Nike, Inc. : Cost of Capital

Background

NorthPoint Large-Cap Fund adalah salah satu perusahaan manajemen pendanaan yang berada dibawah NorthPoint Group yang mengalokasikan dananya untuk berinvestasi di perusahaan-perusahaan besar. NorthPoint Large-Cap Fund sudah banyak menginvestasikan dananya dalam perusahaan-perusahaan Fortune 500, yang menekankan pada nilai investasi. Top holdingsnya mencakup ExxonMobil, General Motors, McDonald’s, 3M, dan modal besar yang lainnya. Walaupun bursa saham telah menurun sejak 18 bulan terakhir, NorthPoint Large-Cap telah menunjukkan performanya yang cukup bagus. Pada tahun 2000, dana-dana tersebut menghasilkan return sebesar 20.7% walaupun S&P 500 turun 7.3%.

Kimi Ford, Portfolio manajer dari NorthPoint Large-Cap sedang memutuskan untuk berinvestasi dalam salah satu perusahaan besar di Amerika Serikat, yaitu Nike, Inc., sebuah perusahaan yang memproduksi sepatu olahraga, tapi dia belum membuat kepastian mengenai keputusan ini, ditambah dengan harga saham Nike, Inc. yang telah menurun secara signifikan sejak awal tahun.

Nike Inc, sebuah perusahaan manufaktur yang berdiri sejak tahun 1964 di Portland. Awalnya perusahaan ini telah memproduksi sepatu atletis, yang kemudian berkembang sehingga pada akhirnya memproduksi berbagai macam produk olahraga. Produk-produk yang diproduksi oleh Nike secara umum dibagi 2 yaitu produk dengan merek Nike serta merek non-Nike. Khusus produk bermerek Nike adalah sepatu, aparel sebagai pelengkap produk sepatu, bola olahraga, perelatan waktu, kacamata, skates, bats. Produk bermerek Non-Nike yang diproduksi adalah Cole-Haan line dress dan casual footwear, ice skates, skate blades, hockey sticks, hockey jerseys, dan produk-produk lain di bawah Bauer trademark.

Nike adalah market leader untuk sepatu atletis. Pangsa pasarnya sampai tahun 2000 adalah 42%. Dengan pendapatan yang stabil yaitu sekitar 9 milliar tiap tahunnya.

Tetapi ternyata ada masalah pada bidang keuangan dari Nike. Inc,. Menurut financial statementnya, Net income Nike menurun dari hampir $800 juta pada tahun 1997, menjadi $589,7 juta di tahun 2001. Selain itu, sekalipun tetap menjadi market leader, namun market sharenya di sepatu atletik di US sebesar 42% pada tahun 2000 ternyata turun dari 48% sebelumnya.

Nike telah mengadakan meeting dengan analis-analis untuk memperlihatkan hasil fiscal year 2001-nya. Nike menargetkan revenue growth sebesar 8-10% dan earnings-growth diatas 15%. Melihat optimisme dari Nike, ternyata para analis memiliki respon yang berbeda-beda. Hal inilah yang membingungkan Kimi Ford apakah akan melakukan investasi di Nike atau tidak.

Lehman Brothers menyarankan Kimi Ford untuk melakukan investasi di Nike karena menurutnya Nike memiliki kesempatan berkembang di apparel line dan di bisnis internasional. Di lain pihak, UBS Warburg dasn analis CSFB sama sekali tidak mendukung investasi di Nike, dengan alasan target mereka terlalu agresif.

SWOT Analysis

Strengths

· Nke, Inc. pemimpin pasar di produk sepatu olahraga.

· Pendapatan yang cukup stabil dari tahun 1997.

· Citra merek yang sudah kuat di pasar dunia.

Weakness

Pangsa pasar untuk sepatu atletik di Amerika menurun dari 48% di tahun 1997 menjadi 42% di tahun 2000.

Harga saham yang terus menurun dari awal tahun 2001.

Opportunity

· Mengembangkan produk sepatu di segmen harga menengah yang sedang bertumbuh.

· Mendorong pendapatan melalui segmen produk apparel.

Threats

· Harga saham yang terus menurun akan terus berkelanjutan.

Statement of the problem

Keputusan apakah yang akan dikeluarkan oleh Kimi Ford dalam investasi NorthPoint Large Cap Fund di Nike, Inc.?

Alternative Course of Actions

1. Membuat keputusan untuk investasi di Nike, Inc. dengan menggunakan perhitungan Weighted Average Cost of Capital yang dibuat oleh Joanna Cohen.

2. Menahan investasi yang akan dilakukan pada Nike, Inc.dengan mempertimbangkan keadaan perusahaan yang sedang menurun.

Recommendation

Kami merekomendasikan alternatif pertama, dimana Kimi Ford harus mengeluarkan investasi untuk Nike, Inc.

Case Analysis of Nike, Inc.: Cost of Capital

Apparently, the issue of Nike’s case is to control and check the calculation cost of capital done by Joanna Cohen who is the assistant of a portfolio manager at NorthPoint Group. But I am willing to tell you that it can be a complex case in which we can doubt about sensitivity analysis done by Kimi Ford (portfolio manager) because her assumptions such as Revenue Growth Rate, COGS / Sales, S &A / Sales, Current Assets / Sales, and Current Liability / Sales have been adopted from previous income statements and balance sheets from 1995 to 2001. Perhaps, we can take new assumptions. Generally, the case issue is to examine if the share price of Nike is undervalue or overvalue and the common stock of Nike Inc should be added to the North Point Group’s Mutual Fund Portfolio or not.Now, let me approve Kimi Ford’s analysis and tell you only the mistakes of Joanna Cohen.What is the cost of capital?The cost of capital is the rate of return that a firm must earn on the projects in which it invests to maintain the market value of its stock. Cohen calculated a weighted average cost of capital (WACC) of 8.4 percent by using the Capital Asset Pricing Model (CAPM) for Nike Inc. I do not agree with Joanna Cohen because of below mentioned:-In the field of Equity’s Cost:

 She should use current yields on US Treasuries 3 to 12 months at 3.59% because the yield curve is upward sloping.  Upward sloping yield curve means that North Point Group should rely to short-term financing instead of long term financing.  In fact, by short term financing, the manager can use cheaper cost of equity. It means that North Point Group should sell the purchased shares of Nike during the period of one year.

 In the case of value of equity, Cohen’s should use liquidation value in calculating value of equity.  Liquidation value per share is more realistic than book value because it is based on the current market value of the firm’s assets by using of balance sheet data. 

Market Value of Equity (E) Calculation:E = Stock Price  x  Number of Shares Outstanding= $42.09 X 271.5= $11,427.44

This figure is should be used for market value of equity (E) rather than Joanna Cohen figure ($3,494.50).

-In the field of Debt’s Cost: In calculating value of debt, Cohen should have discounted the value of long-term debt that

appears on the balance sheet. It means she should also consider the future value of total long term debt base on coupon rate.

To calculate total value of debt, the steps are as follows:

Market Value of Debt (D) Calculation:

I considered the total amount of Debt for all items which are included by a interest rate as follows:

-Current portion of long -term debt-Notes payable-Long - term debt-Redeemable preferred stock

D = Current LT + Notes Payable + LT Debt (discounted)  = $5.40 + $855.30 + $435.9 + 0.3  = $1296.9

Using these figures, we can now find the market value of Nike Inc., and the company’s capital structure.

The Calculation of Weighs:

The weights of debt and equity are calculated using the market values of debt and equity as follows:

Weight of Debt (WD)

D + E = 1296.9 + 11,427.44 = 12724.34

WD = D/ D+E

WD = $ 1296.9 /$12724.34= 10.2%

Weight of Equity (WE)WE = E/ D +EWE = 11,427.44/ 12724.34

     =89.8%

 Cost of Debt

There are two types of interest rate for Nike, Inc. as follows:

1) For Notes payable, Current portion of long - term debt and Redeemable preferred stock, all these debts should be cleared during the period of maximum 12 months. Therefore, I calculated the interest rate in accordance with Exhibit 1(Income Statement) for 2001 year as follows:

Interest rate = Interest payment / Operating incomeCost of Debt = Interest rate = (58.7 / 1014.2) * 100 = 5.78%You can see this interest rate is approximately equal to 20 year yields on U.S Treasuries  

(Exhibit 4).

2) For Long - term debt, Nike, Inc. had issued the Bonds in which the Cost of debt was calculated by finding the yield to maturity on 20-year Nike Inc. debt with a 6.75% coupon semi-annually. I 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.

Before-Tax Cost of Debt 

I used three (3) methods as follows:-Method (1):  Using Cost Quotations Based on Coupon Interest Rate and Yield to Maturity (YTM)

Cost of Debt = 14.14%

-Method (2): Based on calculating the IRRCost of Debt = 14.15%

-Method (3): Approximating the Cost Based on the Value Bond and Coupon Rate

Cost of Debt = 14%All of the calculations have been included in my spreadsheet.

As we can see, all three methods present us approximately the same amount of the cost of debt. I have chosen 14.15% for the cost of debt. 

It is important to find the relationship between the required return and the coupon interest rate. When the required return is greater than the coupon interest rate, the bond value will be less than its par value. We choose cost of debt as 14.15% because it is rational (coupon value annually is 13.50%).  When current value of bond is less than par, required return will be more than coupon rate.

Weight Average of Cost of Debt:

As I mentioned, there are two types of debt and consequently we have two types of Cost of Debt. I calculated the weight average for Cost of debt as follows:

Total debt type 1 = $5.40 + $855.30 + 0.3 = $861 Total debt type 2 = $435.9 Total debt = $1296.9

W (type 1) = (861 / 1296.9) * 100 = 66.4% , Cost of Debt (type 1) = 5.78%W (type 2) = (435.9 / 1296.9) * 100 = 33.6% , Cost of debt (type 2) = 14.15%

Weight Average of Cost of Debt = (66.4% * 5.78) + (33.6% * 14.15) = 

3.84 + 4.75 = 8.59%

Therefore, the Cost of Debt is equal 8.6%

After-Tax Cost of DebtCost of financing must be stated on an after-tax basis.  Because interest on debt is tax deductible, it reduces the firm’s taxable income.

ri =rd x (1 –T)  =8.6% x (1 – 38%)  =5.33%

Nike CaseSummary

We recommend a buy for Nike's stock on July 6, 2001. Our analysis consists of a discounted cash flows model. We projected unlevered free cash flows over the next 10 years and discounted them according to our derivation of Nike's weighted

average cost of capital. Our analysis suggests the stock is significantly undervalued, given our expectation it will deliver earnings in the future.

Below we have analyzed Joanna Cohen's WACC calculation and her projection of cash flows. We then calculate our own WACC, discuss the results of our own model for cash flow projections, and conclude with our valuation and notes regarding our recommendation.

Evaluation of Joanna Cohen's WACC Calculation

Cohen's WACC calculation is decent, but has a few issues, and a number of errors, as described below.

Weighting the capital structure. She weights the capital structure using the book value of equity. Nike is a public company, and its market capitalization is a more relevant metric for equity than the book value of equity.

Cost of debt. To calculate the cost of debt, Cohen simply divides the interest expense by the average balance of the interest-bearing debt. This is an approximation for the true cost of the debt, but is too inaccurate. The interest expense line may include expenses not directly related to the debt of the company (unlikely, but perhaps non-cash payment-in-kind expenses for the preferred stock, or simply interest expense recognized under GAAP, but not necessarily indicative of real costs of debt).

The cost of debt should include the current market yield on Nike's publicly traded debt, as this is a more pertinent metric.

Furthermore, Cohen uses the 20 year yield on treasury bonds to approximate the risk free rate. We feel that the 3-month yield on treasuries is appropriate.

Market premium. Cohen uses a market premium of 5.9%, which is surprisingly low. She claims it is the market performance in excess of the treasury rate, but fails to defend this assertion. Perhaps using the arithmetic mean is a better approximation than the geometric mean for the market risk premium.

Decision to use only one WACC. She divided each division by revenue. In deciding whether to use an overall WACC, or to assign a WACC to each division, she should have weighted each division by cash flows, and not by revenue. It is

reasonable to ignore the other sports division, as it is such a small fraction, but perhaps it would have been wise to calculate different WACC's for the footwear and apparel divisions. However, her evaluation of risk related to each division is a defensible one in using a single WACC for the entire company, and we view this as a potential issue, but not as an error per se.

Cost of Japanese debt. The risk related to Japanese debt comes not only from interest rate risk, but also more significantly from foreign currency exposure. This risk has not been accounted for and is actually a more potent risk to the debt than fluctuations in the yield to maturity.

Tax benefit of interest expense related to Japanese debt. Under U.S. tax law, interest expense on non-dollar-denominated debt is not a tax-deductible expense, and thus these notes should not be tax-effected (our analysis, however, remains within the scope of this class and tax-effects the yield to maturity).

Evaluation of Joanna Cohen's Cash Flow ProjectionsOverall, her projections seem fairly sound. She keeps margins fairly consistent, with only slight variations. Revenue growth projections are modest, and the firm seems decent cash requirements. However, there are a few issues with her projections.

Revenue growth projections. Company executives indicated a long-term revenue growth target of 8% to 10% and earnings growth targets of above 15%. Why has she cut her projections? We do not consider her move unreasonable, but we are interested to hear why she did this.

Capital expenditures and depreciation. She projects depreciation and capital expenditures as equal in the future. It is unlikely, considering the projected growth rates, that Nike could grow without increasing capital expenditures. Looking at their historic financial statements, capital expenditures far outweighed depreciation and amortization, and so Cohen has made the mistake of understating cash requirements related to fixed costs. (See appendix 1 for our projection of capital expenditures and depreciation.)

Positive cash requirement for net working capital. In her first year's projection, she shows a cash inflow of $8.8 million related to working capital. Where does this

come from, and why does it occur? Historically, her working capital requirements have been consistently negative, and since she projects the company to grow, we expect the company to use cash in working capital.

Equity value calculation. The calculation of enterprise value to equity value only removes total debt. It should remove net debt and preferred stock, and so has understated equity value.

Shares outstanding. Her figure for shares outstanding does not match the diluted share count on the income statement, nor does it match the common shares outstanding (when net income is divided by common EPS).

Cash flow recognition method. She assumes an end-point method for recognizing cash flows. While this is not uncommon, it is also probably not appropriate, as Nike receives cash flows throughout each period, and thus should recognize the cash flows using a mid-point method.

WACC CalculationSee appendix 4 for full details of our WACC calculation. We calculated the cost of debt using the yield to maturity, considering an upcoming coupon payment is about to be made. Our cost of equity followed the capital asset pricing model, and the two costs were weighted by their levels within the capital structure, using market valuations in weighting the equity value.

RecommendationIn the attached appendices, we calculated our own WACC and projected cash flows, duplicating Cohen's analysis but with corrections as we saw fit (described above). In the appendix, we projected future capital expenditures and depreciation, as we did not agree with Cohen's assertion that capital expenditures will equal depreciation. We then discount the new cash flows subject to new, but similar, criteria, and arrive at an enterprise value. Finally, we calculate an equity value and produce a similar sensitivity chart as shown before.

The model in the appendices employs methods that correct those used by Cohen. We re-projected capital expenditures and depreciation to be more accurate (as appendix 1 demonstrates) and tweaked the discounting methods, as described in the above sections.

Our analysis, in appendix 3, shows equity prices per share at various discount rates. Most values are above the current share price of $42.09. Our chosen discount rate of 9.09% yields a share price of $61.44, or a current under-valuation of the stock of $19.35 (46%) per share. The discount rate that yields no over- or under-valuation (the current price per share) is 11.41% – significantly higher than our discount rate of 9.09%.

Since the date of the case, Nike's stock rose sharply in the following 9 months, proceeded to drop back down to similar levels after 1 year, and continued to grow significantly thereafter. However, in recent months (2008), it has come down. The short run (after the case) validates our analysis somewhat, however, it is extraordinarily difficult to identify a time period that represents the point at which we agree whether a valuation was "correct" or 'incorrect" (and of course, it is also very difficult to identify what constitutes a correct valuation in the first place).

Appendix - http://www.filedropper.com/appendix1to4

 Executive summaryIn this report we focus on Nike's Inc. Cost of Capital and its financialimportance for the company and future investors. The management of NikeInc. addresses issues both on top-line growth and operating performance. The company's cost of capital is a critical element in such decisions and it isimportant to estimate precisely the weighted average cost of capital (WACC).In our analysis, we examine why WACC is important in decision making andwe show how WACC for Nike Inc. is calculated correctly. Also, we calculatethe company's cost of equity using three different models: the Capital AssetPricing Model (CAPM), the Dividend Discount Model (DDM) and the EarningsCapitalization Model (EPS/ Price), we analyze their advantages anddisadvantages and finally we conclude whether or not an investment in Nikeis recommended.Our analysis suggests that Nike Inc.'s common stock should be added to theNorth Point Group's Mutual Fund Portfolio.I. The Weighted Average Cost of Capital and its Importance for Nike Inc. The Weighted Average Cost of Capital (WACC) is the average of the costs of a company's sources of financing-debt and equity, each of which is weightedby its respective use in the given situation. By taking a weighted average,we can see how much interest the company has to pay for every marginaldollar it finances. A firm's WACC is the overall required return on the firm asa whole and, as such, it is often used internally by company directors todetermine the economic feasibility of expansionary opportunities andmergers. Also, WACC is the appropriate discount rate to use in stockvaluation.II. Calculation of Nike's WACC The calculating methodology for Nike's Inc. WACC seems to be inconsistentwith the principles1 that should be followed when estimating this measure. These are our points of disagreement with the calculations in Exhibit 5:- Calculation of the cost of debt by taking the total interest expense for theyear 2001 dividing it by the company's average debt balance, which is notappropriate for the WACC estimation- Use as tax rate the sum of state and statutory taxes instead of the firm'smarginal tax rate- Use of the Book Value of equity rather than the market value which issuggested as it gives more precise results- Calculation of the cost of equity using long time period for risk free rate and

 risk premiumIn order to make our justifications more comprehensive we need the formulafor estimating WACC:WACC= Wd*Kd(1-T) + We*KeFirst, we reexamine the cost of debt (Kd) which in this case is the yield tomaturity (YTM) on the bonds. The YTM is a good estimate for the cost of debtif a company had issued debt in the past and the bonds are publicly traded just as in Nike's case. Our calculations for Nike's yield to maturity based onthe given data showed that Kd= 7.16%.c1 (See Appendix for detailedcalculations) The second variable that should be noted is T or the tax rate. In hercalculations, Joanna Cohen added the 3% state taxes to the 35% statutorytax where in WACC calculation the marginal rate should be used. Themarginal tax rate generally refers to the "federal income tax that is leviedonto the additional dollar earned" and usually is about 40%. The weights of the costs, Wd and We, are very important in calculatingWACC as they show the company's capital structure. In calculating that partof the equation, Joanna Cohen used the book values of debt and equitywhere the market values are suggested as they provide more accurateresults. As book and market values of debt and equity may differ a lot,market values of debt and equity give a closer estimation of the capitalstructure2. We calculate the enterprise value (P0*#shares outstanding =$11,427.4357m). For debt, the book value gives a close estimation for thecurrent value, whereas the same doesn't hold for the value of equity. Thus,debt is equal to $1,296.6m (current portion of L-T debt + notes payable + L- T debt). In finding the weights, the previous explanation shows that equity is88.65% whereas debt is 11.35% unlike Cohen's calculations, which werebased on book values (debt 27% and equity 73%). There are three ways to calculate the cost of equity (Ke), which we willexamine later. In our calculations of WACC we use the Capital Asset PricingModel (CAPM), as it is considered to be the most complete model forestimating the cost of equity.CAPM Equation is: Ke=Krf+ β(Km-Krf)c2,where Ke is the cost of equity, β is beta that measures the tendency of a stock to move up and down with the market, Km is the required return of the market, Krf is the risk free rate and (Km - Krf) is equal to the market riskpremium.For the Krf (risk free rate), we used the current yield on 10yr bond (5.39) U.S.

 treasuries, instead of the 20yr, as the 10yr matches the duration of cashflows for the Nike's investment project (Exhibit 2) and because it is relativelyless exposed to unexpected changes in inflation and the liquidity premiumwhen compared to the longer 20 yr bond3. For the market risk premium, Km- Krf, we used the arithmetic mean (7.5%). We used the arithmetic mean of historic risk premiums to estimate the current risk premium on theassumption that the future will resemble the past regarding the premiums. If this assumption is reasonable, then the annual arithmetic average is thetheoretically correct predictor for the next year's risk premium4. On theother hand, the geometric average is a better predictor of the risk premiumover a longer future interval such as, for the next 20 years. For β weused the historic average of the past 6 years (0.8). After we calculate thecost of equity with CAPM (Ke= 11.39%), we plug our results in the givenformula of WACC and we get WACC=10.59c3.III. Alternative Methods of Calculating the Cost of EquityAlthough, CAPM approach is considered to be an accurate and preciseestimate of Ke, there are two other models used by those analysts who donot have complete confidence in CAPM. These approaches are the DividendDiscount Model (DDM), which compares dividends forecasted for the nextperiod with the current share price for the firm and then adds the growthrate of the firm and the Earnings Capitalization Model

(ECM), whichcompares forecasted earnings for the next period over the current shareprice. Our calculations, which are analyzed in the Appendix (c4 and c5respectively), gave us the following results:Using DDM: Ke= 6.7%Using ECM: Ke= 9.88%We can see that the three different methods of calculating the cost of equityproduced widely varied estimates. In such situations the financial analyst hasto use his/her judgement as to relative merits of each estimate and thenchoose the estimate which seemed more reasonable under thecircumstances.Comparing the already discussed methods, we found that the mainadvantage of CAPM approach is that it takes into consideration a company'smarket risk as the most relevant risk to stockholders, hence to determine theeffect of the new activities and projects of the company on stock price. Thismethod can be applied to firms that do not pay dividends as well as newfirms, by using betas for similar firms (e.g., other firms in the industry).However, with CAPM all our projections are based on historical data onto thefuture, because of the estimate of Beta we use. Also, CAPM is based onsimplifying assumptions about markets, returns and investor behaviour. The dividend discount model (DDM) is a simple model for valuing equity. It is