Nike Case

P0 =D1 / (r-g)

so

r = D0(1+g)/P0+g

= 0.48(1+0.055)/42.09+0.055In the Nike, Inc.: Cost of Capital case, Kimi Ford, a portfolio manager at a mutual-fund management firm who is deciding whether or not to buy some shares from her fund, the NorthPoint Large-Cap Fund. This fund invests mostly in Fortune 500 companies and has performed very well. One of the companies in the firm, Nike, Inc., has decided to take an aggressive strategy to improve revenue. Analysts who studied this strategy gave mixed reviews, so Ford decided to create her own forecast. This forecast showed that Nike was overvalued in terms of stock price, but undervalued in terms of discount rates. She assigned her assistant, Joanna Cohen, to estimate Nike's cost of capital to help her with her forecast. After extensive work with cost of debt and cost of equity, she determined Nike's weighted average cost of capital to be 8.4%. But were her calculations correct?

1. What is the WACC and why is it important to estimate a firm's cost of capital? Do you agree with Joanna Cohen's WACC calculation? Why or why not?

The weighted average cost of capital (WACC) is a common method in finance used for capital structuring purposes. It is the rate a company will pay on average to its debtors and investors in order to finance its assets. It is important to estimate a firm's cost of capital to provide quantitative data for analysis when deciding whether to invest, to purchase, or to modify the way a company is run.

No, we do not agree with Joanna Cohen's WACC calculation. She made a couple incorrect assumptions. She did not use the yield to maturity (YTM) rate. Instead, she approximated the interest rates by looking at the current debt payments. She also used book values instead of market values for equity.

2. If you do not agree with Cohen's analysis, calculate your own WACC for Nike and be prepared to justify you assumptions.

In her first mistake, Cohen used the historical data in estimating the cost of debt. She divided the interest expenses by the average balance of debt to get 4.3% of before-tax cost of debt. We believe this rate is incorrect because it may not reflect Nike's current or future cost of debt payments. Instead, we calculated the yield-to-maturity of the company's 20-year semi-annual bonds. (see Exhibit 1)

Given these inputs:

PV = 95.60,

N = 40,

Pmt = -3.375,

FV = -100,

We arrived at a semiannual rate of 3.58%, and an equivalent annual rate of 7.29% [(1+x)2-1].

Assuming a 38% tax rate, we arrive at an after tax-tax rate of 4.52% [7.29*(1-38%)].

In her second mistake, Cohen based the total equity value on Nike's book value, rather than the market value in equity markets. The book value does not represent the currently agreed value of ownership in the company. This assumption leads to incorrect weightings in debt and equity (27.0% and 73.0%, respectively), affecting the final WACC value.

Value of Equity ( E ) = Stock price * Number of Shares Outstanding

= ($42.09)*(271.5)

= $11,427.44

So, the weight of debt = D/(D+E) = $1,277.42 / $12,704.86 = 10.05%

and the weight of equity = E/(D+E) = $11,477.44 / $12,704.86 = 89.95%