Table of Contents

1. Weighted Average Cost of Capital...........................................................................................1

2. Importance of calculating cost of capital.................................................................................1

3. Flaws in Johanna’s calculation of WACC...............................................................................2

4. Our calculation of WACC........................................................................................................3

5. CAPM and DDM......................................................................................................................4

6. Recommendations....................................................................................................................5

Appendix 7

1. Weighted Average Cost of Capital

Weighted Average Cost of Capital (WACC) is the required rate of return for the company that is calculated considering all forms of financing source it uses. A company’s capital structure might be a mix of - Bonds (Debt financing), Loans, Preferred Stock, and Common Equity and the rates of return (or the cost of financing) for each of them is different. The WACC of a firm refers to how much, on average, it costs the firm to raise money, in a given capital structure.

To interpret WACC from a finance manager’s perspective or an investor’s perspective, WACC is the overall return that a company must earn from its assets and business operation (net income) so as to maintain its current stock price. WACC can also be used as discount rate to estimate the firm’s value, assuming the capital structure and interest rate remains the same within the given time frame.

WACC = WD * Cost of Debt + WPS * Cost of Preferred Stock + WCE * Cost of Equity

Where,WD = Debt/Total CapitalWPS = Preferred Stock/Total CapitalWCE= Common Stock/Total Capital

Note: 1. Cost of debt is the after tax cost of debt. 2. Company uses only Debt, Preferred Stock or Equity, or combination of these to finance

any project.

Thus, WACC is the firm’s cost of capital that we get by weighing each source of capital proportionately.

2. Importance of calculating cost of capital

Authors Brealey, Myers and Allen in the book Principles of Corporate Finance (11Edition, pp.215.), describe there are few reasons for finding the cost of capital, as shown below:

Mostly projects can be treated as average risk that is neither more nor less risky than the average of company’s other assets. For these types of projects, company’s cost of capital becomes the right discount rate.

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The company’s cost of capital becomes a useful starting point for setting discount rates for unusually risky or safe projects. Also it is easier to add or subtract from the company’s cost of capital than to evaluate each projects capital from the start.

The authors also mention that many large companies use the company’s cost of capital not just as a bench mark but also as all purpose discount rate for every project proposal. As measuring risk objectively is difficult and financial managers do not waste time in arguments over them.

One benefit gained from this is when firms force the use of a single company cost of capital, risk adjustment shifts from the discount rate to project cash flows. The benefit here is while evaluation is going on the top management may request ultra conservative cash flows from high risk projects. So they might reject undertaking such types of projects unless NPV, computed at the company’s cost of capital is well above zero.

Furthermore, cost of capital helps the management of a firm to decide appropriate capital structure. Cost of capital (under WACC) is affected with a change in capital structure. With careful analysis of the cost of capital, a financial manager can recommend changes in capital structure to better accommodate with the market changes and reduce the cost for the company.

3. Flaws in Johanna’s calculation of WACC

There are some serious flaws in Johanna’s calculation of WACC. We found some major mistakes in her underlying assumptions and ways to calculate the input for WACC.

Rate of return for Debt is not properly calculated

She has calculated the required rate of return for Nike Inc.’s debt by taking total interest expenses for 2001 FY and divided it by the firm’s average debt balance. This is does not give the real required rate of return for the debt. We suggest she should have used the Yield to Maturity rate for the long term debt that has been issued by Nike Inc.

Value of equity should not be taken as Book Value

She has used the Book Value of equity which does not give the real picture of the current value of the firm’s total capital. Use of market price for the company’s equity should suggest a more precise result for the weight given to each factor of capital structure. So taking the Book value of equity calculates wrong weight for both debt and equity.

No method to calculate cost of capital is superior from one another

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Johanna uses CAMP method to calculate cost of equity since she believes that CAPM is the superior method to calculate a company’s cost of equity. But there isn’t superior method as such. Adopting a methodology to calculate a company’s cost of equity depends upon the financial scenario of each company. Also the reliability of the data to calculate CAPM or DDM or ECR determines the selection of methodology.

However, in our case CAPM would be the better option to calculate cost of equity rather than DDM. The financial theory underlying DDM is – value of the stock is worth all the future cash flows (dividends) generated by the company’s operation discounted under a rate of return. Since Nike does not provide substantial dividends to its stock holders DDM would not yield appropriate required rate of return for the equity invested.

4. Our calculation of WACC

We have calculated the WACC for Nike Inc. using the CAPM methodology to be 9.846% (Refer to the Appendix)

We believe that there is no need of multiple cost of capital for Nike because the multiple business segments in which it operates are not much different and the risks and betas for all segments would be similar.

The Total capital is calculated to be $ 12724.04 million. Johanna had taken the book value to calculate the total equity, which is not an appropriate approach. We took the market value approach to calculate the total equity. So the total value of Equity is $11427.44 (Current price of stock is $42.09 and current number of outstanding stock is 271.5 million). Total Debt is calculated by adding the current book value of Notes Payable, Current portion of Long term Debt and Long Term Debt, which is equal to $ 1296.6 million. Therefore the weight given to debt is 4.44% and weight of Equity is 89.81%.

We have taken Yield to Maturity rate for the Long term bonds issued by Nike Inc as the required rate of return for debt. The YTM rate with 6.75% coupon rate semi annually is 7.165%. We agree with Johanna and her assumption to get the tax rate 38%. Also, if we can see that the average of tax rate for the past 7 years – from 1995 to 2001 was 38%.

Now, with these values for the cost of debt and the weight for debt in the capital structure, we get the weighted after tax cost of debt is 0.45 %

To get the firm’s cost of capital, we have taken the CAPM approach. Since Nike does not provide significant amount of dividend, it cannot be used to estimate the precise future cash flows for the shareholders.

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For Risk Free rate (RF), we have taken the 20 year yield rate on US Treasuries, which is 5.74%. This time frame would be consistent to the Time to maturity for the Long term debt issued by Nike Inc. For the Risk Premium, we have taken Geometric Mean of Historic Equity Risk Premiums. Our rational for use of Geometric Mean are as follows:

NorthPoint Group emphasize on value investing. They purchase the stock of companies that is perceived to be undervalued and expect to get greater return in the future. And an undervalued stock would not yield to its estimated real value within a short span of time, like one year. Geometric mean is a better option to estimate a longer life valuation for rate of return where as Arithmetic mean is useful for one year estimated expected return.

When we use the risk premium to estimate the cost of equity to discount a cash flow in ten years (as Johanna has done in Exhibit 2), the single period in the CAPM would really mean ten years. So appropriate returns would be defined by Geometric mean.

For Beta value, we have taken the Average of Historical Beta, 0.8. In the analyst meeting, Nike Inc. declared its strategy of revitalizing the company and regaining the market share. The Year to Date Beta only gives the current market scenario of the company’s business practices. But since Nike is looking forward to achieve the success they had previously held, the average historical beta would better reflect the company’s performance in market. With all these assumptions and the related values for input, Weighted Cost of equity for Nike Inc., using CAPM is 9.39%.

5. CAPM and DDM

Cost of Equity using CAPM = 10.46%

Cost of Equity using DDM = 5.5114% (Refer to the Appendix)

CAPM approach is that it takes into consideration a company’s market risk as the most relevant risk to stockholder, therefore to determine the effect of new business or project of company on stock price. Furthermore, CAPM considers the only systematic risks, and provides clearer picture of risks for the company/investors who have used diversified portfolio and thus have decreased the specific risks for the company in question. However, CAPM is based on historical data onto the future with estimation we use. Moreover, CAPM is based on simplifying market, return, and investor behaviors.

DDM is defined in term of ordinary variables with known relationships among the variables. It is a simple model for valuing equity and works well when growth rate is fixed and the dividend

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paid is according to earnings and growth. However, DDM requires enormous amount of speculation in trying to forecast future dividends. It means the model is only as good as the assumptions are accurate. Furthermore, it’s difficult to predict a proper growth rate in economic fluctuation. Also, there are no direct adjustments for risk in this approach.

In sum, while comparing CAPM and DDM, it’s technically comparing how reliable beta and growth rate are. Managers have to make a decision based on how accurate they estimate beta and growth rate under different situations.

6. Recommendations

According to sensitivity analysis (Exhibit 2) devised by Kimi Ford, stocks of Nike are undervalued if the discount rate is less than 11.17%. We have found that the discount rate for Nike Inc. is 9.846%. And since the stock of Nike is currently traded in $42.09, the stock price is undervalued by almost $13 dollars.

With this information, we recommend that Kimi should include Nike Inc. in her investment portfolio because the stock price is currently undervalued. With the change in the company strategy – to focus more on mid-priced segment, and to capitalize on the new leadership in the apparel segment – it is highly probable that the company might incur greater returns in the future.

Also, if we look at the past trends of Nike Inc.’s performance against S&P 500 index, the company has the potential to yield abnormal profits. In addition to that, if we look at some of the ratios for the company like Current ratio (2.03) and Debt to Equity Ratio (0.51), the company is in a good position to realize the goals set by the management.

Thus, we recommend Kimi Ford to ‘Buy’ the stock of Nike Inc.

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Appendix

WACC using CAPM for calculating Cost of equity

WACC = WD * Cost of Debt + WCE * Cost of Equity = 0.1019*4.44% + 0.8981*10.46% = 9.846%

Where, WD = weight for debt WCE = weight for common equity

WACC using DDM for calculating Cost of equity

WACC = WD * Cost of Debt + WCE * Cost of Equity = 0.1019*4.44% + 0.8981*5.5114% = 5.964%

Johanna has taken the book value for total equity, which is a wrong approach. We have taken the market value of the stock and the total value of equity is:

Total Equity =Number of Outstanding shares*Current price per share = 271.5 millions * $42.0 = $ 11427.44 millions

Total debt is calculated by adding Current portion of Long term debt, Notes Payable and Long Term Debt from the balance sheet.

Total Debt = $5.4+$855.3+$435.9 (in millions) = $ 1296.6 millions

Total Capital = Total Debt + Total Equity= $ 1296.6 + $11427.44 = $ 12724.04 millions

Therefore, WD = 1296.6/12724.04= 0.1019

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WCE = 11427.44/12724.04= 0.8981

Cost of Debt = YTM*(1-Tax rate) = 7.165*(1-.38)= 4.44%

Notes:

For YTM, Face value of the bond = $100Rate = 6.5% semiannuallyYears to Maturity = 20 Years (2021 – 2001)Current Price = $95.60Therefore, YTM = 7.165% (for current price to be $95.62)

Tax rate = 38 %

Cost of Equity with CAPM method = RF + β (RP)= 5.74 + 0.8(5.90)= 10.46%

Note: Risk Free rate (RF) = 5.74%Beta (β) = 0.8Risk Premium (RP) = 5.90%

Cost of Equity with DDM method = (DO/Current Stock Price) + g = (0.48/42.09) + 5.50% = 5.5114%

Note: Dividend provided in the current year (DO) = 0.48Dividend growth rate (g) = 5.50% [Value line forecast for Dividend Growth from 98-00 to 04-06]

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