Nike Case

Nike Case

Summary

We recommend a buy for Nike's stock on July 6, 2001. Our analysis consists of a discounted cash flows model. We projected unlevered free cash flows over the next 10 years and discounted them according to our derivation of Nike's weighted average cost of capital. Our analysis suggests the stock is significantly undervalued, given our expectation it will deliver earnings in the future.

Below we have analyzed Joanna Cohen's WACC calculation and her projection of cash flows. We then calculate our own WACC, discuss the results of our own model for cash flow projections, and conclude with our valuation and notes regarding our recommendation.

Evaluation of Joanna Cohen's WACC Calculation

Cohen's WACC calculation is decent, but 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 capitalization is a more relevant metric for equity than the book value of equity.

Cost of debt. To calculate the cost of debt, Cohen simply divides the interest expense by the average balance of the interest-bearing debt. This is an approximation for the true cost of the debt, but is too inaccurate. The interest expense line may include expenses not directly related to the debt of the company (unlikely, but perhaps non-cash payment-in-kind expenses for the preferred stock, or simply interest expense recognized under GAAP, but not necessarily indicative of real costs of debt).

The cost of debt should include the current market yield on Nike's publicly traded debt, as this is a more pertinent metric.

Furthermore, Cohen uses the 20 year yield on treasury bonds to approximate the risk free rate. We feel that the 3-month yield on treasuries is appropriate.

Market premium. Cohen uses a market premium of 5.9%, which is surprisingly low. She claims it is the market performance in excess of the treasury rate, but fails to defend this assertion. Perhaps using the arithmetic mean is a better approximation than the geometric mean for the market risk premium.

Decision to use only one WACC. She divided each division by revenue. In deciding whether to use an overall WACC, or to assign a WACC to each division, she should have weighted each division by cash flows, and not by revenue. It is reasonable to ignore the other sports division, as it is such a small fraction, but perhaps it would have been wise to calculate different WACC's for the footwear and apparel divisions. However, her evaluation of risk related to each division is a defensible one in using a single WACC for the entire company, and we view this as a potential issue, but not as an error per se.

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 potent risk to the debt than fluctuations in the yield to maturity.

Tax benefit of interest expense related to Japanese debt. Under U.S. tax law, interest expense on non-dollar-denominated debt is not a tax-deductible expense, and thus these notes should not be tax-effected (our analysis, however, remains within the scope of this class and tax-effects the yield to maturity).

Evaluation of Joanna Cohen's Cash Flow Projections

Overall, her projections seem fairly sound. She keeps margins fairly consistent, with only slight variations. Revenue growth projections are modest, and the firm seems decent cash requirements. However, there are a few issues with her projections.

Revenue growth projections. Company executives indicated a long-term revenue growth target of 8% to 10% and earnings growth