium, and the average of Nike’s betas from 1996 to 2000 as the beta. The validity of this assumption is that using a single cost of capital instead of multiple costs of capital is accurate. The assistant also notes that all of Nike’s segments, except for Cole Haan, are sports-related and Cole Haan does not make a significant contribution to Nike’s revenues.
Thus, the author suggests that all segments should be categorized as having equal risk. However, I believe it may be reasonable to use multiple costs of capital for one important reason. Although most of Nike’s products are related to sports, not all directly affect an athlete’s performance. Athletes usually choose footwear based on its potential to enhance their skills in a particular area. For instance, basketball shoes focus on providing ankle support and incorporate technology for improved jumping ability, whereas football and soccer shoes prioritize traction improvement.
Apparel items like socks, jerseys, and track suits do not appear to affect athletic performance directly. It is plausible that this distinction in products warrants distinct risk levels for different business segments. The utilization of the WACC is a reliable approach to estimate a company’s capital cost. Considering that Ms. Ford and her assistant are unaware of Nike’s desired capital structure, it is acceptable to establish the capital structure based on the current composition of 27% debt and 73% equity.
There are concerns about the reliability of the methodology used. I disagree with the assistant’s assumption that Nike’s cost of debt can be calculated using the interest expense for 2001 and average debt balance. In my opinion, it should be determined based on the interest rate Nike would have to pay if it were to issue new debt at that time. However, if new debt can be obtained at a similar rate as existing debt, then this approach would not cause any problems.
Alternatively, if new debt is issued at a different interest rate from the existing debt, it implies that the estimated cost of capital was incorrect.
To estimate the cost of equity, the assistant used the CAPM model. This involved taking into account the current yield on 20-year Treasury bonds as the risk-free rate and including the geometric mean of historical equity risk premiums. While using the geometric mean gives a more accurate estimate for long-term risk premium, using the arithmetic average may better represent the risk premium during the specific sample period.
If the arithmetic average is utilized, the cost of equity for Nike will exceed that which is determined using the geometric mean. When employing the arithmetic average, the cost of equity is calculated to be 11.74%. The assistant’s estimation of beta by taking the average of all betas over the course of five years is satisfactory, serving as a fair assessment. Consequently, it can be concluded that Ms. Ford’s assistant’s methodology is valid, and the majority of her estimations are equitable. Nevertheless, the few inaccuracies in her calculations are substantial enough to justify a fresh assessment. Therefore, Ms. Ford should avoid valuing Nike’s stock based on a cost of capital of 8.4%.
