KATHMANDU UNIVERSITY SCHOOL OF MANAGEMENT

Financial Management Case analysis: Nike Inc.: cost of capital

Submitted By:
Group 4 - MBA (2nd term) Sugam Adhikari (12301) Sneha Amatya (12303) Suraj Bansal (12304) Monika Maheshwari (12319) Rojen Shestha

Date: 20th August 2012

Synopsis
The company's cost of capital is a critical element in decision making and is important to estimate precisely the weighted average cost of capital (WACC). Kimi Ford, a portfolio manager of a large mutual fund management firm, is looking into the viability of investing in the stocks of Nike for the fund that she manages. In this case, Kimi Ford asked her new assistant Joanna Cohen to estimate the Nikes Cost of Capital with a keen interest to add Nikes share to her portfolio. Cohen, later, came up with the cost of capital of 8.4% that was contradictory to Fords cost of capital of 12%. This case addresses the flaws in Cohens assumption and recalculates the WACC to obtain the most accurate cost of capital. On the other hand, Nike management addressed several issues that were causing the decrease in market sales and prices of stocks. On this regard, management was presenting its plans to improve and perform better. The Stock being a sound investment was a big question? Thus we tried to see whether the stocks of Nike was a good buy or not and we have recalculated the WACC of Nike as many mistakes were found in the one calculated by Joanna. Thus we tried to conform to all the principles of finance to calculate the WACC and found that the stock of Nike was undervalued as the WACC was found to be 9.54% and we calculated that below 11.2% the stocks of Nike was undervalued. This makes Nike a good investment and Joanna should buy the stocks of Nike even though the revenue has decreased as there is future growth potential in the stock which will lead to great returns for the investors. Not only that but we also tried to justify our findings by calculating the various financial ratios such as the profitability ratio, net margin ratio, liquidity ratios, investment ratios and the debt ratio. We also performed the SWOT analysis of Nike to determine the strength and opportunities of the firm which will subsequently lead to growth in the value of the stocks of the firm. Thus we support the opinion of Lehman Brothers as a Strong Buy as the stock of Nike can yield higher return to the investors in the future.

Joanna Cohens WACC calculation

A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm. Here in the case Joana Cohen has calculated the WACC by using the formula: WACC= Kd (1-t)*D/ (D+E) + Ke* E/ (D+E) Joanna has calculated the WACC on the basis of various assumptions and the appropriateness of the assumptions are mentioned below:

Single cost of capital:

Joanna has computed only one cost of capital for the whole company. Nike has multiple business segments. Aside from footwear that makes 62% of the revenue, Nike also sells apparel that makes 30% of the apparel complementing its footwear. Nike also has some of the non- Nike branded products such as Cole- Haan line, ice skates, skate blades, hockey sticks, hockey jerseys and many other products. But then while comparing these business segments whether they had different enough risks from each other or not she concluded that it was only the Haan line whose profile was different from the others. Moreover Haan line comprised only a small portion of the revenues so she calculated only one cost of capital for the whole company. This analysis seems very fair. Since the apparel and footwear are sold through the same marketing and distribution channels so they face same risk factors. Hence it is better to use only one cost of capital. But Nike has been planning to develop more athletic shoe products in the mid-priced segment which it was overlooking for many years and as well as to push its apparel line which is recently doing well. Due to this, the mid- priced athletic shoes could be treated as a new product and thus may have a different risk as compared with the other business segments. Thus due to this reason multiple cost of capital especially for the new project, is reasonable. Since for every new project a different WACC is calculated due to the difference in the mixture of debt and equity used for every project. However, the data like the rate of return, mixture of debt and equity, weight-age of capital for these new projects are not mentioned in the case.

Cost of Equity Calculation:

The cost of capital is the rate of return that a firm must earn on the projects in which it invests to maintain the market value of its stock. Usually there are two methods to calculate the cost of equity: Discounted cash flow, and CAPM. Joanna has used CAPM method to calculate the Cost of Equity. According to CAPM method: Ke= Rf + (RPm) Joanna has assumed the risk free rate for 20 years on the U.S. Treasuries. However the investment horizon is of 10 years (as per Exhibit 2). It would have been appropriate had she used the similar investment horizon i.e. at 10 years investment horizon on the treasuries. For the other factor required in the formula of CAPM that is risk premium on the market (RPm) she has used Geometric Mean (GM) to calculate the risk premium. Hence this seems to be appropriate as GM considers the compounding effect (Time value effect). Also GM is appropriate if a longer investment horizon is used. To calculate the Cost of Equity Joanna has used average method i.e. she took the average of the past betas from 1996-2000. This seems appropriate but if she had beta for more years, this would also include the riskiness and a more systematic risk would had been obtained. But calculating for this horizon is also appropriate.

Cost of debt calculation:

It is the effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; however, because interest expense is deductible, the after-tax cost is used. The major sources for the debt were current portion of long term debt, Notes Payable, long term debt. Joanna has calculated the cost of debt by simply dividing the total interest expenses by average debt balance. However the Yield to Maturity method to calculate the cost of debt gives more accurate information. Hence this method used by Joanna seems to be quite inappropriate to calculate the cost of debt. Also after evaluating the cost of debt the tax rate is deducted to obtain the required cost of capital. Joanna has used a tax rate of 38 % which she obtained by adding state taxes of 3% to the U.S. statutory tax. This seems to be appropriate but had she used the marginal tax rate the data would had been more appropriate. But this marginal tax rate could not be
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calculated as the data is not given. Marginal tax rate is the tax rate that is applicable to the company on the additional income.

Weightage used for capital structure:

The weightage Joanna has used to calculate is the book value of equity and debt. But it is better to use the market value as the true picture of the firm is shown by the market value. Hence it is more appropriate to use the market value for determining the weights.

Evaluation of Joanna Cohen's WACC Calculation

Hence, Cohen's WACC calculation has a few issues, and a number of errors, as described below. Weighting the capital structure: She weights the capital structure using the book value of equity. Nike is a public company, and its market value is a more relevant for equity than the book value of equity. Cost of debt: To calculate the cost of debt, Cohen simply divided the interest expense by the average balance of the interest. This is not accurate. The cost of debt should include the current market yield on Nike's publicly traded debt. Decision to use only one WACC: Joanna divided each division by revenue. In deciding whether to use an overall WACC, or to assign a WACC to each segment, she has assumed that the risks of the segment are same and thus she has used a single WACC. But since in the case its given that the Nike is also about to explore new segments, hence it would be better to calculate the multiple WACC. Cost of Japanese debt: The risk related to Japanese debt comes not only from interest rate risk, but also more significantly from foreign currency exposure. This risk has not been accounted for and is actually a more risky to the debt than fluctuations in the yield to maturity.

Mistakes that Joanna Cohen made in her analysis:

Joanna Cohen has made various mistakes in calculating the WACC and has gone against various principles in finance for the calculation. As we know that even a minor increase or decrease in the WACC brings about a vast swing in the cost of financing for the company. Therefore analyst should be very careful as well as practical while calculating the WACC. WACC is normally used in the investing decision in a company. It is the total cost of financing which in turn is the return that the investors expect out of investing in the company. These are the mistakes made by Joanna while calculating the WACC:

Value of equity:
The first thing that she did is she calculated the WACC on the basis of the book value of equity. This made the weight of equity to appear a lot less than what it actually is. This leads to wrong projection of the portion of equity in the total capital which will jeopardize the weighted average cost of capital. Had she used the market value of cost capital in her calculation of weight then she would have found that the market value of equity as (271.5 $42.09) = $11427.435. Hence, the weight of equity would be 89.95% of the total value of capital.

Value of debt:
The value of debt has also been calculated at the book value which will provide misappropriation in the weights of the debt and equity in the WACC calculation. Taking the market value for the debt value calculation would have been more appropriate as it provides a more real scenario in the weighted cost calculation. Thus we calculate the market value of debt as $1277.42 which brings the weight of debt down to 10.05% of the total value of capital. And the total value of capital would be $12704.86.

Cost of debt:
The cost of debt has been calculated by taking the total interest expense for the year 2001 and dividing it by the companys average debt balance and the cost of debt was calculated as 4.3%. This is a wrong method to calculate the cost of debt. Here the cost of debt should be calculated by calculating the yield to maturity (YTM). We have calculated the cost of debt by using the formula for YTM and the cost of debt is found to be 7.18%. Therefore the after tax cost of debt is 4.4516%.

Tax rate:
The tax rate used is the addition of the statutory tax rate that is 35% and the state tax rate that is kept at 3% as Nikes state tax rate ranges from 2.5% to 3.5%. It would have been
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better if the firms marginal tax rate was used instead of this tax rate as this provides a more real picture of the after tax cost of debt and subsequently affects the weighted cost of debt in the weighted average cost of capital. But in our calculation due to the lack of sufficient information related to the tax in the case we are also compelled to use the same tax rate as used by Joanna Cohen.

Cost of equity:
The cost of capital has been calculated on the basis of 20 year term Treasury bond as the risk free rate and the compound average premium of the market over Treasury bonds i.e. 5.9% as the risk premium. This has not been justified as the cash flow of only 10 years has been provided. Also matching the investment horizon and the term of the risk free rate would have been a more appropriate approach to calculate the cost of equity. Joanna Cohen has used long term risk free rate and risk premium which might be an inappropriate move towards calculation of the cost as small change can lead to huge difference in the total cost. Therefore we have used the 10 year Treasury bonds rate as the risk free rate and kept the geometric mean equity risk premium as geometric mean considers the time value and is useful for long term investment horizon.

Calculation of WACC
1. Market Value of Equity (E) Calculation: E= Stock Price X Number of Shares Outstanding = $42.09 X 271.5 = $11,427.44 2. Value of Debt Market Value of Debt (D) Calculation: D= Current LT Debt + Notes Payable + LT Debt (435.9 X 95.60) 100* = $5.40 + $855.30 + $416.72 = $1,277.42 *Par value of Nikes Bond is assumed to be $100. Using the above figures, we can now find out the market value of Nike Inc., and the companys capital structure.

3. Weightings The weights of debt and equity are calculated using the market values of debt and equity as follows:

Weight of Debt(Wd)

Weight of Equity(We)

Wd = D/(D+E) =1277.42/(12704.86) =10.05%

We=E/(D+E) =(11427.44/12704.86) =89.95%

We have not used redeemable preferred stock as no sufficient information about it (like dividend costs) is given in the case. 4. Cost of Debt and Equity In order to find an accurate WACC we need to find the correct costs of debt and equity. For the risk free rate, we used the current yield on 10 year bond (5.39) U.S. treasuries, instead of the 20 year, as the 10 year matches the duration of cash flows for the Nike's investment project (Exhibit 2) and because it is relatively less exposed to unexpected changes in inflation and the liquidity premium when compared to the longer 20 year bond. Likewise choosing the appropriate market risk premium is also very important. There are two historical equity risk premiums given for a time period from 1926 to 1999: Geometric mean and arithmetic mean. The geometric mean is a better estimate for longer life valuation while the arithmetic mean is better for a one-year estimated expected return. Therefore, we chose to use the geometric mean to coincide with the choice to use the 10-year yield on U.S. Treasuries, which is 5.9 percent. Next, we have to select the beta to use for Nike Inc. for use in the CAPM approach. The logical choice was to use the average (0.80) to account for the large fluctuations seen in Nikes historic betas. We felt that the YTD beta was a reflection of current business practices, but the goal of Nike Inc. was to look forward and gain back market share and increase its revenues. Consequently, we felt the average beta reflected the historical business practices of Nike Inc. better. From here, we calculated the cost of debt and equity. Cost of debt was calculated by finding the yield to maturity on 20-year Nike Inc. debt with a 6.75% coupon semi-annually.
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Cost of Debt Kd = YTM on 20 Year Nike Inc. Bond = C + FV-MV (n*2) FV+2MV/3 =3.375+ 100-95.6 40________ 100+191.2 3 =3.59% semiannually Kd= 7.18% annually. Cost of Equity Capital Asset Pricing Model (CAPM) Reasons for selecting CAPM: It considers only systematic risk, reflecting a reality in which most investors have diversified portfolios from which unsystematic risk has been eliminated. It generates a theoretically-derived relationship between required return and systematic risk which has been subject to frequent empirical research and testing. It is generally seen as a much better method of calculating the cost of equity than the dividend growth model (DGM) in that it explicitly takes into account a companys level of systematic risk relative to the stock market as a whole.

Cost of Equity (KE) Rf = 5.39% 10 Year Yield on US Treasuries RPm= 5.90% Geometric Mean Beta = 0.8 Average Nike Beta KE = Rf + (Rf - Rm) = Rf + Beta*( RPm) = 5.39 + 0.8*5.90 =10.11% 5. Weighted Average Cost of Capital (WACC) for Nike Inc. CAPM was found to be more superior to other methods of calculating cost of equity, hence the cost of equity used in the WACC is one derived by CAPM.
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The formula used is: WACC = Wd*kd(1-T) + We*ke. WACC = Wd*Kd (1-T) + We*Ke = 10.05%*7.18 %( 1-38%) + 89.95%*10.11% = 0.4473858% + 9.094% = 9.5413% The weighted average cost of capital for Nike Inc. is 9.5413 percent.

Financial performance appraisal: Ratio Analysis

1. Profitability ratios A. Gross Margin: The gross margin is the percentage gross profit on sales. The graph shows the percentage going as low as 36.5% in 1998 and then recovering ever since till 2000 and turned down again .Given the above trend and the managements forecast the gross profit margin seems to improve.

B. Net Margin = Net profit/Sales The graph shows a trend in the net profit margin i.e. the percentage of profit after operating expenses. The Net profit margin is recovering from a low of 4% in 1998 to 6% in 2001 and has been consistent with the Gross profit margin as well as expenses management improving as well hence, profitability of Nike is also improving.

C. Liquidity Ratios: These ratios measure the liquidity position of the firm in question i.e. its ability to meet short term obligations with short term assets. Year Current Asset Ratio = Current Assets/Current liabilities 2000 2001 3625.3/1786.7 2.03times

Current Ratio = 3596.4/2140 = 1.6 times

Acid test ratio = (Current Assets-Stock)/Current liabilities = (3596.4-1446)/2140 = 1.005 times (3625.3-1424.1)/1786.7 1.2 times

Comment: The liquidity ratios are rated good i.e. Nike Inc. is able to meet its current liabilities with current assets even when we have removed inventory (which is considered illiquid among the current assets). Therefore, Nike is still sound on its liquidity position and has even improved from the preceding year 2000. D. Financial/Investment Ratios: Year 2000 2001

Return on Capital Employed (ROCE) = Net profit/Capital Employed

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= 579.1/3716.9 = 15.5%

589.7/4032.9 14.62%

ROCE is a measure of the returns that a company is realizing from its capital employed. It is commonly used as a measure for comparing the performance between businesses and for assessing whether a business generates enough returns to pay for its cost of capital. The result shows that though performance had slowed a bit Nike Inc. is still giving shareholders a return which is more than the cost of capital. Furthermore, with the improvement in profitability on the business it sets to improve. E. Leverage Ratio This is a measure of financial risk within a firm and is calculated as follows; Debt ratio = Debt/ (Debt + Equity) Year 2000 = 580.9/3716.9 = 15.63% 2001 538.4/4032.9 13.35%

The debt ratio of Nike Inc. is very low i.e. has got a low financial risk and given the size of Nike and its establishment it should improve its leverage by use of debt in order to maximize shareholder value. A low leverage for a mature company is not healthy as can be seen that leverage has decreased from 15.63% in 2000 to 13.35% in 2001.

SWOT Analysis
1. Strength Number one Sports brand in the world. Global Brand. Strong R&D and innovation. No factories that tie up cash in buildings and manufacturing. It manufactures wherever it can produce the highest quality products for the lowest price. 2. Weakness Most of the profit margin comes from the shoe sector. The retail sector is very price sensitive. Questionable factory working conditions. 3. Opportunities
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Could develop sportswear, sunglasses and jewelry. Reduce prices in Asian and third world countries to increase market share. Make efforts to reduce pollution generated from Nike manufacturing factors.

4. Threats Nike is exposed to the international nature of trade. Competitive market for sports shoes. The declining market share in U.S. Customer looking for better deal.

Conclusion and Recommendations

From the above calculation and analysis, Nike Inc. seems a sound investment to put your money on by specially taking into consideration the fact that the stock of Nike is clearly undervalued and North-Point Group can take the advantage of the undervaluation to increase its investors wealth. Though the initial analysis, taking 12% discount rate shows stock to be overvalued, our calculation computes the WACC to be 9.54% which is less than 11.2%, which makes Nike a good investment as sensitivity analysis shows that Nike is undervalued at discount rates below 11.2%. Thus the value per share taking WACC of 9.54% will be approximately $ 55.30 while the current price is $ 42.09. So, the difference between the intrinsic value and market value is $13.21 per share which is certainly the good opportunity to grab. Secondly, management has goals for the near future that could provide a great deal of profit for Nike Inc. as it is investing in mid-priced segment that was previously overlooked, pushing its apparel line, expense control and other incentives. This entire managerial plan seems a good bet and can provide a healthy return and diversify its risk. We also have performed SWOT analysis of the company in order to identify its strengths, weaknesses, and the opportunities and threats in the Nikes environment. We can conclude Nike Inc. is strong company. It can capitalize on the various opportunities to increase its market share and profits by overcoming its weaknesses and minimizing the various threats. We also did the ratio analysis of the companys performance, which clearly shows the companys financial position is sound and its targets can be achieved if the plans are effectively implemented as they have the resource to dream big and achieve it. The plans laid out by Nikes executives display that the company is heading on the recovery path and there is potential for abnormal profits given the growth capacity that Nike has got as shown by ratio analysis. It has clearly leaped the low of 1998(i.e. 4% net margin) and move higher to 6% in 2001. Even the debt-equity ratio is very low i.e. 13.35% as on 2001 which signifies lower financial risk and it
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got a financial power to restructure its capital to include higher portion of debt to further reduce its cost of capital. Looking on the past performance of the Nike Inc. share against the market index it has shown that Nike can outperform the market returns and now that it had gown down and is undervalued as well so we would recommend to buy its shares. So we would certainly support the opinion of Lehman Brothers as a Strong Buy which can yield higher return to investor and future is certainly bright for any investor willing to invest in Nike Inc.

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References:
http://www.investopedia.com/terms/w/wacc.asp#ixzz23uQjDaT9 http://emfps.blogspot.com/2011/06/case-analysis-of-nike-inc-cost-of.html http://www.scribd.com/doc/21188529/Nike-Case-Study