UV0010

NIKE, INC.: COST OF CAPITAL

On July 5, 2001, Kimi Ford, a portfolio manager at NorthPoint Group, a mutual-fund

management firm, pored over analysts’ write-ups of Nike, Inc., the athletic-shoe manufacturer.
Nike’s share price had declined significantly from the beginning of the year. Ford was
considering buying some shares for the fund she managed, the NorthPoint Large-Cap Fund,
which invested mostly in Fortune 500 companies, with an emphasis on value investing. Its top
holdings included ExxonMobil, General Motors, McDonald’s, 3M, and other large-cap,
generally old-economy stocks. While the stock market had declined over the last 18 months, the
NorthPoint Large-Cap Fund had performed extremely well. In 2000, the fund earned a return of
20.7%, even as the S&P 500 fell 10.1%. At the end of June 2001, the fund’s year-to-date returns stood
at 6.4% versus −7.3% for the S&P 500.

Only a week earlier, on June 28, 2001, Nike had held an analysts’ meeting to disclose its
fiscal-year 2001 results.1 The meeting, however, had another purpose: Nike management wanted to
communicate a strategy for revitalizing the company. Since 1997, its revenues had plateaued at around
$9 billion, while net income had fallen from almost $800 million to $580 million (see Exhibit 1).
Nike’s market share in U.S. athletic shoes had fallen from 48%, in 1997, to 42% in 2000.2 In
addition, recent supply-chain issues and the adverse effect of a strong dollar had negatively
affected revenue.

At the meeting, management revealed plans to address both top-line growth and
operating performance. To boost revenue, the company would develop more athletic-shoe
products in the midpriced segment3—a segment that Nike had overlooked in recent years. Nike
also planned to push its apparel line, which, under the recent leadership of industry veteran
Mindy Grossman,4 had performed extremely well. On the cost side, Nike would exert more effort

1
Nike’s fiscal year ended in May.
2
Douglas Robson, “Just Do … Something: Nike’s Insularity and Foot-Dragging Have It Running in Place,”
BusinessWeek (2 July 2001).
3
Sneakers in this segment sold for $70-$90 a pair.
4
Mindy Grossman joined Nike in September 2000. She was the former president and chief executive of Jones Apparel
Group’s Polo Jeans division.

This case was prepared from publicly available information by Jessica Chan, under the supervision of Robert F.
Bruner and with the assistance of Sean D. Carr. The financial support of the Batten Institute is gratefully
acknowledged. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling
of an administrative situation. Copyright © 2001 by the University of Virginia Darden School Foundation,
Charlottesville, VA. All rights reserved. To order copies, send an e-mail to [email protected]. No part of this
publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any
means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School
Foundation. Rev. 10/05.

.
 -2- UVA-F-1353

on expense control. Finally, company executives reiterated their long-term revenue-growth

targets of 8% to 10% and earnings-growth targets of above 15%.

Analysts’ reactions were mixed. Some thought the financial targets were too aggressive;
others saw significant growth opportunities in apparel and in Nike’s international businesses.

Kimi Ford read all the analysts’ reports that she could find about the June 28 meeting, but the
reports gave her no clear guidance: a Lehman Brothers report recommended a strong buy, while
UBS Warburg and CSFB analysts expressed misgivings about the company and recommended
a hold. Ford decided instead to develop her own discounted cash flow forecast to come to a clearer
conclusion.

Her forecast showed that, at a discount rate of 12%, Nike was overvalued at its current
share price of $42.09 (Exhibit 2). However, she had done a quick sensitivity analysis that
revealed Nike was undervalued at discount rates below 11.17%. Because she was about to go
into a meeting, she asked her new assistant, Joanna Cohen, to estimate Nike’s cost of capital.

Cohen immediately gathered all the data she thought she might need (Exhibits 1 through
4) and began to work on her analysis. At the end of the day, Cohen submitted her cost-of-capital
estimate and a memo (Exhibit 5) explaining her assumptions to Ford.
 -3- UVA-F-1353

Exhibit 1
NIKE, INC.: COST OF CAPITAL
Consolidated Income Statements

Year Ended May 31 1995 1996 1997 1998 1999 2000 2001
(in millions of dollars except per-share data)

Revenues $ 4,760.8 $ 6,470.6 $ 9,186.5 $ 9,553.1 $ 8,776.9 $ 8,995.1 $ 9,488.8

Cost of goods sold 2,865.3 3,906.7 5,503.0 6,065.5 5,493.5 5,403.8 5,784.9
Gross profit 1,895.6 2,563.9 3,683.5 3,487.6 3,283.4 3,591.3 3,703.9
Selling and administrative 1,209.8 1,588.6 2,303.7 2,623.8 2,426.6 2,606.4 2,689.7
Operating income 685.8 975.3 1,379.8 863.8 856.8 984.9 1,014.2
Interest expense 24.2 39.5 52.3 60.0 44.1 45.0 58.7
Other expense, net 11.7 36.7 32.3 20.9 21.5 23.2 34.1
Restructuring charge, net - - - 129.9 45.1 (2.5) -
Income before income taxes 649.9 899.1 1,295.2 653.0 746.1 919.2 921.4
Income taxes 250.2 345.9 499.4 253.4 294.7 340.1 331.7
Net income $ 399.7 $ 553.2 $ 795.8 $ 399.6 $ 451.4 $ 579.1 $ 589.7

Diluted earnings per common share $ 1.36 $ 1.88 $ 2.68 $ 1.35 $ 1.57 $ 2.07 $ 2.16
Average shares outstanding (diluted) 294.0 293.6 297.0 296.0 287.5 279.8 273.3

Growth (%)
Revenue 35.9 42.0 4.0 (8.1) 2.5 5.5
Operating income 42.2 41.5 (37.4) (0.8) 15.0 3.0
Net income 38.4 43.9 (49.8) 13.0 28.3 1.8

Margins (%)
Gross margin 39.6 40.1 36.5 37.4 39.9 39.0
Operating margin 15.1 15.0 9.0 9.8 10.9 10.7
Net margin 8.5 8.7 4.2 5.1 6.4 6.2

Effective tax rate (%)* 38.5 38.6 38.8 39.5 37.0 36.0
*The U.S. statutory tax rate was 35%. The state tax varied yearly from 2.5% to 3.5%.
Sources of data: Company filing with the Securities and Exchange Commission (SEC), UBS Warburg.
 -4- UVA-F-1353

Exhibit 2
NIKE, INC.: COST OF CAPITAL
Discounted Cash Flow Analysis

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Assumptions:
Revenue growth (%) 7.0 6.5 6.5 6.5 6.0 6.0 6.0 6.0 6.0 6.0
COGS/sales (%) 60.0 60.0 59.5 59.5 59.0 59.0 58.5 58.5 58.0 58.0
SG&A/sales (%) 28.0 27.5 27.0 26.5 26.0 25.5 25.0 25.0 25.0 25.0
Tax rate (%) 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.0
Current assets/sales (%) 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.0
Current liabilities/sales (%) 11.5 11.5 11.5 11.5 11.5 11.5 11.5 11.5 11.5 11.5
Yearly depreciation and capex equal each other.
Cost of capital (%) 12.00
Terminal growth rate (%) 3.00

Discounted Cash Flow

(in millions of dollars except per-share data)
Operating income $ 1,218.4 $ 1,351.6 $ 1,554.6 $ 1,717.0 $ 1,950.0 $ 2,135.9 $ 2,410.2 $ 2,554.8 $ 2,790.1 $ 2,957.5
Taxes 463.0 513.6 590.8 652.5 741.0 811.7 915.9 970.8 1,060.2 1,123.9
NOPAT 755.4 838.0 963.9 1,064.5 1,209.0 1,324.3 1,494.3 1,584.0 1,729.9 1,833.7
Capex, net of depreciation - - - - - - - - - -
Change in NWC 8.8 (174.9) (186.3) (198.4) (195.0) (206.7) (219.1) (232.3) (246.2) (261.0)
Free cash flow 764.1 663.1 777.6 866.2 1,014.0 1,117.6 1,275.2 1,351.7 1,483.7 1,572.7
Terminal value 17,998.3
Total flows 764.1 663.1 777.6 866.2 1,014.0 1,117.6 1,275.2 1,351.7 1,483.7 19,571.0
Present value of flows $ 682.3 $ 528.6 $ 553.5 $ 550.5 $ 575.4 $ 566.2 $ 576.8 $ 545.9 $ 535.0 $ 6,301.2

Enterprise value $ 11,415.4

Less: current outstanding debt 1,296.6
Equity value $ 10,118.8
Current shares outstanding 271.5
Equity value per share $ 37.27 Current share price: $ 42.09

Sensitivity of equity value to discount rate:

Discount rate Equity value
8.00% $ 75.80
8.50% 67.85
9.00% 61.25
9.50% 55.68
10.00% 50.92
10.50% 46.81
11.00% 43.22
11.17% 42.09
11.50% 40.07
12.00% 37.27 Source: Case writer's analysis.
 -5- UVA-F-1353

Exhibit 3
NIKE, INC.: COST OF CAPITAL
Consolidated Balance Sheets
As of May 31,
(in millions of dollars) 2000 2001
Assets
Current assets:
Cash and equivalents $ 254.3 $ 304.0
Accounts receivable 1,569.4 1,621.4
Inventories 1,446.0 1,424.1
Deferred income taxes 111.5 113.3
Prepaid expenses 215.2 162.5
Total current assets 3,596.4 3,625.3

Property, plant and equipment, net 1,583.4 1,618.8

Identifiable intangible assets and goodwill, net 410.9 397.3
Deferred income taxes and other assets 266.2 178.2
Total assets $ 5,856.9 $ 5,819.6
Liabilities and shareholders' equity
Current liabilities:
Current portion of long-term debt $ 50.1 $ 5.4
Notes payable 924.2 855.3
Accounts payable 543.8 432.0
Accrued liabilities 621.9 472.1
Income taxes payable - 21.9
Total current liabilities 2,140.0 1,786.7
Long-term debt 470.3 435.9
Deferred income taxes and other liabilities 110.3 102.2
Redeemable preferred stock 0.3 0.3

Shareholders' equity:
Common stock, par 2.8 2.8
Capital in excess of stated value 369.0 459.4
Unearned stock compensation (11.7) (9.9)
Accumulated other comprehensive income (111.1) (152.1)
Retained earnings 2,887.0 3,194.3
Total shareholders' equity 3,136.0 3,494.5
Total liabilities and shareholders' equity $ 5,856.9 $ 5,819.6

Source of data: Company filing with the Securities and Exchange Commission (SEC).
 -6- UVA-F-1353

Exhibit 4
NIKE, INC.: COST OF CAPITAL
Capital-Market and Financial Information on or around July 5, 2001

Current Yields on U.S. Treasuries Nike Share Price Performance Relative to S&P 500:
January 2000 to July 5, 2001
3-month 3.59%
6-month 3.59%
1.3
1-year 3.59%
5-year 4.88% 1.2
10-year 5.39% 1.1
20-year 5.74% 1.0

0.9
Historical Equity Risk Premiums (1926-1999)
0.8
Geometric mean 5.90%
Arithmetic mean 7.50% 0.7
0.6
Current Yield on Publicly Traded Nike Debt* 0.5
Coupon 6.75% paid semi-annually 0.4
Issued 07/15/96
Maturity 07/15/21
Current Price $ 95.60
Nike S&P 500

Nike Historic Betas

1996 0.98
1997 0.84 Nike share price on July 5, 2001: $ 42.09
1998 0.84
1999 0.63 Dividend History and Forecasts
2000 0.83 Paymt Dates 31-Mar 30-Jun 30-Sep 31-Dec Total
YTD 6/30/01 0.69 1997 0.10 0.10 0.10 0.10 0.40
1998 0.12 0.12 0.12 0.12 0.48
Average 0.80 1999 0.12 0.12 0.12 0.12 0.48
2000 0.12 0.12 0.12 0.12 0.48
2001 0.12 0.12
Consensus EPS estimates:
FY 2002 FY 2003 Value Line Forecast of Dividend Growth from '98-'00 to '04-'06:
$ 2.32 $ 2.67 5.50%
* Data have been modified for teaching purposes.
Sources of data: Bloomberg Financial Services, Ibbotson Associates Yearbook 1999, Value Line Investment Survey, IBES.
 -7- UVA-F-1353

Exhibit 5
NIKE, INC.: COST OF CAPITAL
Joanna Cohen’s Analysis

TO: Kimi Ford

FROM: Joanna Cohen
DATE: July 6, 2001
SUBJECT: Nike’s cost of capital

Based on the following assumptions, my estimate of Nike’s cost of capital is 8.4%:

I. Single or Multiple Costs of Capital?

The first question that I considered was whether to use single or multiple costs of capital,
given that Nike has multiple business segments. Aside from footwear, which makes up
62% of its revenue, Nike also sells apparel (30% of revenue) that complements its
footwear products. In addition, Nike sells sport balls, timepieces, eyewear, skates, bats,
and other equipment designed for sports activities. Equipment products account for 3.6%
of its revenue. Finally, Nike also sells some non-Nike-branded products such as Cole
Haan dress and casual footwear, and ice skates, skate blades, hockey sticks, hockey
jerseys, and other products under the Bauer trademark. Non-Nike brands accounted for
4.5% of revenue.
I asked myself whether Nike’s business segments had different enough risks from each
other to warrant different costs of capital. Were their profiles really different? I concluded
that it was only the Cole Haan line that was somewhat different; the rest were all sports-
related businesses. Since Cole Haan makes up only a tiny fraction of revenues, however,
I did not think that it was necessary to compute a separate cost of capital. As for the
apparel and footwear lines, they are sold through the same marketing and distribution
channels and are often marketed in other collections of similar designs. Since I believe
they face the same risk factors, I decided to compute only one cost of capital for the
whole company.
II. Methodology for Calculating the Cost of Capital: WACC
Since Nike is funded with both debt and equity, I used the WACC method (weightedaverage
cost of capital). Based on the latest available balance sheet, debt as a proportion of total capital
makes up 27.0% and equity accounts for 73.0%:
 -8- UVA-F-1353

Exhibit 5 (continued)

Capital Sources Book Values (in millions)

Debt
Current portion of long-term debt $ 5.4
Notes payable 855.3
Long-term debt 435.9
$ 1,296.6
27.0% of total capital
Equity $ 3,494.5
73.0% of total capital

III. Cost of Debt

My estimate of Nike’s cost of debt is 4.3%. I arrived at this estimate by taking total
interest expense for the year 2001 and dividing it by the company’s average debt
balance.1 The rate is lower than Treasury yields, but that is because Nike raised a portion
of its funding needs through Japanese yen notes, which carry rates between 2.0% and
4.3%.
After adjusting for tax, the cost of debt comes out to 2.7%. I used a tax rate of 38%, which
I obtained by adding state taxes of 3% to the U.S. statutory tax rate. Historically, Nike’s state
taxes have ranged from 2.5% to 3.5%.
IV. Cost of Equity
I estimated the cost of equity using the capital-asset-pricing model (CAPM). Other
methods, such as the dividend-discount model (DDM) and the earnings-capitalization ratio,
can be used to estimate the cost of equity. In my opinion, however, the CAPM is the superior
method.
My estimate of Nike’s cost of equity is 10.5%. I used the current yield on 20-year
Treasury bonds as my risk-free rate, and the compound average premium of the market over
Treasury bonds (5.9%) as my risk premium. For beta, I took the average of Nike’s betas from
1996 to the present.

Putting It All Together

Inputting all my assumptions into the WACC formula, my estimate of Nike’s cost of capital
is 8.4%.

WACC = Kd(1 − t) × D/(D + E) + Ke × E/(D + E)

= 2.7% × 27.0% + 10.5% × 73.0%
= 8.4%

1
Debt balances as of May 31, 2000 and 2001, were $1,444.6 million and $1,296.6 million, respectively.