NorthPoint Large Cap Fund was considering whether to buy Nike’s stock or not. Nike was experiencing declines in sales growth, declines in profits and market share. However, Nike decided it would increase exposure in mid-price footwear and apparel lines, and it also commits to cut down expenses. The market responded with mixed signals to Nike’s changes. Kimi Ford, the portfolio manager at NorthPoint, did a cash flow estimation, and ask her assistant, Joanna Cohen to estimate the cost of capital.

The cost of capital is the rate of return required by a capital provider in exchange for foregoing an investment in another project or business with similar risk.

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Thus, it is also known as an opportunity cost. Since WACC is the minimum return required by capital providers, managers should invest only in projects that generate returns in excess of WACC. There are four main issues:

If Cohen should estimate different costs of capital for the footwear and apparel divisions or use a single one instead.

I agree with the use of the single cost of capital. It is sufficient for this analysis, since Nike’s business segments have very similar risks.

Calculating the Cost of Capital WACC: Cohen is wrong using the book values for debt and equity weights; the Market values are the ones that should be used when calculating weights. The reason for using the Market value is that it is how much it will cost the firm to raise capital today. That cost is approximated by the market value of capital, not by the book value of capital. For market value of equity, $42.09×271.5 shares = 11,427.4 Since we are not given the market value of debt, we use the book value of debt, 1,296.6 Therefore, the market value weight for equity is 11,427.4/(11,427.3+1,296.6) = 89.8%; the weight for debt is 10.2%.

Cost of Debt: The WACC is used for discounting future cash flows; therefore, all components of cost must reflect the firm’s current or future abilities in raising capital. Cohen uses the historical data when she estimating the cost of debt. She divided the interest expenses by the average balance of debt to get 4.3% cost of debt. The cost of debt could be estimated using the Yield to Maturity of a bond. We can calculate the YTM of the Nike’s bond: Coupon Rate= 6.75%

PV= 95.60

N=40 (20 semi-annual)

Pmt=3.375 (100×0.0675/2)

FV=100

YTM = 3.58% (semiannual) 7.16% (annual)

After tax cost of debt = 7.16%(1-38%) = 4.44%

Cost of Equity: Cohen used CAPM to estimate cost of equity. Her number comes from: 5.74% +(5.9%) x 0.80=10.5% Her risk free rate of 5.7% comes from 20-year T-bond rate, average beta from 1996 to July 2001, (0.80), and a Risk premium of 5.9% I do not agree that Cohen uses average beta from 1996 to July 2001 to measure systematic risk, because we need to find a beta that is most representative to future beta. That is why a most recent beta would be more relevant. So I suggest using Beta 0.69. Therefore, the new cost of equity would be:

5.74% + (5.9%) x 0.69 = 9.81%

Putting it all together:

My calculation of the WACC is:

0.0444 x 0.102 + 0.0981 x 0.898 = 9.26%

This new Cost of Capital/WACC will change the terminal value of FCF 2011. 1,572.7 x (1+0.03)/0.0926-0.03= 25,876.7 The new FCF will now be 27,449.4 NPV is now: $17,109.14

New Price= 17,109.14 – 1296.6 + 304 = 16,116.54 / 271.5 = $59.36 which is more than the current market price of $42.09, meaning it is undervalued. Therefore, the recommendation is to BUY!