NorthPoint Group, a mutual fund management firm, focused on investing in Fortune 500 companies such as ExxonMobil, General Motors, McDonald’s, and 3M among others. Despite a decline in the stock market over 18 months, NorthPoint Group performed exceptionally well. In 2000, it achieved a return of 20.7%, while the S&P 500 experienced a decline of 10.1%. By June 2001, NorthPoint Group’s return was 6.4%, compared to the S&P 500’s -7.3%. Nike, Inc., an American multinational corporation, was initially founded as Blue Ribbon Sports on January 25th,1964 and officially became Nike.Inc on May30th ,1978.
The company is engaged in the development, advancement, and global marketing and sale of footwear, apparel, equipment, accessories, and services. Situated close to Beaverton in the Portland metropolitan area of Oregon, the company’s main office serves as one of only two Fortune 500 companies headquartered in Oregon. It holds a prominent position as the leading provider of shoes and apparel worldwide while also being a significant manufacturer of sports equipment. In its fiscal year 2012 ending on May 31st, 2012, the company attained revenue surpassing US$24.1 billion.
Nike, in 2012, had over 44,000 employees worldwide and was the top brand in the sports industry valued at $10 billion. On July 5, 2001, Kimi Ford from Northpoint Group analyzed reports on Nike Inc., which emphasized a substantial decrease in its stock price since the start of that year. To address this matter and explore methods to revive the company, Nike conducted an analysts’ meeting on June 28, 2001. In this meeting, Nike management presented plans to enhance both revenue growth and operational performance.
In 1997, Nike Inc. experienced consistent revenue of approximately $9 million, but its net income decreased from $800 million to $580 million within the same time frame. Moreover, their market share declined from 48% in 1997 to 42% in 2000. The decline in revenue can be attributed to supply chain issues and the adverse impact of a strong dollar. Despite these challenges, company executives have reiterated their long-term goals for revenue growth ranging from 8% to 10%, with a specific emphasis on achieving earnings growth of up to 15%. However, during the June 28 meeting, Kimi faced conflicting recommendations from analysts and was unable to obtain clear guidance.
Kimi Ford decided to create her own discounted cash flow forecast in order to reach a clear conclusion. In her forecast, Nike Inc. was deemed overvalued with a current share price of $42.09 and a discount rate of 12%. However, she discovered that Nike Inc. was undervalued when the discount rate dropped below 11.17%. This led Kimi Ford to ask her assistant, Joanna Cohen, to estimate the cost of capital of Nike Inc.
The case study “Nike, Inc.: Cost of Capital” has three objectives. The first objective is to emphasize the significance of cost of capital.
The importance of cost of capital in determining the allocation of shares for the NorthPoint Large-Cap Fund is discussed. The aim is also to determine the suitable approach for estimating the cost of capital and perform the necessary calculation. Additionally, Cohen’s analysis is compared to identify any errors. Furthermore, the objective is to make an investment decision regarding whether to include Nike’s shares in the NorthPoint Large-Cap Fund. The evaluation of Nike’s share price using the cost of capital will guide a recommendation to either buy, hold, or sell.
Introduction
This paragraph discusses the case study of Nike Inc. as a potential investment. Kimi Ford, a portfolio manager for North Point Large-Cap Fund, is the decision maker in this case. She conducted a thorough analysis of Nike Inc., including reading analysts’ reports on its performance. However, these reports conflicted, with Lehman Brothers recommending investing in Nike while UBS Warburg and CSFB advised against it. As a result, Kimi decided to perform her own discounted cash flow analysis to assess Nike’s investment potential.
Kimi’s new assistant is tasked with calculating the cost of capital for Nike. This calculation is crucial in making an informed investment decision and ensuring accuracy. The cost of capital represents the minimum rate of return needed to satisfy potential investors. It serves to cover the company’s funding expenses and meet investor expectations.
The cost of capital is divided into two categories: debt and equity. Knowing the cost of capital is crucial for making financial decisions because it enables assessment of a company’s financial performance during a particular period. Kimi used the cost of capital to evaluate Nike’s investment proposal and determine if their financial performance met the necessary criteria. However, Cohen’s calculation of the cost of capital differed from accepted methods, resulting in inconsistencies.
Firstly, there are issues with the formulas for calculating the cost of equity and debt. Cohen is using the book value instead of the market value for equity calculation. Moreover, she calculates the cost of debt by considering total interest expenses rather than total debt. It is necessary to correct these errors to ensure accurate results and avoid any negative impact on decision making.
In terms of data analysis, I agree with Cohen’s choice of utilizing a single cost of capital in her analysis.
According to Cohen’s analysis, Nike primarily focuses on sports-related businesses, with the exception of the Cole Haan line which contributes only a small portion of revenues. As a result, calculating a separate cost of capital is unnecessary. The risk level for Nike’s business segment is relatively consistent, so a single cost of equity is sufficient for this analysis.
In Cohen’s analysis, she erroneously used the book value to determine the equity proportion. She derived the equity from the “total shareholders’ equity” on the balance sheet. Utilizing the book value of equity goes against the principle of maximizing shareholders’ wealth.
Using the book value of equity to estimate the weighted average cost of capital (WACC) can lead to incorrect calculations and influence investment decisions. It may result in accepting projects that shareholders would prefer to reject. To avoid this, Cohen should utilize the market value of equity instead. The market value represents the current true value of the company, whereas the book value only indicates the initial value. The market value fluctuates daily, reflecting the actual worth of the firm. By incorporating the market value into WACC estimation, it becomes possible to determine the cost of raising capital in the present day.
To determine the market value of equity, the current share price (which is $42.09) is multiplied by the current shares outstanding (which is 271.5 million). This calculation results in a total equity value of $11,427.435 million. Our analysis yielded a significantly higher equity value compared to Cohen’s analysis, which only found an equity value of $3,494.5 million. The difference in figures arises because we utilized the market value of equity instead of the book value of equity. 4.3 Debt
The estimated WACC (Weighted Average Cost of Capital) is determined using the book value of debt as there is insufficient information on the market value of debt. To calculate the total debt, we add together the current portion of long-term debt, notes payable, and long-term debt after discounting. The discounted long-term debt is calculated as $435.9 million multiplied by [1-[7.17%*(1-38%)]] = $416.72 million.
The total debt is then calculated as $5.4 million + $855.3 million + $416.72 million = $1277.42 million.
The total debt value differs from Cohen’s analysis because I have utilized the discounted long-term debt, resulting in a lower value.
Weightage: 4.44.4.1 Weight of Equity: The weight of equity is calculated by dividing the total equity by the sum of total equity and total debt. In this case, it is $11,427.435 million divided by ($11,427.435 million + $1,277.42 million), which equals 0.8995 or 89.95%. This differs from Cohen’s analysis where he obtained a proportion of 73%.
4.4.2 Weight of Debt: The weight of debt is calculated by dividing the total debt by the sum of total equity and total debt.In this case,it is $1,277.#1005#10#.05#105#.05#.05%.05%million divided by ($11,427.435 million + $1,277.42 million), which equals 0.#1005#10%.05%. This differs from Cohen’s analysis where he obtained a proportion of 27% for debt.
4.#55 Cost#5Cost##55Cost#of Equity:Cohen utilized various models including the capital-asset pricing model (CAPM), dividend discount model (DDM),and earning capitalization model(ECM) to estimate the cost
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Although the three models have distinct assumptions and factors taken into account, they are all employed to estimate the cost of equity. The aim is to compare the adequacy of each model in order to determine the most optimal one. The Capital Asset Pricing Model (CAPM) serves as the primary model utilized in this analysis. It is crucial to identify pertinent information prior to performing any calculations. Moreover, Cohen also utilizes CAPM for estimating the cost of equity, enabling a comparison between her calculation and ours.
Cohen proposes using the rate on 20-year U.S. Treasuries as the risk-free rate for discounting long-term cash flow. He disagrees with using the average beta from 1996 to July 2001 to represent systematic risk, suggesting instead the use of the most current beta of July 2001. Nevertheless, Cohen concurs that the geometric mean is a suitable measure for representing the risk premium.
When estimating returns over longer time horizons and when the returns are more serially correlated, it is more appropriate to use the geometric risk premium. To estimate long-term cash flow, we use the 20-year Treasuries rate as our risk-free rate. In summary, if we want to estimate the expected return over a long time frame and use the Treasury bond rate as the risk-free rate, the preferred method is to use the geometric mean.
The calculation of the cost of equity using CAPM is as follows: risk-free rate (20-year U.S. Treasuries rate) = 5.74%, Beta (YTD 6/30/01) = 0.69, risk premium (Geometric mean) = 5.0%. Therefore, 0.0574 + 0.69(0.059) = 0.0574 + 0.04071 = 0.09811 = 9.81%.
*80*(–
In our analysis, the cost of capital is only 9.81% because of the different beta value used in the model (4.5).
The second model used is the dividend discount model, which compares forecasted dividends for the next period with the current share price ($42.9 for the firm). It then adds Nike’s growth rate (5.50%). However, we rejected this model as it does not reflect the true cost of capital, as Nike Inc. does not pay significant dividends.
The dividend discount model calculation was as follows: = 4.5.
Another model used to determine the cost of equity is the earning capitalization model (ECM). The ECM is straightforward to understand but does not consider company growth.
It is considered poor in estimating equity costs for Nike, Inc. Consequently, we chose to reject this calculation. The earnings capitalization model was calculated as follows: = Therefore, in this case study, CAPM is the most appropriate method to estimate cost of equity. CAPM is useful because it explicity accounts for an investment’s riskiness and can be applied by any company, regardless of its dividend size or growth rate. 4.
6 Cost of Debt Cost of Debt was computed by Joanna Cohen as total interest expense for the year 2001 divided by average debt balance.
We disagree with using the coupon rate of existing debt to determine the cost of debt. Instead, it should be based on the interest paid if new debt were issued at that time. Our calculation for Nike Inc.’s cost of debt involved finding the yield to maturity on their 20-year debt with a semi-annual coupon rate of 6.75%. Despite having multiple business divisions, we assumed Nike Inc. has one overall cost of capital.
The reason for these divisions carrying similar risks and betas is that the cost of debt was determined based on certain calculations. The PMT (payment) is 3.375, with a total of 40 periods. The par value is $100 and the current price is $95.60. The marginal tax is 38%. The yield to maturity is calculated as 3.375 + [($100 – $95.60)/40] / [($100 + $95.60)/2] = 3.56%. This is then multiplied by 2 to give a final yield of 7.13%. After-tax, the cost of debt is calculated as 7.13% * (1-0.38) = 4.42%. This differs slightly from Joanna Cohen’s calculation of a cost of debt of 4.3% to 4.7%. The weighted average cost of capital (WACC) for Nike Inc. is 9.26%. The calculation for the cost of debt used the yield to maturity as a coupon payment is forthcoming.Next, the cost of equity was determined to be more appropriate using the capital asset pricing model and weighed according to their levels within the capital structure. The equity value was weighted using market valuations. The cost of capital was calculated as follows: = = 9.27%. In comparison to Joanna Cohen’s calculation: =(2.7%)(27.0%)+(10.5%)(73.0%) =8.4%.
Recommendation Discount Rate | Equity Value
8.00% | $75.80
8.50% | $67.85
9.00% | $61.25
9.50% | $55.68
10.00% | $50..92
10…50%| $46..81
11…00%| $43..22
11….17%| $42..09
11….50%| $40..07
12…..00%| $37..27
Table 1: WACC used as a discount rate to calculate the share price or equity value.
Based on our analysis, the estimated cost of capital is 9…27%. Using this cost of capital, we estimate the share price of Nike and compare it with the actual market share price to determine if the share is undervalued or overvalued.
The purpose of stock valuation is to predict future market prices and capitalize on price movements
The practice of buying undervalued stocks and selling overvalued stocks is common. As per Table 1.1, Nike’s share has an intrinsic value of $55.68 at a discount rate of 9.50%. However, the actual cost of capital estimation is rounded up to 9.50% from 9.27%. Currently, Nike’s share is priced at $42.09 with a discount rate of 11.17%. If the discount rate were lower than 11.17%, the market share price would be higher.
Our assessment reveals that Nike is undervalued by $13.90 compared to its current market price of $42.09, indicating potential for an increase in price and an opportunity for profit from the price difference. Therefore, based on this analysis, we recommend including Nike, Inc.’s share in the NorthPoint Large-Cap Fund to Kimi Ford due to Nike’s undervaluation and our anticipation of a rise in price.
References
- DRAGONWTX. (2012, March 19). Nike, Inc. : Cost of Capital. Retrieved March 20, 2013, from Blogger: http://lepicisheng. blogspot. com/2012/03/nike-inc-cost-of-capital. tml emfps. (n. d. ). Retrieved from emfps. blogspot. com: http://emfps. blogspot. com/2011_06_12_archive. html Jmatsanurai. (2009, October 17).
- Nike Case Study. Retrieved March 20, 2013, from Scribd: http://www. scribd. com/doc/21188529/Nike-Case-Study tienucd. (n. d. ). Retrieved March 20, 2013, from tienucd. blogspot. com: http://tienucd. blogspot. com/2012/05/nike-inc-analysis-cfm-corporate-finance. html Zywmelody. (2012, June).
- Case Study of Nike Company. Retrieved March 20, 2013, from Studymode: http://www. studymode. com/essays/Case-Study-Of-Nike-Company-1018065. html
