MM5007

FINANCIAL MANAGEMENT

Nike, Inc. Cost of Capital

Dr. Subiakto Soekarno, MBA, CFP

Syndicate 7
Rizkie Immadudien (29117102)
Hana Nurdina (29117117)
Hanif Sulistyo (29117190)
Rachman Ikhwanto (29117271)

MASTER OF BUSINESS ADMINISTRATION

SCHOOL OF BUSINESS AND MANAGEMENT
INSTITUT TEKNOLOGI BANDUNG
2018
 EXECUTIVE SUMMARY

I. Objective

II. Analysis
Cost of Capital
Represent the firm’s cost of financing and is the minimum rate of return that a
project must earn to increase firm value. The rate of return that is required by investors to
forega another project with similar risk. Dependant on the mode of financing that is used
by firm are equity financing and debt financing. Cohen calculated a weighted average
cost of capital (WACC) of 8.4 percent by using the Capital Asset Pricing Model (CAPM)
for Nike Inc.
The Weighted average cost of capital (WACC) is the rate (expressed as a
percentage, like interest) that a company is expected to pay to debt holders (Cost of debt)
and shareholders (cost of equity) to finance its assets. It is the minimum return that a
company must earn on existing asset base to statisfy its creditors, owners, and other
providers of capital. Companies raise money from a number of sources : common equity,
preferred equity, straight debt, convertible debt, exchangeable debt, warrants, and
options, pension liabilities, executive stock options, govermental subsidies, and so on.
Different securities are expected to generate different returns. WACC is calculated taking
into account the relative weights of each component of the capital structure debt and
equity, and is used to see if the investment is worthwhile to undertake.
Why is WACC important ?
- WACC is essential to make a capital budgeting project or company decision
- Helps managers predict risk and maximize profit (choose projects with greater returns
than the cost of capital to invest in them).
- Helps determine the acceptability of investment opportunities
- Set by investors or markets not managers, therefore can only estimate it.
Using WACC formula
WACC = Kd (1-t) x D / (D+E) + Ke x E /(D+E)
D : Debt V : D+E = Total Capital Ke : Cost of Equity
E : Equity Kd : Cost of Debt t : Tax Rate

Joanna Cohen’s Analysis

Joanna analysis based on book values
WACC (Weighted Average Cost of Capital) Joanna Cohen’s Analysis Comparison
Total Equity (E) 3.494,50
Total Debt (D) 1.296,60
Total Capital (E + D) 4.791,10
 Tax Rate (t) 38%
Weight of Equity 72,94%
Weight of Debt 27,06%
Cost of Debt (Kd) 4,30%
Cost of Equity (Ke) 10,50%
After tax cost of debt 2,70%
WACC 8,38%

1. Multiple or Single Cost of Capital?

Based on the understanding about single and multiple cost of capital, we agree that the
single cost of capital is the best way to value the cash flows for the entire firm. The
reasons are as following :
- Nike has multiple segments that contribute to revenue like sports balls, apparel,
skates, bats, etc. Beside footwear, which is a main segment, contributes about 62% to
Nike’s revenue. Nike’s business segments include apparel (30% of revenue), sport
balls, timpepieces, eyewear, and other equipment designed for sport activities (30%
of revenue). We can see clearly that apparel, equipment produts gained over a half of
footwear, but this is not enough evidence to consider them as a cost of capital distinct
from footwear.
- The first deficiency is the risk rate. Except the non-Nike branded products such as
Cole Hann have some differences, but they only contributed a tiny part of Nike’s
revenue. There are not significantly different between the risk rate that every Nike’s
segments stand because all of these segments are related to sport business.
- The second deficiency is about business activities such as marketing, distribution
channel. With the management of Nike, all of therse segments are set in the same
state. They have the same marketing project, distribution channel, customer service,
qualify guarantee, etc. They are displayed in stores with the same design.
- For these deficiencies, it is company to claim that computing all of the segments as
only one cost of capital for whole company, is the true way.

2. What mistake Joana Cohen in her analysis?

We do not agree with Joana analysis, and the reason to that are postulated as follows:

a. Cost of Debt (Kd)

By following Joanna Cohen’s calculation, she estimated the firms’s cost of debt base
in its hitorical data. In other words, she use today’s figure that is total interest expense for
the year 2001 (58,7 millions), and then divided it by the average debt balance of the year
2000 and 2001 (Debt Balance sheet as of May, 31 2000 and 2001), were $1444,6 million
and $1296,6 million, respectively), which eventually showed 4,3% as the predicted cost
of debt. It may not reflect Nike’s current of future cost of debt. Thus, she made a mistake
for estimating the firm’s cost of debt when taking historical data for calculation, because
in terms of academic theory, the WACC is the required return on investments by the firm
in the future, so all components of the WASS, of which is the cost of debt that must
reflect the future interest rate the firm has obligations to pay upon its new borrowing.
* Cost of capital based on market value not book value
Cohen is wrong to use book values as the basis for debt and equity weights; the market
values should be used instead. The reasoning of using market weights to estimate WACC
is that it is how much it will cause the firm to raise capital today.
Market value of equity – current share price x average shares outsanding
= ($42.09 x 273,3) million = $11.503 million
Thus, Market value weight for equity is
= 11.503 million / (11.503 million + 1.291 million) = 89,9%
The weight for debt is (100-89,9)% = 10,1%

The more appropiate cost of debt can be calculate by using data provide in Exhibit 4.
We can calculate the current yield to maturity of the Nike’s bond to represent Nike’s
current cost of debt.
From this case :
Current Bond Price = 95,6 with r = discount rate
Face value = 100
Annual coupon rate = 0,0675/2 = 0,03375
 Coupon = 100 x 0,03375 = 3,375
Bond issue in 07/15/96, its maturity is 07/15/21  25 years bond
The bond was issued 5 years ago, because now is year 2001. As the result we have
n=2x(25-5) = 40 years (paid semiannually)
𝑟 −40
1−(1+ ) 100
2
95,6 = 3,375 + 𝑟
𝑟/2 (1+ )40
2
r = 7,16%
Cost of debt (after tax) is  7,16% x (1-0,38) = 4,4%

b. Cost of Equity (Ke)

We estimated the cost of equity using the capital asset pricing model CAPM. Another
method, such as the Dividend Discount Model DDM cannot be used.

1. Using DDM (Dividend Discount Model)

The assumption made with this model is that the company pays a substantial dividend,
but Nike Inc. does not. Therefore, we rejected this model because it does not reflect the
true cost of capital.
Ke = D1 / P0 + g
 D1 = D0 x (1 + g)
D0 = 0,48 , g = 5,5%  D1 = 0,48 x (1+0,055) = 0,5064
P0 = D1 / P0 + g
= 0,5064 / 42,09 + 5,5% = 1,20% + 5,5% = 6,70%
Because Nike did not pay any dividend for shareholders since after June 30, 2001, so
this model (DDM) cannot be used for calculating KE in this case because it does not
reflect the true cost of capital.
Using DDM (Dividend Discount Model) also have advantages and disadvantages.
 Advantages of using DDM are significant flexibility when estimating future
dividend streams, provide useful value approximations even when the inputs are
overly simplified, can be reversed so the current stock price can be used to impute
market assumptions for growth and expected return, specifying the underlying
assumptions allows for sensitivity testing and analyzing market reactions to
changing circumstances.
 Disadvantages are subjective inputs can result in unspecified models and bad
results, over-reliance on a valuation that is at heart an estimate, high sensitivity to
small changes in input assumptions

2. Using Earning Capitalization Model

Capitalization refers to the return on investment that is expected by an investor.

Capitalization methods for valuing a business are based upon return on the new owner's
investment.
The problem with this model is that it does not take into consideration the growth of
the company, it is appropriate for no-growth firms. Therefore we chose to reject this
calculation. The earnings capitalization model calculations were found this way:
ECM= E1 / P0 = 216 / 42.09 = 5.31%
where E1 is the earnings for the upcoming year (forecasted) and P0 is the stock price
today.
Earnings Predictions: One disadvantage of basing your valuation of a company on
future earnings is that the projected future earnings may wrong. Estimates may not be
accurate. Unforeseen circumstances could cause earnings to be much less than
anticipated. If you purchase such a business, you could not get the income from it that
you want.
Current Capitalization Rate Errors: Because capitalization of future earnings depends
on the current capitalization rate for its formula, you must make sure that rate is reliable.
Sometimes business owners use the most recent year's earnings. Ask for an average over
the past three to five years, and you will mitigate the effect of unusual spikes in any given
year.
 3. Using CAPM for calculate Ke

KE = KRF + (KM – KRF) x Beta

In which : Rrf = risk-free rate (profitability rate of goverment bonds (U.S Treasury), in
Exhibit 4 we have U.S Treasury 20-year Krf = 5,74%.
(Km – KRF )  Risk market premium. (Exhibit 4, geometric mean = 5.90%, arithmetic
mean = 7.50%). Because of arithmetic mean is better for one-year period estimated
expected returns, while geometric mean is better for long-term period valuation. So, for
long life valuation, we can find stable valuation.
Beta: ‘index of responsiveness’ of changes in a security’s returns relative to changes in
returns on the market, in this case is sport utility industry (Exhibit 4 of Nike Inc., given
from 1996 is Average beta = 0.98, beta in 2001 is 0.69). We need to find out a beta that is
most representative to future beta (not as beta from 1996 to 2001 is 0.8 according to
Cohen). Most recent beta estimate is recent beta at 06 June 2001 is 0.69.
Given that KRF = 5,74%, KM - KRF = 5,9%, Beta = 0,69
KE = 5,74% + 5,9% x 0,69 = 9,811%

Which method is the best for calculating the cost of equity?

CAPM has the advantage of simplicity and can be applied in practice. However, like
many other models, CAPM inevitable limitations and criticism. Maybe the attraction of
CAPM is simplicity and easy to apply, but may be CAPM too simple to apply, it lead to
reflect not really true happen, it is normally just a model. There are some limitations of
the CAPM model. These abnormalities include:
Unrealistic assumptions: CAPM is based on a number of assumptions that are far from
the reality. For example it is very difficult to find a risk free security. A short term highly
liquid government security is considered as a risk free security. It is unlikely that the
government will default, but inflation causes uncertain about the real rate of return. The
assumption of the equality of the lending and borrowing rates is also not correct. In
practice these rates differ. Further investors may not hold highly diversified portfolios or
the market indices may not well diversify. Under these circumstances CAPM may not
accurately explain the investment behavior of investors and beta may fail to capture the
risk of investment.
Difficult to validity: Most of assumptions may not be very critical for its practical
validity. Therefore is the empirical validity of CAPM. Need to establish that the beta is
able to measure the risk of a security and that there is a significant correlation between
beta and the expected return. The empirical results have given mixed results. The earlier
tests showed that there was a positive relation between returns and betas. However the
relationship was not as strong as predicted by CAPM. Further these results revealed that
returns were also related to other measures of risk, including the firm specific risk. In
subsequent research some studies did not find any relationship between betas and returns.
 On the other hand other factors such as size and the market value and book value ratios
were found as significantly related to returns.
Betas do not remain stable over time: Stability of beta, beta is a measure of a securities
future risk. But investors do not further data to estimate beta. What they have are past
data about the share prices and the market portfolio. Thus, they can only estimate beta
based on historical data. Investors can use historical beta as the measure of future risk
only if it is stable over time. Most research has shown that the betas of individual
securities are not stable over time. This implies that historical betas are poor indicators of
the future risk of securities.
CAPM is a useful device for understanding the risk return relationship in spite of its
limitations. It provides a logical and quantitative approach for estimating risk. It is better
than many alternative subjective methods of determining risk and risk premium. One
major problem is that many times the risk of an asset is not captured by beta alone.

c. WACC : Putting it all together

Apply in to formula WACC
WACC = Kd (1-t) x D / (D+E) + Ke x E /(D+E)
D : Debt V : D+E = Total Capital Ke : Cost of Equity
E : Equity Kd : Cost of Debt t : Tax Rate

WACC = Kd (1-t) x D / (D+E) + Ke x E /(D+E)

WACC = 10,1% x 4,44% + 89,9% x 9,81%
= 0,45% + 8,82%
= 9,27%

III. Conclusion and Recommendation

3.1 Conclusion
In conclusion, based on all data including history data, recently data and future data, it
is clearly that decision is Kimi Ford should buy Nike’s shares because it quite safe,
underestimate of market and growth dramatically compare with its history, other
companies in industry and other shares in S&P 500.
Overall, Nike’s shares are very potential. In details, Kimi Ford also should consider
before buy Nike’s shares depend on some of reasons. First of all, Nike’s shares long-term
always is wonderful investment, but short-time buying also should becareful because of
the changing fast of industry, the changing of Nike, the changing of trend in footwear
industry and so on. Beside that, Kimi Ford also don’t forget monitor its activities very
closely. If North-Point Large-Cap Fund want to invest in Nike’s shares in short-term,
 they should buy Nike’s shares at the end of the year, while others not really pay attention
to much in market and sell it in the first month of next year. In January, when people have
a little overestimate, North-Point Large-Cap Fund can sell for achieve their profit.

3.2 Recommendation
What should Kimi Ford recommend regarding an investment in Nike?
According to Kimi Ford’s quick sensitive analysis, Nike was undervalued at discount
rate below 11.17%.
Kimi Ford used a discount rate of 12 percent to find a share price of $37.27. This
makes Nike Inc. share price overvalued by $4.82 as Nike is currently trading at $42.09.
We already established that we found this discount rate to not reflect the true market
value and solved for a discount rate that would be more accurate. Furthermore,
discounting cash flows in Exhibit 2 with the calculated WACC is 9.27%, the present
value of Nike is $58.13 much higher than Nike’s current market price of $42.09.
If we assump the terminal value growth rate is 3%
So Nike shares price is undervalued. Moreover, Nike also changed their business
strategy by more concentrate in mid-priced segment, which is Nike less concentrate for a
long time before. That’s mean their total of sales might increase, lead to avenue increase,
lead to profit increase, of course, Nike’s share prices and dividend will be increase in
long-term.
Using this data, we found that North Point Large-Cap Fund should buy Nike Inc.,
shares at this time because the stock is undervalued and because it had growth potential
that would be beneficial to the fund.
Technical analysis also supports a buy decision, because looking on the past
performance of the Nike Inc. share against the market index. It has shown that Nike can
outperform the market returns and now that it had gown down, it is left with the upside
given plans that are being put in place. Once more we recomendation decision to buy for
Nike Inc. and monitor its activities very closely.