Nike - Discussion and Analysis 1108

Nike, Inc.
: Cost of Capital
Discussion and Analysis
The cost of capital is the rate of return required by a capital provider in exchange for
forgoing an investment in another project, asset, or business with similar risk. For this
reason, it is also known as an opportunity cost. Managers need to estimate the cost of
capital in order to assess business or projects. ince the cost of capital is the minimum
return required by investors, managers should invest only in projects that generate returns
in excess of the cost of capital. !s such, the cost of capital is set by investors, not
managers.
"n general, a single cost of capital for #ike, "nc is sufficient since the task here is to value
the cash flows of the entire firm. Thus, we need a discount rate appropriate for those cash
flows. !lso, #ike$s business segments have fairly similar business risks.
Cost of debt (kd)
"n the case, the analysis mistakenly calculates the cost of debt using historical
information. The %!&& is supposed to represent the return that capital providers will
require today' thus to use a company$s historical cost of debt would be inappropriate.
"nstead, one should turn to market yields to gauge the cost of debt. (ata on a publicly
traded #ike bond issue have been given in case )xhibit *. The yield to maturity is the
proper cost of debt input.
+,- ./0.12
# -34 x 3 - *4
+MT - 5.560
F, - 744
" - 8 5.09: .semiannually2 thus the ytm is 6.71: annually
The after;tax yield to maturity is *.**:
Cost of equity (ke)
<istorical betas must only be used if they provide a good estimate of a stock$s expected
beta. =therwise, an investor must use his or her own estimate of expected beta.
The cost of equity using CAPM is 9.!, using the following assumptions>
?f - 0.6*: 34 year @.. Treasuries
?f;?m- 0./4: Aeometric Mean B
Ceta - 4.1/
B%hy do we use geometric mean8
For example, a security that increases in price from ?p. 7444 to ?p. 3444 during year 7
and drops back to ?p. 7444 during year 3. The annual holding period returns .<+?2
would be>
Dear Ceginning
value
)nding
,alue
<+?
.percent2
?eturn
?elative
7 7444 3444 744 3.4
7
3 3444 7444 ;04 4.0
!n arithmetic mean rate of return would be>
.744 E .;0422 F 3 - 30:
The geometric mean rate of return would be>
G.3.442.4.02H
I
;7 - .7.442
I
;7 - 4.44 4:
"e usin# DDM
#ike$s cost of equity co$es out to %.&!. The growth rate in dividends is 0.0: as
estimated by ,alue Jine .)xhibit *2. The annual dividend was 4.*9. !nd #ike$s share
price was K *3.4/. Lust to keep on your mind that the cost of capital calculation should be
forward;looking. !s such, the ,alue Jine estimate for g is more appropriate. The ,alue
Jine is a very prestigious name in investment field .visit> www.valueline.com2.
"e usin# 'CM
The cost of equity using the earnings capitaliMation model co$es out (.(!.
Ne - )7F+o - 3.53 F *3.4/
)7 is )arning +er hare .)+2 estimates in 3443 .?emember> %e are Luly 0, 34472
+o is current share price.
I$po)tant: The further question is whether the difference between kd and ke is too small
relative to their embedded risks. The cost of equity obtained from using the ((M is
much lower than that obtained from &!+M. "t is also lower than the yield to maturity of
#ike debt .6.71:2, and must therefore be questions; debt cannot cost $o)e t*an equity.
"n this instance, the ((M does not seem to be a reliable model for estimating the cost of
equity in #ike$s case. (ividends are so managed that the growth of a company is often
not well represented by dividends.
ometimes, it may be better to use )+ growth rates as a proxy for dividends.
The ((M is best used for mature, stable;growth companies with a constant and
predictable growth rate in dividends. !lthough #ike has somewhat of a mature business
in @. footwear, the same cannot be said for its apparel and international businesses. "n
conclusion, &!+M approach is the most reasonable estimate.
Debt and 'quity +ei#*ts
Dou should not use book values as the basis for debt and equity weights. Market, #=T
book, values should be used in calculating weights. %e need to use market values in
calculating the weights because we are concerned with estimating how much it will cost a
company to raise capital today. Target weights may also be used in calculating %!&&
since companies will often lever up or down toward a desired debt;equity weighting
.usually toward the average debt;equity weighting in its industry or peer group2.
3
For debt, book values usually approximate market values, but for equity, book values do
not reliably reflect market values. Thus, using debt figures from #ike$s latest balance
sheet .)xhibit 52, the company$s current share price of K*3.4/, and average shares
outstanding of 367 million, the weights for debt and equity are 74: and /4:,
respectively.
,alue Po)tion Cost
(ebt 7,3/6 74: 6.71
+f tock 4.5 4: 9.0 .estimates2
&o tock 77,*36 /4: /.9
The %!&& is>
%!&& - kd.7;t2 B (F.(E+fE)2 E kpf B +fF.(E+fE)2 E ke B )F.(E+fE)2
- 6.71.7;59:2 B 74: E 4E /.9 B /4:
- /.0 :
!t this %!&&, #ike$s equity value is K63.3*.
This value is higher than its current share price of K*3.4/ C@D.
5

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