Nike, Inc.: Cost of Capital
This paper will present the financial importance of Cost of Capital for Nike and its future investors. Nike Inc. tries a new strategy to revitalize the company by focusing on top-line growth and operating performance. As such, the cost of capital is a critical factor in decision-making and in estimating the weighted average cost of capital (WACC). Our analysis will include how WACC is calculated using the Capital Asset Pricing Model (CAPM) to find out if NorthPoint Group should include Nike, Inc. in its portfolio. A firm’s WACC shows the required return on the firm and is used by the firm’s decision makers to determine which expansionary opportunities and or mergers to take. Investors also use WACC as discount rate in stock valuation. The result of our analysis suggests that it is a sound financial decision to include Nike Inc. to NorthPoint Group’s mutual fund portfolio.
I. Single Cost of Capital
It is sufficient to use the single cost instead of multiple costs of capital to compute WACC to be able to value the cash flows of the firm. Additionally, Nike Inc.’s business segments relatively have the same risk. Thus, based on our assumption, a single cost of capital is more appropriate
II. Capital Structure
The weights of the costs, Wd and We, are very important in calculating WACC because these show the company's capital structure. In calculating the weights, Joanna Cohen, Ford’s assistant, used the book values of debt and equity. But using the market values provide more accurate results. As book and market values of debt and equity tends to differ a lot, I used market values of debt and equity to get a closer estimation of the capital structure.
III. Cost of Debt
Cohen miscalculated the cost of debt by using the historical data. She divided the interest expenses by the average balance of debt to get 4.3 percent of before tax cost of debt. This may not reflect Nike’s current or future cost of debt because the cost of debt should be forward-looking.
First, I reexamine the cost of debt (Kd), which in this case is the yield to maturity (YTM) on the bonds. The YTM is a good estimate for the cost of debt if a company had issued debt in the past and the bonds are publicly traded just as in Nike's case. My calculations for Nike's yield to maturity based on the given data showed that Kd is 7.16 percent.
IV. Cost of Equity
For the risk-free rate, Krf, I used the current yield on 10-year US treasury bonds (5.39) instead of the 20-year because the 10-year bond matches the tenor of cash flows for the Nike's investment project [as seen on Exhibit 2], which is 10 years. Secondly, it is relatively less exposed to unexpected changes in inflation and liquidity premium when compared to the 20-year bond.
For the market risk premium, Km –Krf, I used the arithmetic mean of 7.5 percent of historic risk premiums to estimate the current risk premium on the assumption that the future will resemble the historical behavior. Given that this is a viable assumption, the annual arithmetic average is the theoretically correct predictor for the next year's risk premium. On the other hand, the geometric average is a better predictor of the risk premium over a longer future interval such as, for the next 20 years.
For Beta, I used the most recent beta estimate, 0.69. I did not use 0.80 to be the measure of systematic risk because I need to find a beta that is most representative of future beta. As such, I believe that the most relevant beta in this respect is 0.69.
I used the Capital Asset Pricing Model (CAPM) in estimating the cost of equity, which is 10.57 percent.
V. Weighted Average Cost of Capital (WACC)
Using the above values, the WACC is computed as follows:
VI. Computing for the Enterprise Value
With WACC at 9.95 percent, I recomputed the enterprise value and equity value per share of Nike. My computation showed that at 9.95 percent, the value of equity and equity value per share is $19,135.53 and $65.71 respectively. [See Annex A for details of computation.]
Kimi Ford should recommend to the NorthPoint Group Board that acquiring Nike Inc. shares is a SOUND INVESTMENT. To discount cash flows in Exhibit 2 with the calculated WACC of 9.95 percent, the present value of Nike is $65.71 per share, which is more than its current market price of $42.09. I believe that this value is still understated because the current growth rate used—6 to 7 percent is much lower than that estimated by Ford—8 to 10 percent. To conclude, since the data shows that Nike Inc.’s common stock is undervalued NorthPoint Group should add Nike Inc. to its Large Cap Fund.