Case questions answered:

1. What is the WACC and why is it important to estimate a firm´s cost

of capital? Do you agree with Joanna Cohen´s WACC calculation?
Why or why not?
2. If you do not agree with Cohen´s analysis, calculate your own
WACC for Nike and be prepared to justify your assumptions.
3. Calculate the costs of equity using CAPM and dividend discount
model. What are the advantages and disadvantages of each method?
4. What should Kimi Ford recommend regarding an investment in
Nike?
5. 1. What is the WACC and why is it important to estimate a firm’s cost of
capital? What does it represent? Is the WACC set by investors or by
managers?
6. 2. Do you agree with Joanna Cohen’s WACC calculation? Why or why not?
7. 4. Calculate the costs of equity using CAPM, the dividend discount model,
and the earnings capitalization ratio. What are the advantages and
disadvantages of each
8. method? Which method is best for calculating the cost of equity? Which of
these
9. methods be most appropriate particularly for Nike and why?

1. What is the WACC and why is it important to estimate

a firm's cost of capital? Do you agree with Joanna
Cohen's WACC calculation? Why or why not?
The WACC (Weighted Average Cost of Capital) is a firm's cost of capital,
its components allow us to see how much it costs a company to raise
money to finance new projects. Calculating a company's WACC, allows
investors and the company itself to determine an average acceptable
return for projects. By knowing the costs of financing a new project, we
can select projects which offer a return that is higher than the WACC.

We agree with certain elements about Joanna's calculation, we agree

with the assertion that Nike's footwear and apparel divisions share
similar enough risks to warrant one WACC calculation. We also agree
that Cole Haan faces different risks in an entirely different industry but
since it represents such a small fraction of total revenues, we should not
calculate its individual WACC. We agree with Joanna's use of a 38% tax
rate, the U.S. statutory rate is 35% and by adding the average of Nike's
state taxes (2.5%-3.5%) we get a tax rate of 38%. The aforementioned
statements are the only parts of Joanna's calculation that we entirely
agree with.

We disagree with the way she calculated Nike's cost of debt since the
purpose of WACC calculations is to determine the cost of new projects,
we don't believe that using interest expenses for the past year is an
accurate representation of the company's cost of debt. We disagree with
the use of book weights to determine equity's weight in the company's
financing. The final disagreement we have with Cohen's calculations is
her beta calculation for the CAPM, we disagree with taking the average of
Nike's beta through the years and using this as Nike's current beta.

2. If you do not agree with Cohen's analysis, calculate

your own WACC for Nike and be prepared to justify
your assumptions.
The first thing we will do in our WACC calculation is to calculate Nike's
cost of debt. Nike's last issue of debt had a rating of A2 by Moody's or A
by S&P, given on October 25, 2000. Given this rating, we can determine
an approximation of Nike's cost of debt, we will use the 10-year Treasury
rate as our base rate and add the spread required, given Nike's debt
rating. The following chart shows the movement of ten-year Treasury
yields and the spread for S&P companies with different ratings (the red
line represents Nike's rating):
The black line represents the period in question and the dotted line
represent the average yield of A-rated corporate bonds in this period.
Utilizing this graph, we can determine that Nike's cost of debt would be
6.75%.

The second part of our WACC calculation involves the cost of equity, the
required return using the CAPM, just as Joanna did. Joanna estimated a
cost of equity of 10.5% by using 5.75% as the risk-free rate (20-year t
bonds), 5.9% as the market risk premium and a beta of 0.80. Since she
used the current yield on 20-year treasury bonds and the compound
average premium of the market, we will use the same numbers she did,
except for her beta calculation. Instead of averaging Nike's beta from
1996 to the present, we will take the current betas of similar companies
in the same industries and average them. The companies we will use are
Puma, Adidas, Reebok, Skechers, and, obviously, Nike:

Puma's beta: 0.61

Adidas' beta: 0.89

Reebok International's beta: 0.579

Skechers USA's beta: 0.47

Nike's beta: 0.83

(Source: Reuters and InFront Analytics)

Average industry current beta: 0.68

 Our cost of equity calculation is now this:

Rs= 5.75 + 5.90(0.68)

Rs= 9.762%

The final part of our WACC calculation pertains to...

_____________________________________________________________________________________
----

Introduction

The following case is about a portfolio manager who works at North Point Group
named Kimi Ford who is trying to decide whether to buy Nike’s stock. However,
Nike had a negative year which lead in a severe decline in sales growth, decline
in profits and market share due to supply-chain issue and it was adverse effect
of a strong dollar. A meeting was held to look at different strategies where Nike
has revealed that it can boost revenues by having additional exposure in mid-
price footwear and apparel lines as well as exerting more effort in controlling the
expenses. Analysts had very different reactions to Nike’s changes.

Kimi Ford later created her own discounted cash flow forecast (DCF) to get a
clearer conclusion, she asked her assistant Joanna Cohen to estimate the cost
of capital. The aim of this case and analysis is to find and show the mistakes
that are arising when estimating the cost of capital which was done by Cohen.
When estimating the cost of capital she used a single cost instead of a multiple
one and we agree with her. Even though there are different business segments
for Nike, they all seem to have the same risk, thus using a single cost is more
effective. This case shows the importance of weighing a company’s stock prior
to buying them via using valuation models which is the WACC the importance of
carefully selecting of carefully selecting the variables that are used in the WACC
formula.

1. What is the WACC and why is it important to estimate a firm’s cost of capital?
What does it represent? Is the WACC set by investors or by managers?

The weighted average cost of capital (WACC) is simply the cost of the individual
sources of capital. Capital is almost usually comprised of the equity that
shareholders decided to in a company, or the debt that the lenders decided to
invest in a company, with each source being individually being proportionally
weighted. Calculating the WACC is important as when using that capital in any
way would be an opportunity cost to the investors as that any capital that is
being invested can be used in any other investment. In calculating the WACC the
shareholders or lenders would be able to estimate the return that they would be
able to earn when they decide to the invest in this company.

WACC is set by investors not by the managers, as it assists when they choose
their final decision in the whether to proceed with that particular investment or
not. Having the calculated the WACC which is the minimum rate of return that
the investor will accept, for the investor they can find the yield that they will
receive as their return by deducting the WACC from the company’s returns. If the
WACC > Company’s returns investors would go ahead with their decision to
invest. However, if the WACC < Company’s returns then the investor will withhold
his decision to invest.

2. Do you agree with Joanna Cohen’s WACC calculation? Why or why not?

No we don’t agree with Cohen’s Weighted Average Cost of Capital for these
reasons:

1. She calculated the weights of debt and equity using book value rather than
market value. Book value is the price paid for an asset that will never change as
long as you own that asset. Therefore, she did a mistake by using historical data
in estimating the cost of debt as it is a must for her to use the market value,
based on current data. The reason behind this decision is it shows how much it
will cost the firm to raise the capital today.

2. Using historical data doesn’t reflect Nike’s current or future cost of debt,
therefore Cohen’s cost of debt calculation which was done by taking the total
interest expense for 2001 and dividing it by the company’s average debt balance
is wrong. She should have instead calculated the yield to maturity on a 20-year
debt basis with a coupon rate that is paid semiannually.

3. Another error that was done was using the average beta (from 1996-2001),
which is 0.80, this number doesn’t represent the future systematic risk, so it is
better to use the most recent beta (0.69)

3. If you do not agree with Cohen’s analysis, calculate your own WACC for Nike
and justify your assumptions?
Weights of Equity and Debt:

Market value of equity = (Current Share Price x Current Shares Outstanding)

= $42.09 x 271.5 million

= $11,427.44 million.

There is not enough information to find the market value of debt, therefore, we
are going to use the book value for computing:

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, = = 89.81 % whereas = = 10.19%

In order to find cost of debt, what we need to do is to calculate the YTM (yield to
maturity) of Nike’s bonds so that we can be able to represent the most recent
cost of debt.

Current price (Po)= $95.60, Issued date= 07/15/96. Maturity date= 07/15/21,
Coupon Rate= 6.75% (Semiannually), Payment (PMT)= , PAR value = $100, a 25-
year bond (year 1996 minus year 2021) and since the case is in 2001 the bond
was issued 5 years ago therefore N= (25-5) x 2= 40 paid semiannually. This can
be calculated by either using an excel worksheet or by using a financial
calculator. To calculate the YTM, we can either use the financial calculator or
the excel sheet and the result would be; r= 3.58% Semiannual. Rd= 3.58% x 2=
7.16%.

So the after tax cost of debt = 7.16%(1-38%) = 4.439%

To compute the Cost of Equity (CoE), we used the 20-year treasury bond rate
(5.74%) to represent the risk free rate as this rate is considered the longest one
available. Choosing the 20-year rate is the most applicable, since the CoE and
the WACC are actually used to discount cash flows in the long-term as well as
the WACC calculations below depend on a mix of debt and equity weights both
being long-term. Another reason why choosing this maturity is that long-term is
better than short-term as the cumulative from 20-years is accurate that a 1-year
figure. So the Rf used is equal to 5.74%.

The next step is to find the market risk premium, we used from the historical
equity risk premium. The geometric mean is (5.90%) as it is actually
compounded the returns where as the arithmetic mean can actually overstate
the return. So the risk premium = 5.90%.

The beta used is the most recent one for 6/30/01 which is equal to 0.69.

Re=Rf +B * (Market Risk Premium)

= 5.74%+0.69 (5.90%)

= 9.811%

The tax rate that was taken was the same as what Joanna Cohen took which
was computed by adding the US statutory tax rate with the state taxes (35%+3%
= 38%), so the tax rate taken is 38%.

Weighted Average Cost of Capital (WACC)= Wd x Rd x (1-T) + We x Re

=10.19% x 7.16% x (1-38%) + 89.81% x9.811%

= 9.264%.

4. Calculate the costs of equity using CAPM, the dividend discount model, and
the earnings capitalization ratio. What are the advantages and disadvantages of
each method? Which method is best for calculating the cost of equity? Which of
these methods be most appropriate particularly for Nike and why?

Cost of Equity RE :-

a. Using Dividend Discount Model (DDM)

RE = D1/P0 + g D1 = D0 (1+g)

D0 = 0.48; g = 5.5%  

D1 = 0.48 x (1+ 0.055)= 0.5064

P0 = 42.09 RE= D1/P0 + g = 0.5064/42.09 + 5.5%= 6.70%

Based on the above calculations, we can see that after June 30, 2001 the
company did not pay any dividends to its shareholders, so this model (DDM) is
not useful since it doesn’t reflect the intrinsic cost of capital.

Advantages of this model;

· There is a flexibility in forecasting the future dividends.

· It assists in the approximations, no matter the impact of the inputs.

· Helps in sensitivity analysis and analysis of markets variations to changing

situations

· Method is very simple.

Disadvantages of this model;

· The model is not suitable to use in many cases so it will result in inaccurate
answers.

· High sensitivity to minor variations in the inputs of the models and assumptions

· The model assumes that the company pays substantial dividends that will grow
at a constant rate.
· It carries no consideration for systematic risk.

b. Using Earning Capitalization Model

ECM= E1 / P0 = 2.16 / 42.09 = 5.13%

E1: forecasted earnings, current diluted earnings per share P0: stock price
today.

This model is not recommended due to that that it ignores the potential growth
of the firm.

Advantages of this model;

· It helps in predicting the earnings

· It carries consideration for the forecasted earnings and the current price of the
stock.

Disadvantages of this model;

· It ignores the growth of the company

· This model is not appropriate for the firms with no growth

· The estimates may not be accurate

· It has errors in the current capitalization rate.

c. Using Capital Asset Pricing Model(CAPM) to calculate RE:

RE = RRF + (RM – RRF) x Beta

→RE =5.74% + 5.9% x 0.69 = 9.811%

The model is the recommended way to calculate the cost of equity for Nike Inc.,
as it is very simple to apply, an addition to that it includes the most important
variables for instance Beta (systematic risk), risk free rate and also market
return.

Advantages of this model;

· Simple

· Applied in practice

· Adjusts for risk

· Can be used by companies that do not have steady dividend growth

Disadvantages of this model;

· Unrealistic assumptions specially in estimations of risk free rate

· Sometimes it fails in explaining the behaviors of the investors and the used
beta will not be successful in capturing the risk of investment
· Difficult to validity

· Predicts future based on past (there is change in economic conditions)

· It is important to consider the market value, book values ratios, as it is highly

relevant to return.

5. What should Kimi Ford recommend regarding an investment in Nike?

The calculated WACC is 9.27% and the present value per share is $58.13
(15,782.295/271.5). This shows that the present value is higher by 1.38 times
than Nike’s current market price of $42.09. The shares price of Nike is
undervalued by $16.04 (58.13-42.09) as Nike is presently trading in 2001. The
current growth rate that is about 6 to 7% is much lower than the one estimated
which was 9.27%. This value is considered majorly understated. Nike Changed
their business technique by focusing in mid-priced segment, which for a long
time was less concentrated. This means that there is a possibility for their sales
total to increase that that will lead to an increase in revenues and profit. In
addition to this Nike’s share prices and dividend will be increased in the long-
term.

Based on these records, we recommend to the North Point Large-Cap Fund to

buy Nike’s shares, because the stock is currently undervalued and it has a major
growth potential that will be beneficial to the fund. In addition to this, the goals
that were set by the management of Nike Inc. could be a great source of profit.
Also by the past performance of Nike Inc. shares against the market index,
technical analysis supports the buy decision. The past performance shows that
Nike can out preform the current market returns and now that it has gone down,
it is left with the hope for an increase based on the plans being set up.

Conclusion

In conclusion, before buying Nike Inc. shares, Kimi Ford must decide whether
she wants the shares for long or short term. If it is for the long-term, then the
decision to invest is a good one and if it is for the short-term she should be
cautious about the fast changing industry the changes that Nike is doing and
also changes in the footwear trends. However, based on historical, recent and
future data the decision that Kimi should consider that is to buy Nike’s shares
for the reason that it is quite safe, currently undervalued and has great potential.