Case Study -Case Study -Nike Inc.: Nike Inc.:

Cost of CapitalCost of Capital

Case BackgroundCase Background::

• NorthPoint Large Cap Fund – consider to buy Nike’s stock?

• Nike declines in sales growth, profits and market share.

• Strategic Plan – to increase exposure in mid-price footwear and apparel lines; commits to cut down expenses.

• Market response: mixed signals • Kimi Ford has done a cash flow estimation,

and ask her assistant, Joanna Cohen to estimate cost of capital.

Nike Inc.:Nike Inc.:

What is WACC? Why is it important to What is WACC? Why is it important to estimate a firm’s cost of capital?estimate a firm’s cost of capital?

Cost of capital - Cost of capital - rate of return required by a capital provider in exchange for foregoing an investment in another project or business with similar risk (or opportunity cost).

Invest only in projects that generate returns in excess of WACC.

The WACC is set by the investors (or markets), not by managers. Cannot observe the true WACC, only estimate it.

What is WACC? What is WACC?

WACCWACC: : rrdebt debt (1-t)(D/V) + r(1-t)(D/V) + requityequity (E/V) (E/V)

where V = D + E => (total value of debt) + (market where V = D + E => (total value of debt) + (market value of equity)value of equity)

Cost of DebtCost of Debt (r (rdebtdebt): After-tax yield of outstanding ): After-tax yield of outstanding debt. (t = tax) debt. (t = tax)

Cost of Equity (Cost of Equity (rrequityequity): ): rrequityequity = risk-free rate + beta (market risk = risk-free rate + beta (market risk premium)premium)

Assumptions and Considerations to Assumptions and Considerations to determine intrinsic value?determine intrinsic value?

Issues•Projected free cash flow•Single cost or Multiple Cost of

WACC?•Cost of debt•Cost of equity•Weights of capital components

FFree cash flow projections

Assumptions• What is FCF?• Sales growth – different business units?• Capital Expenditure requirement?• Working capital• Depreciation• Tax• Terminal value – growth at what rate?

I. Single cost or Multiple Cost?I. Single cost or Multiple Cost?

Use different cost of capital for footwear and apparel divisions?

In this case, use single cost instead of multiple costs of capital.

Other related businesses is relatively small to impact major component of business. business segments of Nike basically have about the same risk; thus, a single cost is sufficient for this analysis.

Estimating WACC is to value the cash flows for the entire firm

II. To determine the weightsII. To determine the weights

Key considerations:Key considerations: Book value or market value of debt Book value or market value of debt

and equity?and equity? How calculate debt? (consider long-How calculate debt? (consider long-

term debt only)term debt only) Equity – market capitalizationEquity – market capitalization

Weights of capital componentsWeights of capital components

Wrong to use book values as the basis for Wrong to use book values as the basis for debt and equity weightsdebt and equity weights

Market values should be used in calculating Market values should be used in calculating weights. weights.

Use market weights to estimate WACC - how Use market weights to estimate WACC - how much it will cause the firm to raise capital much it will cause the firm to raise capital today. That cost is approximated by the today. That cost is approximated by the market value of capital, not by the book market value of capital, not by the book value of capital. value of capital.

For market value of equity: For market value of equity: share price: $42.09share price: $42.09 No. of shares: 271.5 mil shares No. of shares: 271.5 mil shares Market value = price x no. shares = Market value = price x no. shares =

$11,427 mil.$11,427 mil. Different from book value of equity of Different from book value of equity of

$3,494 mil. $3,494 mil.

Weights of capital components – Weights of capital components – market value of equitymarket value of equity

Market value of debt is found by:Market value of debt is found by: Adding current portion of LT debt, notes Adding current portion of LT debt, notes

payable, and LT debt discount at Nike’s payable, and LT debt discount at Nike’s current coupon:current coupon:

= 5.40 (current LTD) + 855.30 (NP) + = 5.40 (current LTD) + 855.30 (NP) + 416.72 (LTD discount)416.72 (LTD discount)

= $1,277.42= $1,277.42

Weights of capital components – Weights of capital components – market value of debtmarket value of debt

WACCWACC

Market value of weight:Market value of weight: Equity = 11,503 / (11,503+1,291) = Equity = 11,503 / (11,503+1,291) =

89.9%; 89.9%; Debt = 1 – 0.899 =10.1%.Debt = 1 – 0.899 =10.1%.

III. Calculation of cost of debtIII. Calculation of cost of debt

KEY CONSIDERATION:

Book value or current debt? Which period bonds to use? Interest is tax deductible – what tax rate to

use? (home country tax rate?) Estimate tax rate – in real life, effective tax

rate that counts!

Cost of debtCost of debt The WACC is used for discounting cash flows in

the future, thus all components of cost must reflect firm’s concurrent or future abilities in raising capital.

Mistake to use the historical data in estimating the cost of debt. Cohen’s divided the interest expenses by the average balance of debt to get 4.3% of before tax cost of debt. It may not reflect Nike’s current or future cost of debt.

The cost of debt, estimated by The cost of debt, estimated by i. yield to maturity of bond, or i. yield to maturity of bond, or ii. according to credit rating.ii. according to credit rating. Calculated by using data provided in Exhibit 4. Calculated by using data provided in Exhibit 4.

Calculate the current yield to maturity of the Calculate the current yield to maturity of the Nike’s bond to represent Nike’s current cost of Nike’s bond to represent Nike’s current cost of debt.debt.• PV= 95.60PV= 95.60• N=40 (semi-annual coupon for 20 years)N=40 (semi-annual coupon for 20 years)• Pmt= 3.375Pmt= 3.375• FV=-100FV=-100• Compute Int = 3.58% (semiannual) 7.16% (annual)Compute Int = 3.58% (semiannual) 7.16% (annual)

After tax cost of debt = 7.16%(1-38%) = 4.44%After tax cost of debt = 7.16%(1-38%) = 4.44% (assume 38% tax rate in US)(assume 38% tax rate in US)

IV. Cost of equityIV. Cost of equity KEY CONSIDERATIONS:KEY CONSIDERATIONS:

Risk free rate – long-term bond or short term (T-Risk free rate – long-term bond or short term (T-bills)?bills)?

Beta – use current or historical average? Beta – use current or historical average? (Beta normally available in Bloomberg or if not, (Beta normally available in Bloomberg or if not,

need to determine (but how?))need to determine (but how?)) Market risk premium (use arithmetic or geometric Market risk premium (use arithmetic or geometric

mean?)mean?) In Malaysia (can be obtained from Bloomberg or In Malaysia (can be obtained from Bloomberg or

refer to publications)refer to publications)

Cost of equityCost of equity Cohen uses CAPM to estimate cost of Cohen uses CAPM to estimate cost of

equity. Her number comes from equity. Her number comes from following:following:

10.5%10.5% = 5.74% +(5.9%)*0.80 = 5.74% +(5.9%)*0.80

AssumptionsAssumptions::•Risk free rate comes from 20-year T-bond rate Risk free rate comes from 20-year T-bond rate •Average beta from 1996 to July 2001, 0.80.Average beta from 1996 to July 2001, 0.80.•Cohen uses a geometric mean of market risk Cohen uses a geometric mean of market risk premium 5.9%premium 5.9%

Comments on cost of equity –Comments on cost of equity –The risk-free rateThe risk-free rate

Use T-Bills or long-term bond rate?Use T-Bills or long-term bond rate? Better to use 20-year T-bond rate to Better to use 20-year T-bond rate to

represent risk-free raterepresent risk-free rate The cost of equity and the WACC are used The cost of equity and the WACC are used

to discount cash flows of very long run, to discount cash flows of very long run, use T-bond with 20 years maturity, 5.74%, use T-bond with 20 years maturity, 5.74%, is the longest rate that are available is the longest rate that are available (number of years left in 25 year bond).(number of years left in 25 year bond).

***not wrong to consider 10 years bond to match same ***not wrong to consider 10 years bond to match same period of forecast projection of revenue.period of forecast projection of revenue.

Use a geometric mean of market risk premium Use a geometric mean of market risk premium 5.9% is also correct – if available – ( normally 5.9% is also correct – if available – ( normally available from Bloomberg). available from Bloomberg).

Using arithmetic mean to represent true market Using arithmetic mean to represent true market risk premium, we have to have independently risk premium, we have to have independently distributed market risk premium. It is often distributed market risk premium. It is often found that market risk premium are negatively found that market risk premium are negatively serial correlated.serial correlated.

Comments on cost of equity –Comments on cost of equity –The market risk premium The market risk premium

Cohen uses average beta from 1996 to July 2001, Cohen uses average beta from 1996 to July 2001, 0.80 to be the measure of systematic risk.0.80 to be the measure of systematic risk.

Need to identify a beta that is most representative Need to identify a beta that is most representative to future beta. to future beta.

Use the most recent beta estimate provided, 0.69.Use the most recent beta estimate provided, 0.69. **Note - beta varies according to time and depend **Note - beta varies according to time and depend

on the which type of stock indices as reference for on the which type of stock indices as reference for market)market)

Comments on cost of equity –Comments on cost of equity –The market risk, betaThe market risk, beta

Cost of equityCost of equity

Therefore:Therefore:

Estimate of cost of equity will be:Estimate of cost of equity will be:

5.74% + (5.9%)* 0.69 = 5.74% + (5.9%)* 0.69 = 9.819.81%%

WACCWACC

Based on the values obtained:Based on the values obtained:

Calculation of the WACC is as follow:Calculation of the WACC is as follow: WACCWACC: : rrdebt debt (1-t)(D/V) + r(1-t)(D/V) + requityequity (E/V) (E/V)

4.44%*0.101 + 9.81%*0.899 = 9.27%4.44%*0.101 + 9.81%*0.899 = 9.27%

Next StepNext Step

Use WACC as the discount rate to bring Use WACC as the discount rate to bring the FCF and TV to present value the FCF and TV to present value

You get the firm valueYou get the firm value Need to minus the debt to get Need to minus the debt to get

shareholder value (equity) shareholder value (equity) Divided by no. of shares to get intrinsic Divided by no. of shares to get intrinsic

valuevalue Compare with current stock market Compare with current stock market

price of Nike!!! price of Nike!!!

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011Free Cah Flows to Firm 764.1 663.1 777.6 866.2 1014 1117.6 1275.1 1351.7 1483.7 1572.7Terminal Value 25835.42Cash flows 764.1 663.1 777.6 866.2 1014 1117.6 1275.1 1351.7 1483.7 27408.12The Firm Value $17,079Less: Current debt 1296.6Equity Value $15,782Shares Number 271.5Equity Value per share 58.13052

Terminal Value 25835.422012 Cash Flow 1619.881Permanent Growth 0.03WACC 0.0927

ConclusionConclusion

What should Kimi Ford recommend regarding What should Kimi Ford recommend regarding an investment in Nike?an investment in Nike?

Discount cash flows (see Exhibit 2) Discount cash flows (see Exhibit 2) Calculated WACC 9.27%, the present value equals Calculated WACC 9.27%, the present value equals

$58.13 per share, which is more than current market $58.13 per share, which is more than current market price of $42.09. price of $42.09.

Some might think this value is still understated, due to Some might think this value is still understated, due to that current growth rate used (6% to 7%) is much lower that current growth rate used (6% to 7%) is much lower than that estimated by manager (8% to 10%). So the than that estimated by manager (8% to 10%). So the recommendation is to recommendation is to BUY!BUY!