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Nike, Inc. : Cost of Capital Case 14 A Case Brief Submitted to Submitted by In Partial Fulfillment of the Requirements for Date Submitted September 28, 2011 Summary This case highlights Kimi Ford, a portfolio manager with NorthPoint Group, a mutual-fund management firm. She managed the NorthPoint Large-Cap Fund, and in July of 2001, was looking at the possibility of taking a position in Nike for her fund. Nike stock had declined significantly over the previous year, and it appeared to be a sound value play.
Nike had held an analysts’ meeting one week earlier to release the company’s fiscal results for 2001. Apparently Nike had an ulterior motive; the management wanted this opportunity not only to release their fiscal results, but to convey a strategy to revitalize the company as well. Revenues had been relatively flat since 1997, and net income had decreased over that time (EXHIBIT 1). They had lost 6% of the market share, realized some supply-chain problems, and were suffering negative effects as a result of the strengthening U. S. dollar.
At the analysts’ meeting Nike unveiled plans to remedy both the revenue growth, or lack of, and the operating performance. The company planned to grow revenues through the development of more mid-priced athletic shoe products, and by putting more emphasis on their apparel line. Nike also stated that they would be more focused on controlling their expenses. In addition to this, Nike’s executives reaffirmed their long-term revenue-growth targets of 8% to 10% and earnings growth targets of more than 15%. The analysts’ had mixed reactions.
While some thought that Nike might be a bit aggressive with their growth targets, others felt there were real growth opportunities in apparel and the international business. Ms. Ford read all the reports covering the analysts’ meeting and could not see any clear consensus. So, she decided to create her own discounted cash flow forecast. Her forecast (EXHIBIT 2) showed that, at a 12% discount rate, Nike was overvalued at a price of $42. 09. Ms. Ford also found that at a discount rate below 11. 17%, the company was undervalued.
In order to be more confident in her forecast, she asked her assistant to estimate Nike’s cost of capital. Nike’s Estimated Cost of Capital Ms. Ford’s assistant estimated Nike’s cost of capital to be 8. 4%. This is based on four main assumptions. First, a single cost of capital for all of Nike’s various business segments will be sufficient, rather than using a business segment specific cost of capital. Seeing as footwear made up 62% of revenues, and that all the significant segments were sport related, the assistant felt that the risk factors were similar for all of the business segments.
Next, since Nike was funded through both debt and equity, the WACC was used to calculate the cost of capital. Third, the cost of debt was estimated to be 4. 3%. This was calculated by taking the interest expense for the entire year of 2001 and dividing it by Nike’s average debt balance. Tax adjusted, the cost of debt is 2. 7%; this uses a tax rate of 38% based on a state tax of 3% and the U. S. statutory tax rate. Lastly, the CAPM was used to estimate the cost of equity.
Using the current yield of the 20-year Treasury bond as the risk-free rate, the compound average premium of the market over Treasury bonds as the risk premium, and the average of Nike’s betas from 1996 to 2000 as the beta, Nike’s cost of equity was estimated to be 10. 5%. Validity of the Assumptions Single Cost of Capital The first assumption is that using a single cost of capital versus using multiple costs of capital is accurate. The assistant points out that all of the company’s segments are sports-related except for Cole Haan; however, that particular segment does not contribute significantly to Nike’s revenues.
Therefore she justifies labeling all of the segments as having the same risk. While this is probably a safe assumption, I believe that multiple costs of capital might be used for one main reason. The majority of Nike’s products are sports-related, but they are not all related to the athlete’s performance. The footwear that an athlete uses is typically chosen for some sort of performance enhancing quality. Basketballs shoes have more ankle support and technology to increase the athlete’s jumping skills. Football and soccer shoes are more focused on enhancing traction.
Apparel such as socks, jerseys, and track suits are not known to have an effect on the athletic performance itself. It is possible that this difference in the products justifies different risk rates for the various business segments. Methodology Using the WACC is an accurate method of estimating a firm’s cost of capital. Seeing as Ms. Ford and her assistant did not know Nike’s target capital structure, basing the capital structure on the current capital components of 27% debt and 73% equity is acceptable.
The methodology is sound. Cost of Debt The assistant estimates the cost of debt based on the interest expense for the year 2001and Nike’s average debt balance. I believe this assumption to be flawed. The cost of debt should never be based on the coupon rate of a firm’s existing debt. It should be based on the interest rate that Nike would pay if the company issued new debt at that time. If new debt can be issued at the about the same rate as existing debt, then this is not an issue.
On the other hand, if new debt would be issued at a relatively higher or lower rate than existing debt, this would mean that the estimated cost of capital is not accurate. Cost of Equity The assistant estimated the cost of equity using CAPM. She uses the current yield on the 20-year Treasury bonds as the risk-free rate. The geometric mean of historical equity risk premiums is used as well. While the geometric mean might be the better estimate for the longer-term risk premium, the arithmetic average may better represent the risk premium for the sample period.
If the arithmetic average is used, Nike’s cost of equity will be higher than if the geometric mean is used. The cost of equity comes out to 11. 74% when the arithmetic average is used. The assistant’s estimate of the beta using the average of all betas over the five years is adequate. This was a fair estimate. Conclusion Ms. Ford’s assistant’s methodology is reasonable, and most of her estimates are fair. However, the few flaws in her calculations are significant enough to warrant a new estimate. Ms. Ford should not value Nike’s stock using the cost of capital of 8. 4%.