Nike, Inc.

: Cost of Cupital
On July 5, 2001, Kimi Ford, a porrfolio 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 20.7Vo, even as the S&P 500 fell
IO.lVo. At the end of June 2001, the fund's year-to-date returns stood at 6.4Vo versus
-74%o 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.l 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 failen
from almost $800 million to $580 million (see Exhibit L). Nike's market share in
U.S. athletic shoes had fallen from 48Vo, \n 1991, to 427o in2OOO.2In addition, recent
supply-chain issues and the adverse effect of a strong dollar had negatively affected
revenue.
management revealed plans to address both top-line growth and
operating performance. To boost revenue, the company would develop more athleticshoe 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

At the meeting,

lNike's fiscal year ended in May.

2Douglas

Robson, "Just Do . . . Something: Nike's insularity and Foot-Dragging Have It Running in P1ace,"

BusinessWeek, (2 July 2001).

3Sneakers
in this segment sold for $7G-$90 a pair.

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 O 2001 by the University ofVirginia Darden
School Foundation. Charlottesville, VA. A11 rights reserved. Tb order copies, send an e-mail ro saies@
dardenbusinesspublishing.com. No part of this publicafion may be reproduced, stored in a retrieval syslem,
used in a spreadsheet, or transmitted in any form or by any means-electronic, mechanical, photocopying,
recording, or otherwise-without rhe permission of the Darden School Foundation. Rev. 10/05.

40

Part

Three Estimating &e

Cost of Capital

industry veteran Mindy Gr-ossman,4 had performed exkemely well. On the cost side,
Nike would exeft more effort on expense control. Finalty, company executives reiterated their long-lerm revenue-growttr targets of 9Vo to \l%o and eamings-growth targets

of

above LSVo.

Analysts' reactions were mixed. Some thought the financial targets were too
aggressivq others saw significant growth opportuoities in apparel and in Nike's international businesses.
Kimi Ford read all the analysts' report$ that she could find about the June 28
meeting, but the reports gave her no clear guidance: a khman 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 t2Vo, Nike was overvalued at its
crurent share price of $42.09 (Exhibit 2). However, she had dore a quick sensitivity
analysis that revealed Nike was undervalued at discounr rates below ll.Ll 7o . Because
she was about to go into a meoting, she asked her new assistant, Joanna Cohen, to
estimate Nike's cost of capital.
Cohen immediately $ithered 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 (Elhibit 5) explaining her assumptions

to Ford.

'
oMindy

'j

Grossman joined Nike in September 2000. She was the former president and chief executive

Jones Apparel Group's Polo Je.ans division.

of

Case

rl

14

ztr

Nike, Inc.: Cost of Capital

Consolidated lncome Statements

gf dollarsrexcept
data)

. r":

lgg5i

.,,

:'

1996.:. ,,,r..19g7,,1.. r,,.1gg8

1999

$4,760.8 $6,470.6 $9,186.5 $9,553.1 $8,776.9 $8,99s.1

Flevenues

Cost of goods sold

Gross profit
Selling and administrative

ft,Operating income
I Interest expense
Other expense, net
Restructuring charge, net

rlncome before income taxes

,lncome taxes

,N"t in"om"
'Diluted earnings per
;. common share
Average shares
outstanding (diluted)

'ir

(%)
Revenue
rncome

llAet income
:,Mergins (%)
iGross margin
Operating margin
margrn
Effective tax raie (%).

2001

2000

$9,488.8

2,865.3 3,906.7 5,503.0 6,065.5 5,493.5 5,403.8 5,784.9

1,895.6 2,563.9 3,683.5 3,487.6 3,283.4 3,591.3 3'703-9
1,209.8 1,588.6 2,303.7 2,623.8 2,426.6 2,606.4 2'689.7

685.8 975.3 1,379.8 863.8

52.3 60.0
24.2 39.s

11.7

,U. ,r.

,?z:.3

856.8
44.1

21.5
45.1
746.1
294.7

984.9
45.0

1'014-2

23.2
(2.5)

919.2
649.9 899.1 1,255.2 653.0
340.1
250.2 345.9 499.4 253.4
$ 399.7 $ 553.2 $ 795.8 $ 399.6 $ 451.4 $ S29,1 $

58.7
34.1

921-4
3?1.7
589.7

$1.s6

$1.88

$2.68

$1.35

$1.57

$2.07

$2.16

294.0

293.6

297.O

296.0

287.5

275.8

273.3

(8.1)
(0.8)
13.0

2.5
15.0
zo.J

5.5
3.0

36.5
9.0
4.2

37.4
9.8
5.1

39.9
10.9
6.4

39.0
10.7
6.2

38.8

39.5

37.0

36.0

35.9
42.2
38.4

42.0
41.5
43.9

39.6

40.1
15.0
8.7
38.6

'15.1

8.5
38.5

4.O

(37.4)
(49.8)

U.S. statutory tax rate was 35%. The state tax varied yearly from 2.5"klo 3.5"k.
of data: Company liling with the Securities and Exchange Commission (SEC), UBS Warburg.

1.8

2t2

Part

EXHIBIT

Three

2 |

Estimating the Cost of Capital

Discounted Cash Flow Analysis

2002

2003

2AO4

2005

2007

2006

2008

2009 2010

2011

Assumptions:
Bevenue growth (%)
COGS/sales ('/d

7.0

b.5

6.5

60.0

60.0

59.5
27.0

26.5

Tax rate (%)

38.0

38.0

38.0

38.0

Current assets/sales (%)

38.0

38.0

38.0

38.0

Current liabilities/sales (%)

1.5

11.5

11.5

I 1.5

SG&A"/sates (%)

6.0
59.0
26.0
38.0
38.0
1 r.5

qoE

6.0
59.0
25.5
38.0
38.0
11.5

6.0
58.5
25.0
38.0
38.0
11.5

6.0
58.5
25.0
38.0
38.0
11_5

6.0
58.0
25.0
38.0
38.0
11.5

6.0
58.0
25.0
38.0
38.0
11.5

Yearly depreciation and

capex equal each other.
Cost of capital (%)

12.00

Terminal value groMh

rale (/a)

3.00

Discounted Cash Flow (in millions of dollars except per-share data)

Operating income

Taxes
NOPAT

$ 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
463.0 513.6 590.8 652.5 741.0 811.7 915.9 970.8 1,060.2 1,123.9
755.4 838.0 963.3 1 ,064.5 1,209.0 ,324.3 1 ,494.3 1 ,584.0 1,729.9 1,833.7
1

Capex, net of depreciation

8.8 (174.9) (186.3) (1 e8.4)

764.1 663.1 777.6 866.2

Change in NWC
Free cash flow

(1e5.0)
1

.014.0

,014.0

(206.7\ (21e.1) (232.3) (246.2\

1

,117.6 1 ,275.2 1,351.7 1,483.7

1 ,572.7
17,998.3

Terminal value

/o+. I

Total flows

ooJ.

777

Present value of flows

$ 682.3 $ 528.6

Enterprise value

$1

1,296.6

.6

866.2

553.5$550.5$57s.4

,415.4

Less: current outstanding

debt
Equity value

$10,1 18.8

Current shares
outstanding
Equity value per share

zt t-3

3?El

current share

Sensitivity of equity value to discount rate:

rate
8.00%
8.50%
9.00%

Discount

9.50%

10.00%
10.50%
11.00%
11.177o
11.50y"
12.00%

Equity value
$ 75.80
67.85
61.25
55.68
50.92
46.81
43.22
42.09
40.07

37.27

Source: Case writer's analysis.

il:11,1:rrr

t.-r

price:

4mtl

(261.0)

1,117.6 1,275.2 1,351.7 1,483.7

$ 566.2 $ s76.8 $ s4s.9

I

19,571.0

$ 53s.0 $6,301.2

Case

EXHIBIT

3 |

14

Nike, Inc.: Cost of Capital

Consolidated Balance Sheets

As of May 31,
2001

2000

(in millionsof dollars)

Assets
Current assets:
Cash and equivalents
Accounts receivable
lnventories
Deferred income taxes
Prepaid expenses

254.3
1,569.4
1,446.0
111.5
215-2

304.0
1,621 .4
1,424.1

113.3
162.5

Total current assets

3,596.4

3,625.3

Property, plant and equipment, nei

ldentifiable intangible assets and goodwill, net
Deferred income taxes and other assets

1,583.4
410.9

Total assets

zoo.z,
$ 5^8563

,618.8
397.3
178_2

$ 5,819.6

Liabilities and shareholders' equity

Current liabilities:
portion of long-term debl
. Current
- Noies payable
Accounts payable
Accrued liabilities
lncome taxes payable
Total current liabilities

Longterm debt
Deferred income taxes and other liabilities
Redeemable preferred stock
Shareholders' equity:
Common stock, par
Capital in excess of stated value
Unearned stock compensation
Accumulated other comprehensive income
Retained earnings
Total shareholders' equity

Total liabilities and shareholders' equity

924.2
543.8

5.4
855.3
432.0

621 .9

472.1

2,140.O

1,786.7

470"3
1 10.3
0.3

435.9
102.2
0.3

2.8
369.0
(11.7)

2.8
459.4
(e.e)
(152.1)
3,194.3

50.1

21.9

(1 1

1.1)

2,887.0
3,136.0

3,494.5

$ s,856.9

$ 5,819.6

Source of data: Company filing with the Securities and Exchange Commission (SEC).

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Case

TO:
FROM:
DATE:
SUBJECT:

14

Nike. Inc.: Cost of CaPital

215

Kimi Ford
Joanna Cohen
JulY 6, 2001

Nike's cost of caPital

is 8.4"/""
Based on the tollowing assumptions, my estimate of Nike's cost of capital

l.

Single or Multiple Costs of Capital?

costs of capital, given that Nike has
The first question that I considered was whether to use single or multiple

of its revenue, Nike also sells apparel

multiple business segments. Aside from footwear, which makes up 620/"
sells sport balls, timepieces, eyeNike
products.
ln
addition,
its
footwear
complements
that
(30o/. of revenue)
products account lor 3'6% of
Equipm-ent
activities'
for
sports
wear, skates, bats, and other equipment designed
Haan dress and casual
as
Cole
products
such
non-Nike-branded
some
sells
also
Nike
its revenue. Finally,
products
under the Bauer
jerseys,
other
and
hockey
footvvear, and ice skates, skate blades, hockey sticks,
revenue'
of
4'5%
for
accounted
brands
trademark. Non-Nike
enough risks from each other to warrant
I asked myself whether Nike's business segments had different
that it was only the Cole Haan line thal
I
concluded
different?
different costs of capital. Were their profiles really
cole Haan makes up only a tiny
Since
businesses.
all
sports-related
were
rest
the
different;
was somewhat
a separate cost of capital. As for
to
compute
necessary
it
was
fraction of revenues, however, I did not think that
distribution channels and are
and
marketing
the
same
through
sold
are
they
lines,
footwear
the aoDarel and
the same risk factors, I decided
face
they
I
believe
ffi"riileted.*i,ioin"i.orr""tions of similar designs. Since
company'
whole
the
for
of
capital
cost
to compute only one

ll. Methodology for Calculating the Cost of Capital: WACC

(weighted-average cost of capital)'
since Nike is funded with both debt and equity, I used the wAcc method
makes up 27.0% and equity
capital
proportion
total
of
a
as
debt
Based on the latest available balance sheet,
accounts lor 73.0ok:
Capital Sources

Book Values (in millions)

Debt

Current Portion ol longterm debt

Notes payable
Long-term debt

$1

Equity

s.a
855.3
435.9

,296.6 )

27.O"/o of total capital

$3,494.5 + 73.Oo/" of total capital

lll. Cost ot Debt

by taking total interest expense for the year

My estimaie of Nike,s cost of debt is 4.3%. I arrived at this estimate
is lower than Treasury yields, but that is
rate
The
balance.r
debt
average
company's
2001 and dividing it by the
yen
notes, which carry rates between
because Nike raised a portion of iti funding needs through Japanese
2.O1" and 4.3ok.

tax rate of 38%' which I obtained

After adjusting for tax, the cost of debt comes out to 2.7o/o.l used a
state taxes have ranged from
Nike's
Historically,
by adding state taxls ol 3% to the U.S. statutory tax rate.
2.5o/"lo 3.5"k.

lDebt balances as ol May 31,

2O0O and 2001 , were $1 ,444.6 million and $1 ,296.6 million, respectively

216

Part

EXHfBE
lV. Cost

Three Estimathg

5 |

the Cost of Capital

(continued)

of Equity

I estimated the cost of equity using the capital-asset-pricing

model (CAPM). Other mbthods, such as the

dividend-discount model (DDM) and the earnings-capitalization ratio, can be used to estimate the cost of equity.
ln 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-yearTreasury bonds as my
riskJree rate, and the compound average premium of the market over Treasury bonds (b.g%) as my risk premium. For beta, I took the average of Nike's betas from 1996 to the present.

Putting it AllTogether
lnputting all my assumptions into the WACC formula, my estimate of Nike's cost of capital is 8.4"/o.

WACC

:
=
:

G(l

- 0 x D(D + E) + lGx U(D + E)

* 1A.50/o x73.Oo/o

2.77" x 27.Ao/o
8.4%

.,li.

,I

lir:iil'

+$ri
ri.li,;

'