1. I. INTRODUCTION
1.1. SUMMARY
Kimi Ford, a portfolio manager at NorthPoint Group, a mutual-fund management firm, analyzed the
stock of Nike Inc., whether she would add Nike stock in his portfolio or not. Nike’s share price had
declined significantly from the beginning of the year. Since 1997, its revenues had plateaued at around
$9 billion, while net income had fallen from almost $800 million to $580 million. Nike’s market share in
U.S. athletic shoes had fallen from 48%, in 1997, to 42% in 2000. Finally, company executive reiterated
their long-term revenue-growth targets of 8% to 1-5 and earnings-growth targets of above 15%.
Ford decided instead to develop her own discounted cash flow forecast to come to a clearer
conclusion. Her forecast showed that at the discount rate at 12%, Nike was overvalued at its current
share price of $42.09. On her analysis, Nike was undervalued at discount rate below 11.17%. Because
she was about to go into a meeting, she asked her new assistant, Joanna Cohen, to estimate Nike’s cost
of capital. In this case, we suppose to analyze whether her calculation is right or not.
1.2. OBJECTIVE
- To explain the importance of WACC and to clarify the Cohen’s calculation.
- To calculate the costs of equity using CAPM, the dividend discount model, the earnings
capitalization ratio and the advantages and disadvantages of each method
- To give a good recommendation for Kimi Ford whether to buy the stock or not
II. ANALYSIS
2.1 Weighted Average Cost of Capital (WACC)
The weighted average cost of capital (WACC) is the rate that a company is expected to pay on
average to all its security holders (debt holders and shareholders) to finance its assets. Companies raise
money from a number of sources: common equity, preferred equity, straight debt, convertible debt,
exchangeable debt, warrants, options, pension liabilities, executive stock options, governmental
subsidies, and etc. 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. A calculation of a firm's cost of capital in
which each category of capital is proportionately weighted. All capital sources - common stock,

2. preferred stock, bonds and any other long-term debt - are included in a WACC calculation. All else equal,
the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC
notes a decrease in valuation and a higher risk.
The WACC equation is:
Where,
Wd: weight of debt
We: weight of equity
Kd: cost of capital
Ke: cost of equity
T: tax rate
The advantages of WACC:
- To help company when make decision for capital budgeting. The company will choose the
projects that have a good return, which is bigger than the cost of capital.
- To help when the company designing corporate financial structure. The cost of capital is
significant in designing the firm's capital structure. The cost of capital is influenced by the
chances in capital structure.
- To measure the performance of top management. The evaluation for top management can be
measure by the difference between actual and forecast profit of the project and by the overall
cost of the project.
- To help company when make a decision for dividend policy.
- To determine a strong estimate if not an exact cost of capital leveraging. Ideally, the lower the
WACC percent is the better for the company.
2.2 Calculation for WACC
We don’t agree with Cohen’s calculation because Cohen used book value in her calculation where
we consider market value.
a. Value of equity

3. Book value of equity should not be used when calculating cost of capital. The market value of
equity is found by multiplying the stock price of Nike Inc. by the number of shares outstanding.
Market Value of Equity (E)
E = Stock Price × Shares Outstanding
b. Value of debt
We should consider the value of long-term debt on balance sheet. This long-term debt is related to
the Nike’s bond yield and coupon rate. So, Joanna Cohen should discount the value of long-term debt.
Here is the way we calculate the market value of debt:
Market Value of Debt (D)
D = current portion of long-term debt + notes payable + long term-debt
c. The weight of equity and debt
Then, we calculate the weight of each equity and debt.
Weight of Debt
Wd = D/ (D+E)
Weight of Equity
We = E/(D+E)
d. Cost of debt and cost of capital
The next step is calculating the Cost of Debt and Cost of Capital
Cost of Debt
To calculate the cost of debt, we use YTM on 20 years of Nike’s bond.
From exhibit 4:
Coupon rate = 6.75% paid semi-annually  3.375% per 6 months
15 July – 15 January = 3.375% (6 months)
Current Price = $95.6
Par value = $100
Coupon rate = 3.375%
Maturity time = 20 years paid semi-annually (40 times paid)

4. As it pays semiannually, the YTM per year would be 7.13% (3.56%x2) for 20 years. So, the cost of
debt is (Kd)
Cost of Equity
To calculate the cost of equity, we use geometric mean for the historical risk premium rather
than arithmetic mean because it is more applicable for long-term estimation. The arithmetic mean is
better to analyze the year to year condition.
From exhibit 4
Risk free rate (20-year) = 5.74%
Risk Premium = 5.90%
Beta = 0.8 (the average beta represents the historical business condition)
Tax Rate = 38% (35% corporate tax+3% state taxes)
So, the cost of equity (Ke) is calculated as below:
Ke = CAPM
= Risk free + (β x Risk Premium)
e. Weighted average cost of capital
2.3 Calculation Another Method for Cost of Equity
a. CAPM
The capital asset pricing model (CAPM) is used to determine a theoretically appropriate required rate
of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's
non-diversifiable risk.
Recall the calculation from 2.2 ,
Ke = CAPM
= Risk free + (β x Risk Premium)
b. Dividend Discount Model
From exhibit 4:

5. D0 =$0.48
P0 =$42.09
Forecast of Dividend growth (g) = 5.50%
D0 = Current Dividend (year 0)
P0 = Current share price
g = Dividend growth
c. Earning Capitalization Model
- From the case, Nike targeted its earnings-growth of above 15%
- Current diluted earnings per share is $2.16
- Current market share is $42.09
So, we calculate the cost of capital based on earnings capitalization model as follow:
Ke = E1 / P 0
E1 = Forecasted earning
P0 = Current share price