Nike Inc: Cost of Capital.
NIKE INC:COST OF CAPITAL
AJAY PATHANIA
CHITTARANJANESWAR JHA
DEVENDER AGARWAL
INDRANIL DAS
SUNIL PATNAIK
NIKE BACKGROUND
Nike's share price had declined significantly from the start of the year. Nike's market share in U.S. athletic shoes had fallen. In addition, recent supply-chain issues and the adverse effect of a strong dollar, had negatively affected its revenue. However, Nike management communicated a strategy for revitalizing the top-line growth and operating performance.
Nike management proposes to develop more athletic shoe products in the mid-priced segment and also to push its apparel line. Nike was also exerting efforts on expense control. It targeted a long run revenue growth of 8 -10% and earning target of 15%.
OBJECTIVE
The main purpose of this evaluation is to provide information to Kimi Ford, the portfolio manager, and help her determine if the common stock of Nike Inc. should be added to the NorthPoint Group's Mutual Fund Portfolio. The main consideration for Ford in buying shares had an emphasis on value investing with the aim for long term growth. Apart from gathering information from Analysts, Ford developed a discounted cash flow forecast based on a discount rate of 10%. However, her sensitivity analysis revealed that with a marginal difference in discount rate from 10% to 9.4% changed the positioning of share from overvalued to undervalued. Therefore, in order to arrive at a sound judgment, it became imminent to accurately calculate the cost of capital for Nike Inc.
CALCULATING COST OF CAPITAL: WACC
Broadly, the assets of a company are financed by either debt or equity or both. Since Nike is funded by both debt and equity, we need to calculate Weighted Average Cost of Capital (WACC). WACC is the average of the cost of each of these sources of financing weighted by their respective usage in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it borrows.
In other words, a firm's WACC is the overall required return on the firm as a whole. It is the appropriate discount rate to use for cash flows similar in risk to the overall firm.
Thus, the Weighted Average Cost of Capital model is concerned with the return on assets to maintain the current stock price. A lower WACC implies that the firm must see a lower return on assets to maintain the stock price; the lower the value, the less the firm must produce from its assets.
So we are primarily concerned with Nike's WACC since this is an indicator of its future stock price. A lower WACC would mean that Nike can perform at a lower rate to maintain its stock price.
The formula for WACC is given by
WACC= Kd (1-t) * D/(D+E) + Ke * E/(D+E)
Where Kd = Pre-tax market expected yield to maturity on non-convertible debt
Ke = Market determined cost of equity
T = Tax-rate
D = Market value of interest bearing debt
E = Market value of equity
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So we are primarily concerned with Nike's WACC since this is an indicator of its future stock price. A lower WACC would mean that Nike can perform at a lower rate to maintain its stock price.
The formula for WACC is given by
WACC= Kd (1-t) * D/(D+E) + Ke * E/(D+E)
Where Kd = Pre-tax market expected yield to maturity on non-convertible debt
Ke = Market determined cost of equity
T = Tax-rate
D = Market value of interest bearing debt
E = Market value of equity
COMMENTS ON JOANNA COHEN'S NUMBERS
Joanna Cohen, Kimi Ford's new assistant, reviewed the financial numbers and calculated the WACC as 8.3% for the company. In order to arrive at this, she based her calculations on the following assumptions:
. One cost of capital for the whole company (Single cost of capital)
Our Comment: We have noticed that Nike has clearly two different segments of business - one in footwear and another in apparel. Even though we understand that the marketing channels and consumer segment for both the products would be the same, the pre marketing risks are clearly different for the two products. However, in absence of data, we accept the assumptions.
2. Calculation of debt equity ratio - She used book value to determine the debt equity ratio of 27:73.
Our Comment: Joanna Cohen does not include the proper valuation of equity in her calculation. She utilizes the book value of the equity as stated in the financial statements, rather than the market value, which is based on the number of shares outstanding, multiplied by the current market price per share.
3. Cost of debt - She calculated the cost of debt as 4.3% by taking total interest expense for the year 2001 and dividing by the average debt balance.
Our comment: The interest expense for the whole year cannot be a proper determinant of the interest for the entire set of debts as it does not indicate the different components of the debt and the corresponding interest rates. For example, a company could have capital leases, besides regular debt, with varying degrees of each one in the debt structure. Thus, a good indicator of the cost of debt is the current yield from publicly traded debt in the market.
4. Cost of equity - She has considered CAPM method for calculating cost of equity. She used 20 year treasuries bond rates for risk free rate and equity risk premium of 5.9% (geometric mean). The beta considered by her is the average beta since 1996.
Our Comment: We are in agreement with the above assumptions. CAPM method uses well defined parameters and generally is superior to the other models. However, we also looked at the DDM model as Nike has been giving divedends year-in and year-out.
The equity risk premium considered is the historical geometric mean. We have chosen geometric mean because in the context of corporate finance, expected returns are compounded over long time periods, the geometric mean provides a better estimate of the risk premium.
The beta considered is average beta because it takes care of business cycle and shows more consistent results.
RECALCULATION OF COST OF DEBT
The yield to maturity of the current outstanding bond of Nike is 6.75%, which is paid semi-annually. This implies that, after adjusting for tax, the cost of debt comes out to 4.18%. We have used a tax rate of 38%, which is what Nike effectively pays for the year 2001.
Cost of debt = Kd * (1-t)
= 6.75 * (1 - 0.38)
= 4.185
COST OF EQUITY
While calculating WACC, there are three ways to calculate the cost of equity, a necessary component of the model:
* Capital Asset Pricing Model
* Dividend Discount Model
* Earnings Capitalization ratio
CAPM takes into account the firm's beta, the risk free rate and the diversified portfolio rate. The Dividend Discount Model compares the dividend forecasted for the next period with the current share price for the firm and then adds the growth rate of the firm. Finally, the Equity Capital Model compares forecasted earnings for the next period over the current share price.
Though each model has strengths and weaknesses relative to the other, CAPM is considered a preferred model as DDM and ECR are dependent on the forecasts of dividends or earnings and disregards the impact of the market. Overall, however, each model should generate a comparable cost of equity when market performances and forecasts move in a similar direction.
COST OF EQUITY CALCULATION
As mentioned above, the cost of equity can be calculated using three different models. Though we think the CAPM model to be superior to the DDM and ECR models, we have calculated the cost using CAPM and the DDM model for comparative basis:
(i) CAPM Model:
The cost of equity in this model is given by the formula
Equity (Ke) = Kf + ?(Km-Kf)
i.e., risk free rate of return + stock's beta coefficient * market risk premium.
Ke = 5.74 + 0.8(5.9) = 10.5.
* The risk free rate, 5.74, is derived from the 20 year yield on US Treasuries
* 0.8 is the average beta based on the 6 year average historic beta
* The historical equity risk premium used is 5.9%, which is the compound average premium of the market over Treasury bonds.
(ii) Dividend Discount Model:
The cost of equity in this model is given by the formula
Equity (Ke) = D?/Po + g
where g= dividend growth rate
Annualized cost of equity, in the case of Nike, thus becomes
Ke = 0.48 * (1+0.055) / 42.09 + 0.055 = 0.067 or 6.7%
CALCULATION OF WACC
Before we calculate the WACC for the two models, it is essential to arrive at the capital structure of the firm, i.e., the proportion of debt and equity that the firm uses.
Debt = Notes Payable + Long term debt
= 855.3 + 435.9 = 1,291.2
Equity = Price per share * shares outstanding
= 42.09 * 271.5 = 11,427.435
Debt + Equity = 1,291.2 + 11,427.435 = 12,718.635
Debt = 1,291.2 / 12,718.635 = 10.1%
Equity = 11,427.435 / 12,718.635 = 89.9%
Therefore, debt equity ratio = 10.1:89.9
Putting in the equation for WACC:
WACC= Kd (1-t) * D/(D+E) + Ke * E/(D+E)
Considering CAPM Model,
WACC = 4.185 * 10.1% + 10.5 * 89.9%
WACC = 9.86%
Considering DDM Model,
WACC = 4.185 * 10.1% + 6.7 * 89.9%
WACC = 6.44%
DISCOUNTED CASH FLOW ANALYSIS
For our Discounted Cash Flow Analysis we chose a cost of sales approach over a 10 year time period. For the risk free rate we used 5.74% which is the current 20 year bond rate. For the market risk premium we used 5.9% geometric mean. For the revenue growth assumptions, COGS and S&A, we used guidance taken directly from Ford's analysis. NWC numbers are taken from Ford's analysis. All cash flows were discounted by the weighted average cost of capital of 9.86%. The cash flow analyses are carried out considering both CAPM and DDM models. The cash flows are enclosed as Annexure-I.
WHAT DOES THIS MEAN?
Nike currently has long-term growth targets of 8-10% and earnings growth targets of above 15%. If Nike is to achieve these growth figures, significant investment in new products and advertising is required. The cost of Nike's capital will have a significant impact on the ability of Nike to achieve these growth estimates profitably.
During Kimi Ford's Discounted-Cash-Flow analysis of Nike share values, she utilizes a cost of capital of 10%.With her current analysis, Kimi estimates that using a discount rate below 9.4% shows an undervaluation of Nike stock, indicating it should be purchased. We have calculated WACC to be 9.86, which hovers around that figure.
RECOMMENDATION
Nike has a major share of the sports footwear and apparel market and has taken steps to improve market share and increase customer loyalty. They have aligned themselves to a specific set of core competencies which we believe gives them a strategic advantage over other firms in this industry. The management has revealed plans to address both top-line growth and operating performance. The company is also set to develop mid price segment. With this they are well prepared to maintain a lead in this market. We recommend addition of Nike to the portfolio. The inclusion of Nike will increase portfolio diversification as the existing portfolio mix consists of Exxon Mobil, General Motors, McDonalds, 3M etc. The inclusion of Nike, which is from separate segment of business, will form a non perfect positive correlation with the portfolio. It will thus enhance the portfolio performance.
CHALLENGES
* The manner in which Nike is going to affect the beta of the portfolio is not known.
* That Nike will be able to correctly achieve its projections.
* Nike will be able to control its expenses.
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