Nike’s Cost of Debt and Equity Essay

Table of Contents Cost of Capital2 Value of Equity2 Cost of Equity2 CAPM Model2 Dividend Growth Model3 Value of Debt3 Cost of Debt4 WACC (Weighted Average Cost of Capital)4 Comparison to Joanna Cohen’s Analysis4 Financial Statement Analysis5 Nike Inc. 5 Financial Ratios6 Leverage Ratios6 Efficiency Ratios6 Liquidity Ratios7 Profitability Ratios7 Valuation Ratios7 Conclusion8 Appendix A – Ratio Calculation9 Leverage Ratios9 Efficiency Ratios9 Liquidity Ratios9 Profitability Ratios10 Valuation Ratios10 Cost of Capital Value of Equity

Cohen’s calculation considered the book values to calculate the proportion of equity for calculating the value of WACC which should only be done if the target or market values are not available. In order to determine a more realistic cost of equity, it is recommended to use the market value. The current market share price of Nike as of 2001 is $42. 09 and there are 271. 5 total shares outstanding. Therefore the market value of equity is: Current share price * Average shares outstanding: (42. 09 * 271. 5) = $11,427. 44 million This figure is much higher than the book value of $3,494. million that Cohen used to calculate the value of equity. Cost of Equity There are two approaches that can be used to calculate the cost of equity: the Dividend Growth Model or the CAPM model. CAPM Model The formula to calculate CAPM considers three important variables, the Risk Free Rate (RF), the Market Risk Premium (RM – RF) and the company Beta (? ). 1. Risk Free Rate: RF = 5. 74 (Current yield on 20-year U. S. treasuries) The maturity period for Nike’s current publicly traded debt is 25 years. The closest available information on current risk free yields is for 20-year bonds. 2. Market Risk Premium: (RM – RF) = 5. % (Geometric mean) Here the geometric mean is used instead of the arithmetic mean as it is better long-term measure of the market risk premium. 3. Company Beta: ? = 0. 80 (Average) The formula to calculate CAPM is: Ke = RF + ? (RM – RF) Therefore Ke = 5. 74 + 5. 9 (0. 80) = 10. 46% Dividend Growth Model The DDM growth model considers the expected dividend growth rate (g), the current annual dividend (d) and the current price of common shares (P0). 1. Dividend Growth Rate: g = 5. 5% 2. Current Annual Dividend: d = $0. 48 3. Current Share Price: P0 =$ 42. 09 The formula for the DDM is: Ke = d (1+g)P0+g

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Therefore Ke= 0. 48 (1+0. 055)$42. 09+0. 055 = 6. 7% In theory the value derived by DDM should equal the value derived by CAPM. As this is not the case the CAPM model will be used to determine the cost of equity. The CAPM method is preferred in this instance because of the consistently low dividend yield that did not reflect the change in Nike’s earnings during the period of time between 1998 and 2001. Value of Debt When calculating the value of the debt it is important to separate debt from other types of liabilities in order to get the closest to market value of the actual debt of the company.

When interest rates have been relatively stable, the book values debt can be used. In the case of Nike, it is calculated by adding the values of: 1. Current portion of long term debt: $5. 4 2. Notes payable : 855. 3 3. Long Term Debt : 435. 9 Therefore the current value of Nike’s debt is $1,296. 6 million. Cost of Debt When calculating the cost of debt (Kd) the following are considered: the current yield on publicly traded Nike debt and the corporate tax rate (T) and the federal tax rate of 35% plus an average state tax rate of 3% for a total tax rate of 38%: Here the following inputs are used to calculate the cost of debt: 1.

PMT = 6. 75/2 (as 6. 75% is a semi-annual rate) = $3. 375 2. Face Value = $100 3. Present Value = $95. 60 4. Years (N) = 25*2 (for semi-annual payments) = 50 This gives a yield to maturity (YTM) of 3. 56%, multiplied by two for an annual YTM of 7. 1296%. To take into consideration the tax deduction, this number must then be multiplied by (1-T) to arrive at the actual cost of debt of 4. 42%. WACC (Weighted Average Cost of Capital) To calculate the Weighted Average Cost of Capital (WACC) the proportion of debt and equity are determined: Proportion of Debt: 1296. 6 / (1296. 6 + 11427. 44) = 10. 19%

Proportion of Equity: 11427. 44/ (1296. 6 + 11427. 44) = 89. 81% The WACC can then be determined by multiplying the proportions of Debt and Equity by Kd and Ke: | Proportion| Cost| Weighted Average| Equity| 89. 81%| 10. 46%| 9. 39%| Debt| 10. 19%| 4. 42%| 0. 45%| TOTAL WACC| | | 9. 84%| Comparison to Joanna Cohen’s Analysis With a WACC of 9. 84% the share price of Nike is undervalued, rather than overvalued (as originally analyzed). According to the sensitivity analysis table provided in Exhibit 2, the share price should be valued between $50. 92 and $55. 68, whereas the current share price is $42. 9 (an undervaluing of approximately 17%-24%). It should be noted however, that when re-computing the present value of the estimated future cash flows computed by Ms. Ford, the shares should be valued at $44. 17; in this case the share is undervalued by 4. 7%. Joanna Cohen determined the cost of capital to be 8. 4% and the share price to be $69. 44. According to her work the share value was undervalued by $27. 35 (approximately 39%). Despite these discrepancies, according to the above analysis and Ms. Cohen’s calculations the share price is undervalued. Financial Statement Analysis

The current share valuation and WACC are not the only considerations that should be taken into account when making investment decisions. The following will provide a brief analysis of Nike Inc. ’s financial position and subsequently a recommendation will be made as to whether to buy, hold or sell shares in the company. Nike Inc. Nike’s revenues have been stagnant at approximately $9 billion from 1997 to 2001. Nike’s net income has dropped by 25. 9% during the same time period, a decrease of $206. 1 million dollars. In addition their share of the US athletic shoe market fell from 48% to 42% from 1997 to 2000.

Currently Nike management has plans to boost top-line growth by widening their product scope to include the mid-priced segment, while at the same time increasing operational efficiency by focusing on cost control. Additionally, Nike recently hired Mindy Grossman, former president and CEO of Jones Apparel Group’s Polo Jeans division, to head up their apparel line. Thus, Nike’s growth targets are in the range of 8-10%. Financial Ratios Leverage Ratios Ratio| 2000| 2001| Debt-Equity| 0. 46| 0. 37| TIE| 19. 43| 14. 69| For every dollar of equity invested in 2001, Nike has borrowed $0. 7 of interest-bearing debt. This has decreased from 2000 indicating they have changed their capital structure to take on less debt and more equity. Considering that the cost of debt is less than the cost of equity, it is possible that this has been a contributing factor towards the lower profit margins of 2001. The times interest earned (TIE) ratio has decreased, this is not a good sign as it indicates that for every dollar of interest expense in 2001, Nike had approximately $14. 69 of income available to pay interest and taxes down from $19. 43 in 2000. Efficiency Ratios

Ratio| 2000| 2001| Asset Turnover| 1. 54| 1. 62| Inventory Turnover| 3. 73| 4. 06| Days Inventory| 97. 67| 89. 85| Days Receivable| 63. 68| 62. 37| Between the years 2000 and 2001 Nike improved in all aspects of its asset utilization. Sales generated for every dollar’s worth of assets has increased from $1. 54 to $1. 62. Inventory is turning over at a faster rate, and therefore being held in stock for a shorter period of time. Meanwhile Nike has become more efficient at collecting outstanding accounts receivable by decreasing the average number of days to collect on outstanding invoices.

These are all indications of increased efficiency. Liquidity Ratios Ratio| 2000| 2001| Quick Ratio| 0. 85| 1. 08| Cash Ratio| 0. 12| 0. 17| Nike’s liquidity ratios vastly improved between 2000 and 2001. While the cash ratios are quite low, the quick ratio in 2001 has increased to greater than 1, indicating an ability to pay their debts in a timely fashion. Profitability Ratios Ratio| 2000| 2001| Return on Assets| 14. 9%| 14. 8%| Return on Equity| 18. 5%| 16. 9%| Gross Margin| 39. 9%| 39. 0%| Operating Margin| 10. 9%| 10. 7%| Profit Margin| 6. 4%| 6. 2%|

All of Nike’s profitability ratios have fallen. While the decrease has not been significant, this is contrary to the corresponding 3% increase in revenues. This is further indication that Nike will need to decrease expenses and continue to increase operational efficiency in order to achieve their targeted growth percentage. Valuation Ratios Ratio| 2000| 2001| Dividend Yield| 1. 21%| 1. 14%| Price/Earnings| 19. 23| 19. 49| The decrease in the dividend yield is observed as a result of the increase in share price and the consistency of the dividend payout ($0. 06 per share in both 2000 and 2001).

A slight increase in price to earnings is noted; however, it may be an insignificant amount with respect to how the Nike stock is valued in the market (ie. future earnings expectations). Conclusion Nike Inc. ’s management has a plan to improve their performance in the future. While the financial ratios do not necessarily show a positive trend in all areas, the improvement in liquidity and asset utilization give hope that the plan can be implemented with success. In addition, based on the recalculated WACC, the stock is currently undervalued. Taking these two points into consideration, it is advisable to buy Nike stock.

Appendix A – Ratio Calculation Leverage Ratios Ratio| Formula| Values – 2000| Values – 2001| Debt-Equity| Total DebtTotal Equity| (50. 1+924. 2+470. 3)3,136. 0= 0. 4607| (5. 4+855. 3+435. 9)3,494. 5= 0. 3710| Times Interest Earned (TIE)| EBITInterest| (919. 2-45)45. 0= 19. 43| (921. 4-58. 7)58. 7=14. 69| Efficiency Ratios Ratio| Formula| Values – 2000| Values – 2001| Asset Turnover| RevenueTotal Assets| 8,995. 15,856. 9 = 1. 54| 9,488. 85,819. 6= 1. 62| Inventory Turnover| COGSInventory| 5,403. 81,446. 0 =3. 73| 5,784. 91,424. 1= 4. 06| Days Inventory| Accounts Receivable(Rev365)| 1,569. (8,995. 1365) =97. 67| 1,621. 4(9,488. 8365)=89. 85| Days Receivable| InventoryCOGS x 365| 1,446. 05,403. 8? 365 =63. 68| 1,421. 15,784. 9? 365= 62. 37| Liquidity Ratios Ratio| Formula| Values – 2000| Values – 2001| Quick Ratio| (Cash & Equivalents+A/R)Current Liabilities| (254. 3+1,569. 4)2,140. 0= 0. 8522| (304. 0+1,621. 4)1,786. 7= 1. 0776| Cash Ratio| (Cash & Equivalents)Current Liabilities| 254. 32,140. 0= 0. 1188| 304. 01,786. 7= 0. 1701| Profitability Ratios Ratio| Formula| Values – 2000| Values – 2001| Return on Assets| EBITAvg. Assets| (919. 2-45)5856. 9=0. 1493| (921. -58. 7)5819. 6=0. 1482| Return on Equity| Net IncomeEquity| 579. 13,136=0. 1847| 589. 73,494. 5=0. 1688| Gross Margin| Gross ProfitRevenues| 3591. 38995. 1=0. 399| 3,703. 99,488. 8=0. 390| Operating Margin| Operating IncomeRevenue| 984. 98995. 1=0. 109| 1,014. 29,488. 8=0. 107| Profit Margin| Net IncomeRevenue| 579. 18995. 1=0. 064| 589. 79,488. 8=0. 062| Valuation Ratios Ratio| Formula| Values – 2000| Values – 2001| Dividend Yield| Div. Per ShareShare Price| 0. 4839. 81=1. 21%| 0. 4842. 09=1. 14%| Price per Earnings| Share PriceEarnings Per Share| 39. 812. 07=19. 23| 42. 092. 16=19. 49|

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