Nike, Inc: Cost of Capital

“Application of Concepts in Capital Costing

to provide relevant assistance
in Investment Decisions.”

A Case Study in fulfillment of the requirements for

AC 60: Financial Markets
at

CENTRAL MINDANAO UNIVERSITY

College of Business and Management
Department of Accountancy

Submitted by:
Christine G. Uriarte

Submitted to:
Ms. Rose Mae S. Langot, CPA, MSA

April 27, 2020

 Background of the Case

As a portfolio manager of a mutual fund management firm – NorthPoint Group, Kimi

Ford is facing an investment decision of whether to buy shares of Nike, Inc. In its recent
financial report and status, it showed that Nike, Inc. experienced significant decline in share
price, profits, and market share. Moreover, supply-chain issues and the adverse effect of a
strong dollar are viewed as factors that caused negative impacts on the company’s revenue.

In their analysts’ meeting, Nike devised a strategy to boost revenues by entering the
mid-priced segment, joining the market of apparel line, and exerting more effort on expense
control. Its management plans focus both on top-line growth and operating performance.
This action elicited different reactions from analysts varying from views of being too
aggressive to seeing significant growth opportunities of the company.

The various analysts’ reports gave no clear guidance for Ford. Instead, she
developed her own discounted cash flow forecast to come to a clearer conclusion and asked
her assistant, Joanna Cohen, to estimate Nike, Inc.’s cost of capital. Cohen proceeded using
single cost of capital for the entire company despite Nike’s multiple business segments and
made use of the weighted-average cost of capital (WACC) as the suitable method in
calculating Nike’s cost of capital.

The case demonstrates the relevance of calculating a company’s stock prior to

arriving at a decision of investing or withholding through the WACC valuation model. It
includes the careful selection of data and variables, which are also essential in valuation, to
be applied in the model and hence, be able to attain a well-informed decision.

Statement of the Problem

Kimi Ford is about to decide wisely in investing or not in Nike, Inc. and stock
valuation methods are sought to help her decide. Her assistant, Joanna Cohen, aided her in
computing for Nike, Inc.’s cost of capital. However, there seems to be a need to identify and
correct possible errors that were overlooked in calculating the aforementioned company’s
cost of capital.
 Discussions

This section will identify and elaborate key variables that must be considered in Nike
Inc.’s stock valuation.

1. Estimating Costs of Capital

Cost of capital is the overall cost of the funds to finance a firm’s assets and
operations, which typically is some combination of debt and equity financing [ CITATION
Ber131 \l 1033 ]. The estimation of such is important in making capital budgeting
decisions and even with investments decisions. One step of the valuation is choosing
either: single or overall cost of capital for a company with similar business segments or
with different business segments still having similar risk; and multiple or divisional costs
of capital for a company with different business segments having different risks.

It is not logical to use the overall cost of capital to discount divisional cash flows
that don’t have the same risk as the company’s average cash flows [ CITATION Eug17 \l
1033 ]. Despite Nike, Inc.’s involvement in multiple business segments, a single cost of
capital was used for estimation instead of multiple costs of capital. It is reasonable since
Nike’s different business segments seem to have similar risks.

2. WACC and Debt and Equity Weights Calculation

The capital of the company consists of various components. Consequently, to

calculate the total cost of capital, the weights of each component must be identified and
be used in the calculations known as the WACC. In the Nike Inc. case, the weights of
debt and equity were calculated using book value instead of market value. The use of
book value will not reflect accurate returns as it differ significantly with the market value.
Moreover, the cost of capital is calculated in comparison with the market hence, recent
data must be used. However, if market value is not available, the book value can be
used as in the case of Nike’s debt. Using the market value, the weights of debt and
equity are as follows:

Market Value of Equity = (Current Share Price x Current Shares Outstanding)

= $42.09 x 271.5 million
= $11,427.435 million.
Market Value of Debt = (Current Portion of Long-Term Debt + Notes Payable +
Long-Term Debt)
= $5.4 m + $855.3 m + $435.9 m
= $1,296.6 million

Therefore, Weight of Equity = $11,427.435 m/($11,427.435 m + $1,296.6 m) = 89.81%

Weight of Debt = $1,296.6 m/($11,427.435 m + $1,296.6 m) = 10.19%

3. Cost Of Debt and Cost Of Equity

A more appropriate calculation for the cost of debt can be done compared to taking
total interest expense for 2001 and dividing it by the average debt balance. It is through
computing for the yield to maturity of Nike Inc.’s bonds which can represent the most
recent cost of debt. The following data can be used: a 25 year bond paid semiannually
with 20 years remaining to maturity; current price = $ 95.60; issued date = 07/15/96;
maturity date = 07/15/21; coupon rate 6.75%, semiannually; payment = $3.375; PAR
value = $100; and yield to maturity = 7.16% derived from 3.58% x 2 (using financial
calculator).

To find the after tax cost of debt = effective interest (1- tax rate)
= 7.16%(1-38%)
= 4.4392%

The calculation for the Cost of Equity as what have been done in the case was
reasonable except for the use of an average beta. The 0.80 average beta does not
represent the future systematic risk. The more recent beta should have been used
particularly the 0.69 beta dated 6/30/01. However, the use of CAPM was suitable since it
retains simplicity while still being able to consider significant variables such as the beta
or the systematic risk, the risk free rate, as well as the market return. Using the 20 year
bond rate as the benchmark of the risk free rate also entails relevance since the cost of
capital is paralleled to a long term valuations. Using the geometric mean as basis for the
market risk premium is likewise appropriate since geometric mean takes into account the
effect of compounding, therefore, better suited for calculating the returns. Arithmetic
mean may only provide accurate results if data sets are not skewed and independent.

To find cost of equity using CAPM = risk free rate + (market risk premium x beta)
 = 5.74% + (0.69 x 5.90%)
= 9.811%

4. Weighted Average Cost of Capital

Consequently, the Weighted Average Cost of Capital (WACC) is computed using the
respective weights and costs of debt and equity.

WACC = (weight of debt x cost of debt) + (weight of equity x cost of equity)

= (10.19% x 4.4392%) + (89.91% x 9.811%)
= 9.27%

Recommendations

To provide fitting calculations of Nike Inc.’s cost of capital to Kimi Ford and hence,
come up with informed decision the following differences from Joanna Cohen’s calculation
must be considered:

1. Calculating through the use of market value instead of book value in computing
for weights.
2. Figuring cost of debt based on Nike Inc.’s yield to maturity of bonds rather than
interest expense for the year and average company debt.
3. Using a recent beta over an average beta to avoid an inclusion of unsystematic
risk.

Considering the above variables will give a WACC of 9.27% and a present value per
share of $58.13 which is apparently higher than Nike Inc.’s current market price of $42.09
and is therefore undervalued by $16.04. Nike Inc.’s strategy of focusing in mid-priced
segment, joining the market for apparel line, and effective minimization of operating
expenses may potentially boost their performance to positive results. In addition, the
estimated growth rate of 9.27% is relatively lower compared to its current 6 to 7 percent.
Looking at the figures and derivations, much can be expected from Nike, Inc. in the long run
thereby making Nike, Inc.’s shares to appeal as a good buy.

Conclusion
 An informed decision can be achieved by maximizing available quantitative and
qualitative information. In Nike Inc.’s case, financial reports and information about their
strategic measures had been provided which made way for a possible better valuation
although still vulnerable to estimations. The case provide emphasis that looking for ways to
value investments are still better than having an uncalculated jump to risks. Kimi Ford, can
and must make use of the relevant quantitative and qualitative resources.

The shares of Nike Inc.’s seemed to be a good buy especially if the investments will
be made for longer terms for the following reasons: the company is a built up one and had
already penetrated deep in the market which made it appear like a safe deal; the shares are
currently selling at a discount and are therefore advantageous to investors; and there is an
emerging potential that the company will perform good especially in the longer run.

Lastly, investors should always be vigilant and cautious about their investments. A
quick measure to cope up with fast industry changes is another key area. It is not that bad to
expect positive returns of investments in the future but it is still better to be aware of the
trends and be prepared to deal with it.

References

EDUCBA. (2020). Retrieved April 27, 2020, from EDUCBA: https://educba.com/geometric-mean-vs-

arithmetic-mean/

Bertrand C. Liang MD, P. M. (2013). The Pragmatic MBA for Scientific and Technical Executives.

Brigham, E. F., & Ehrhardt, M. C. (2017). Financial Management: Theory and Practice. Cengage
Learning.

Brigham, E. F., & Houston, J. F. (2009). Fundamentals of Financial Management. Mason, OH 45040:
Cengage Learning.