NorthPoint Group is a mutual fund management firm which invested mostly in Fortune 500 companies. Its top holding included ExxonMobil, General Motors, McDonald’s, 3M and other large cap. NorthPoint Group performed extremely well although the stock market had declined over 18 months. In 2000, it earned a return of 20. 7% while the S&P 500 fell 10. 1%. At June 2001, NorthPoint Group’s return stood at 6. 4% while the S&P 500 stood at -7. 3%. Nike, Inc. is an American multinational corporation which is founded on January 25, 1964 as Blue Ribbon Sports by Bill Bowerman and Phil Knight and officially became Nike, Inc. n May 30, 1978.

The company is engaged in the design, development and worldwide marketing and selling of footwear, apparel, equipment, accessories and services. The headquarter of the company is near Beaverton, Oregon, in the Portland metropolitan area, and is one of only two Fortune 500 companies headquartered in Oregon. It is the world’s leading supplier of shoes and apparel and a major manufacturer of sports equipment, with revenue in excess of US$24. 1 billion in its fiscal year 2012 with an ending May 31, 2012.

As of 2012, it employed more than 44,000 people worldwide. The brand alone is valued at $10. billion making it the most valuable brand among sports businesses. On July 5, 2001, Nike’s share price had declined significantly from the beginning of the year while Kimi Ford, a portfolio manager at Northpoint Group, a mutual fund management firm, pored over analysts’ write-up of Nike Inc. On June 28, 2001, Nike held an analysts’ meeting to disclose its fiscal year 2001 results with another purpose of Nike management wanted to communicate a strategy for revitalizing the company. In the meeting, management revealed plans to address both top-line growth and operating performance.

In 1997, the revenue of Nike Inc. was stable around $9 million while the net income has declined from $800 million to $580 million. Nike Inc. market share had fallen from 48%, in 1997, to 42% in 2000. Nike Inc. recent supply chain issues and the adverse effect of a strong dollar had negatively affected revenue. Company executives reiterated the company’s long term revenue growth targets of 8% to 10% and targeted the earnings growth up to 15%. Kimi could find about the June 28 meeting gave her no clear guidance which having different recommend among the analysts.

So, she decided to develop her own discounted cash flow forecast to get a clear conclusion. In her forecast, Nike Inc. was overvalued with the current share price of $42. 09 when the discount rate was 12%. However, she found that Nike Inc. was undervalued when the discount rate was below 11. 17%. So, Kimi Ford has asked her assistant, Joanna Cohen to estimate the cost of capital of Nike Inc. 2. 0 Objective There are three objectives in the case study “Nike, Inc. : Cost of Capital”. The first objective is to explain the importance of cost of capital.

Why cost of capital is important in deciding the allocation of share for NorthPoint Large-Cap Fund. The second objective is to identify the appropriate method in estimating the cost of capital and carry out the proper calculation. Besides that, Cohen’s analysis is being compared in order to identify the error. The third objective is to make investment decision whether to include Nike’s share in NorthPoint Large-Cap Fund. Nike’s share price is evaluated using cost of capital and make appropriate suggestion: buy, hold or sell.

## Introduction

From the case study, Nike Inc. s the listed company that under consideration, whether it is worth to invest in or not. Kimi Ford, a portfolio manager in North Point Large-Cap Fund was act as decision maker for this case. She done her in-depth analyze on Nike Inc. and read through all the analysts’ report against the performance for Nike. From those reports, it is confusing Kimi because Lehman Brothers is recommended to invest in Nike while UBS Warburg and CSFB are recommended not to invest in Nike. Hence, Kimi decided to make an own discounted cash flow analysis to evaluate the potential investment of Nike.

Due to the contradiction from the result, Kimi’s new assistant is asked to calculate the cost of capital of Nike in order to make an accurate and right investment decision. Cost of capital is a minimum rate of return that has to be earned for an investment, so that it can satisfy the investors for making investment for the particular company. Company must achieved the require rate to cover the cost of fund. Therefore, cost of capital can be defined as the cost of the company in collecting fund or the return of an investor in providing fund.

Cost of capital consists of two categories, which are cost of debt and cost of equity. The concept of cost of capital is important in financial decision making. It is used to evaluate the financial performance for a company in the particular period. In this case, Kimi used cost of capital to measure the investment proposal for Nike, whether the financial performance for Nike is satisfying the requirement or not. From the cost of capital calculation that done by Kimi’s assistant, Cohen, we found that there are some error in the calculation, the process in estimating cost of capital is wrong and it does not match the standard.

Firstly, the formula for calculate cost of equity should be using current market value of stock, while Cohen is using book value of the stock. Meanwhile, the way to calculate cost of debt is also differ from standard. Cohen is using total interest expenses instead of total debt. It should have some adjustment to correct the errors that exist in the report, this is because the error may make the results become inaccurate, and hence it affect decision making. 4. 0 Data Analysis 4. 1 Single or Multiple Cost of Capital I agree with Cohen use of single cost of capital in her analysis.

In Cohen’s analysis, she stated that Nike’s major businesses are all sports-related. The only different is the Cole Haan line which makes up a tiny fraction of revenues. Therefore it is unnecessary to compute a separate cost of capital. The business segment of Nike has about the same risk, a single cost of equity is sufficient enough for this analysis. 4. 2 Equity In Joanna Cohen’s analysis, she wrongly used the book value to get the equity proportion. She obtained the equity from the balance sheet’s “total shareholders’ equity”. Using book value of equity is against the principle of shareholders’ wealth maximization.

If we use the book value of equity, we might get a wrong weighted average cost of capital and affect the investment decision. We may accept projects that the shareholders would want us to reject. Therefore, instead of using book value of equity, Cohen should use the market value of equity. Market value shows the actual current value of the company; whereas book value only shows the original value of the company. The value of a company may varies from day to day. Using market value to estimate WACC can tell us how much it will cost the firm to raise capital today.

To find the market value of equity, we multiply the current share price by the current shares outstanding. Current share price = $42. 09 Current shares outstanding = 271. 5 million Total Equity= Current share price X Current shares outstanding = $42. 09 X 271. 5 millions = $11,427. 435 millions The equity value that we got is different with Cohen’s. The equity value in her analysis is only $3,494. 5 millions. Whereas in our analysis, the equity value is $11,427. 435 millions. There is a huge difference in the figure because we use the market value of equity instead of the book value of equity. 4. 3 Debt

Due to lack of information of market value of debt, book value of debt is used to estimate the WACC. Before adding up current portion of long-term debt, notes payable and long-term debt to get the total debt, I will discount the long-term debt. Discounted long-term debt= $435. 9 millions X [1-[7. 17%*(1-38%)]] = $435. 9 millions X 0. 956 = $416. 72 millions Total debt = $5. 4 millions + $855. 3 millions + $416. 72 millions = $1277. 42 millions The total debt value is different from Cohen’s analysis, This is because I’ve used the discounted long-term debt which make the value smaller. 4. 4 Weightage

After getting the value of equity and debt, the weightage of both equity and debt are being calculated. Total weightage is equal to total equity plus total debt. 4. 4. 1 Weight of Equity ( ) The weightage of equity is calculated as follow: = Total Equity / (Total equity + Total debt) = $11,427. 435 millions / ($11,427. 435 millions + $1,277. 42 millions) = $11,427. 435 millions / $12,704. 855 millions = 0. 8995 = 89. 95% The weightage of equity is different with Cohen’s analysis. Cohen got 73% for the equity proportion whereas we got 89. 95% in our analysis. 4. 4. 2 Weight of Debt ( ) The weightage of debt is calculated as follow: Total debt / (Total equity + Total debt) = $1,277. 42 millions / ($11,427. 435 millions + $1,277. 42 millions) = $1,277. 42 millions / $12,704. 855 millions = 0. 1005 = 10. 05% The weightage of debt is different with Cohen’s analysis. Cohen got 27% for the debt proportion whereas in our analysis the debt proportion is 10. 05%. 4. 5 Cost of Equity ( ) Cohen used the capital-asset pricing model (CAPM) to estimate the cost of equity. In general, there are three models to calculate cost of equity, capital asset pricing model (CAPM), dividend discount model (DDM) and earning capitalization model (ECM).

These three models are varied significantly from each other, due to the different models are based on different assumptions and different models take different factors. The cost of equity is estimated using all three types of model. The suitability of each model is being compared and finally choose the best model. 4. 5. 1 Capital Asset Pricing Model (CAPM) The first model is capital asset pricing model (CAPM). The relevant information need to be identified before proceed to the calculation. Cohen also use CAPM in her estimation of cost of equity. Therefore, there is a comparison among Cohen’s calculation with our calculation.

Cohen use the 20-year U. S. Treasuries rate as the risk-free rate. It is correct to use the 20-year Treasuries rate as the risk-free rate. Since the cost of equity and WACC are use to discount long term cash flow, we should adopt the longest rate available, which is the 20-year U. S. Treasuries rate. I do not agree with Cohen use of the average beta ranging from 1996 until July 2001. Instead of using average beta to represent systematic risk, we should use a beta which can most represent the future beta. Thus the most current beta of July 2001 should be used. I agree with Cohen in using the geometric mean to represent the risk premium.

It is better to use the geometric risk premium when it has a longer time horizons and the returns become more serially correlated. We use the 20-year Treasuries rate as our risk-free rate, means we are estimating the long term cash flow. As a whole, the geometric mean is more appropriate when the Treasury bond rate is use as risk-free rate, have a long time horizon and want to estimate the expected return over the long time horizon. The calculation of cost of equity using CAPM is as follow: = risk-free rate (20-year U. S. Treasuries rate) = 5. 74% = Beta (YTD 6/30/01) = 0. 69 = risk premium (Geometric mean) = 5. 0% = 0. 0574 + 0. 69 (0. 059) = 0. 0574 + 0. 04071 = 0. 09811 = 9. 81% Compared with Joanna Cohen’s calculation : = 0. 0574 + 0. 80 ( 0. 059) = 10. 5% The final value for the cost of equity is different with Cohen’s analysis. Cohen estimate of Nike’s cost of equity is 10. 5%.

Whereas in our analysis, the cost of capital is only 9. 81%. This is due to the different value of beta being used in the model. 4. 5. 2 Dividend Discount Model (DDM) The second model is the dividend discount model. The dividend discount model compares dividends forecasted for the next period with the current share price which is $42. 9 for the firm and after that adds the growth rate of Nike, 5. 50%. The theory made with this model is that the company pays a significant dividend, but Nike Inc. does not. Hence, we rejected this model because it does not mirror the true cost of capital. The dividend discount model was calculated as follows: = 4. 5. 3 Earning Capitalization Model (ECM) Another model used to work out the cost of equity was the earning capitalization model. The earning capitalization model (ECM) is an easy model to understand. Yet, this model does not take into concern the growth of the company.

It is considered poor in estimating equity costs for Nike, Inc. Consequently, we chose to reject this calculation. The earnings capitalization model was calculated as follows: = Therefore, in this case study, CAPM is the most appropriate method to estimate cost of equity. CAPM is useful because it explicity accounts for an investment’s riskiness and can be applied by any company, regardless of its dividend size or growth rate. 4. 6 Cost of Debt Cost of Debt was computed by Joanna Cohen as total interest expense for the year 2001 divided by average debt balance.

We consider this is not an exact method to interpret for cost of debt. This is because the cost of debt is based on the coupon rate of a firm’s existing debt. As an alternative, it should depend on the interest that would be paid by the company if it were to issue new debt at that time. From this case, cost of debt was calculated by computing the yield to maturity on 20-year Nike Inc. debt with a 6. 75% coupon rate which is semi-annually. Even though the Nike Inc. has numerous business divisions, for instance apparel, sports equipment, etc. but we still assumed Nike Inc. to have only one single cost of capital.

This is because of those divisions would involve in alike risks and betas. The cost of debt was calculated as follows: PMT = 3. 375 n = 40 Par Value = $100 Current Price = $95. 60 Marginal Tax = 38% Yield to Maturity = 3. 375+ [($100-$95. 60)/40] / [($100+$95. 60)/2] = 3. 56% = 3. 56% * 2 = 7. 13% Cost of Debt after- tax = 7. 13% (1-0. 38) = 4. 42% Compared with Joanna Cohen’s calculation : Cost Of Debt = = = 4. 3% 4. 7 Weighted Average Cost of Capital (WACC) The weighted average cost of capital for Nike Inc. is 9. 26%. We calculated the cost of debt using the yield to maturity, since an upcoming coupon payment is about to be made.

Next, the cost of equity was found to be more suitable by using the capital asset pricing model, and the two costs were weighted by their levels within the capital structure, using market valuations in weighting the equity value. The cost of capital was calculated as follows: = = 9. 27% Compared with Joanna Cohen’s calculation : =(2. 7%)(27. 0%)+(10. 5%)(73. 0%) =8. 4% 5. 0 Recommendation Discount RateEquity 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 Table 1. WACC as discount rate to compute the share price or equity value Based on our analysis, our estimation of cost of capital is 9. 27%. With this cost of capital, the share price of Nike is estimated. The estimated share price will then be compared with the actual share price. If the estimated share price is higher than the market share price, it shows that the share is undervalued. Whereas in the other way round, the share is overvalued. The purpose of stock valuation is to predict future market price, or more generally known as potential market price, and thus to profit from price movement.

Stocks that are judged undervalued are bought, while stocks that are judged overvalued are sold. According to table 1. 1, the intrinsic value of the Nike’s share is worth $55. 68 at the discount rate of 9. 50%. The discount rate is based on the estimation of cost of capital where 9. 27% is being rounded up to 9. 50%. Nike’s share is currently priced at $42. 09 at the discount rate of 11. 17%. Any discount rate below 11. 17% will constitute a higher share price than the market share price. Our estimation on the intrinsic value of Nike’s share shows that Nike is undervalued by $13. 9. This shows that there is a potential rise of price by looking at its current market price of $42. 09. There is probability to gain profit from the difference of prices. Therefore, based on our analysis, we will suggest Kimi Ford to include Nike, Inc. ’s share into the NorthPoint Large-Cap Fund. This is based on the reason where Nike’s share is undervalued and we foresee the potential rise of price.

## References

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