Cost of capital case study

Approved Logo 1 Sept 2013

Case 3

Nike Inc.: Cost of Capital

BNFN 4304- Financial Policy

Mr. Masood Aijazi

Group members:

Nour Abdulaziz 1420149

Maryam Barifah 1420023

Balquis Mekhlafi 1420231

Shrouq Al-Jaaidi 1420072

Dar Al Hekma University: Business School

Spring Semester 2017-2018

25th February 2018

Introduction

The following case is about a portfolio manager who works at North Point Group named Kimi Ford who is trying to decide whether to buy Nike’s stock. However, Nike had a negative year which lead in a severe decline in sales growth, decline in profits and market share due to supply-chain issue and it was adverse effect of a strong dollar. A meeting was held to look at different strategies where Nike has revealed that it can boost revenues by having additional exposure in mid-price footwear and apparel lines as well as exerting more effort in controlling the expenses. Analysts had very different reactions to Nike’s changes.

Kimi Ford later created her own discounted cash flow forecast (DCF) to get a clearer conclusion, she asked her assistant Joanna Cohen to estimate the cost of capital. The aim of this case and analysis is to find and show the mistakes that are arising when estimating the cost of capital which was done by Cohen. When estimating the cost of capital she used a single cost instead of a multiple one and we agree with her. Even though there are different business segments for Nike, they all seem to have the same risk, thus using a single cost is more effective. This case shows the importance of weighing a company’s stock prior to buying them via using valuation models which is the WACC the importance of carefully selecting of carefully selecting the variables that are used in the WACC formula.

1. What is the WACC and why is it important to estimate a firm’s cost of capital? What does it represent? Is the WACC set by investors or by managers?

The weighted average cost of capital (WACC) is simply the cost of the individual sources of capital. Capital is almost usually comprised of the equity that shareholders decided to in a company, or the debt that the lenders decided to invest in a company, with each source being individually being proportionally weighted. Calculating the WACC is important as when using that capital in any way would be an opportunity cost to the investors as that any capital that is being invested can be used in any other investment. In calculating the WACC the shareholders or lenders would be able to estimate the return that they would be able to earn when they decide to the invest in this company.

WACC is set by investors not by the managers, as it assists when they choose their final decision in the whether to proceed with that particular investment or not. Having the calculated the WACC which is the minimum rate of return that the investor will accept, for the investor they can find the yield that they will receive as their return by deducting the WACC from the company’s returns. If the WACC > Company’s returns investors would go ahead with their decision to invest. However, if the WACC < Company’s returns then the investor will withhold his decision to invest.

2. Do you agree with Joanna Cohen’s WACC calculation? Why or why not?

No we don’t agree with Cohen’s Weighted Average Cost of Capital for these reasons:

1. She calculated the weights of debt and equity using book value rather than market value. Book value is the price paid for an asset that will never change as long as you own that asset. Therefore, she did a mistake by using historical data in estimating the cost of debt as it is a must for her to use the market value, based on current data. The reason behind this decision is it shows how much it will cost the firm to raise the capital today.

2. Using historical data doesn’t reflect Nike’s current or future cost of debt, therefore Cohen’s cost of debt calculation which was done by taking the total interest expense for 2001 and dividing it by the company’s average debt balance is wrong. She should have instead calculated the yield to maturity on a 20-year debt basis with a coupon rate that is paid semiannually.

3. Another error that was done was using the average beta (from 1996-2001), which is 0.80, this number doesn’t represent the future systematic risk, so it is better to use the most recent beta (0.69)

3. If you do not agree with Cohen’s analysis, calculate your own WACC for Nike and justify your assumptions?

Weights of Equity and Debt:

Market value of equity = (Current Share Price x Current Shares Outstanding)

= $42.09 x 271.5 million

= $11,427.44 million.

There is not enough information to find the market value of debt, therefore, we are going to use the book value for computing:

Market Value of Debt= Current portion of long-term debt + Notes Payable + Long-Term Debt

= $5.4 m + $855.3 m + $435.9 m

= $1,296.6 million

Therefore, = = 89.81 % whereas = = 10.19%

In order to find cost of debt, what we need to do is to calculate the YTM (yield to maturity) of Nike’s bonds so that we can be able to represent the most recent cost of debt.

Current price (Po)= $95.60, Issued date= 07/15/96. Maturity date= 07/15/21, Coupon Rate= 6.75% (Semiannually), Payment (PMT)= , PAR value = $100, a 25-year bond (year 1996 minus year 2021) and since the case is in 2001 the bond was issued 5 years ago therefore N= (25-5) x 2= 40 paid semiannually. This can be calculated by either using an excel worksheet or by using a financial calculator. To calculate the YTM, we can either use the financial calculator or the excel sheet and the result would be; r= 3.58% Semiannual. Rd= 3.58% x 2= 7.16%.

So the after tax cost of debt = 7.16%(1-38%) = 4.439%