nike

1. Nike, Inc. : Cost of Capital
Background
NorthPoint Large-Cap Fund adalah salah satu perusahaan manajemen pendanaan yang
berada dibawah NorthPoint Group yang mengalokasikan dananya untuk berinvestasi di
perusahaan-perusahaan besar. NorthPoint Large-Cap Fund sudah banyak menginvestasikan
dananya dalam perusahaan-perusahaan Fortune 500, yang menekankan pada nilai investasi.
Top holdingsnya mencakup ExxonMobil, General Motors, McDonald’s, 3M, dan modal besar
yang lainnya. Walaupun bursa saham telah menurun sejak 18 bulan terakhir, NorthPoint
Large-Cap telah menunjukkan performanya yang cukup bagus. Pada tahun 2000, dana-dana
tersebut menghasilkan return sebesar 20.7% walaupun S&P 500 turun 7.3%.
Kimi Ford, Portfolio manajer dari NorthPoint Large-Cap sedang memutuskan untuk
berinvestasi dalam salah satu perusahaan besar di Amerika Serikat, yaitu Nike, Inc., sebuah
perusahaan yang memproduksi sepatu olahraga, tapi dia belum membuat kepastian
mengenai keputusan ini, ditambah dengan harga saham Nike, Inc. yang telah menurun
secara signifikan sejak awal tahun.
Nike Inc, sebuah perusahaan manufaktur yang berdiri sejak tahun 1964 di Portland. Awalnya
perusahaan ini telah memproduksi sepatu atletis, yang kemudian berkembang sehingga
pada akhirnya memproduksi berbagai macam produk olahraga. Produk-produk yang
diproduksi oleh Nike secara umum dibagi 2 yaitu produk dengan merek Nike serta merek
non-Nike. Khusus produk bermerek Nike adalah sepatu, aparel sebagai pelengkap produk
sepatu, bola olahraga, perelatan waktu, kacamata, skates, bats. Produk bermerek Non-Nike
yang diproduksi adalah Cole-Haan line dress dan casual footwear, ice skates, skate blades,
hockey sticks, hockey jerseys, dan produk-produk lain di bawah Bauer trademark.
Nike adalah market leader untuk sepatu atletis. Pangsa pasarnya sampai tahun 2000 adalah
42%. Dengan pendapatan yang stabil yaitu sekitar 9 milliar tiap tahunnya.
Tetapi ternyata ada masalah pada bidang keuangan dari Nike. Inc,. Menurut financial
statementnya, Net income Nike menurun dari hampir $800 juta pada tahun 1997, menjadi
$589,7 juta di tahun 2001. Selain itu, sekalipun tetap menjadi market leader, namun market
sharenya di sepatu atletik di US sebesar 42% pada tahun 2000 ternyata turun dari 48%
sebelumnya.

2. Nike telah mengadakan meeting dengan analis-analis untuk memperlihatkan hasil fiscal year
2001-nya. Nike menargetkan revenue growth sebesar 8-10% dan earnings-growth diatas
15%. Melihat optimisme dari Nike, ternyata para analis memiliki respon yang berbeda-beda.
Hal inilah yang membingungkan Kimi Ford apakah akan melakukan investasi di Nike atau
tidak.
Lehman Brothers menyarankan Kimi Ford untuk melakukan investasi di Nike karena
menurutnya Nike memiliki kesempatan berkembang di apparel line dan di bisnis
internasional. Di lain pihak, UBS Warburg dasn analis CSFB sama sekali tidak mendukung
investasi di Nike, dengan alasan target mereka terlalu agresif.
SWOT Analysis
Strengths
· Nke, Inc. pemimpin pasar di produk sepatu olahraga.
· Pendapatan yang cukup stabil dari tahun 1997.
· Citra merek yang sudah kuat di pasar dunia.
Weakness
Pangsa pasar untuk sepatu atletik di Amerika menurun dari 48% di tahun 1997 menjadi 42%
di tahun 2000.
Harga saham yang terus menurun dari awal tahun 2001.
Opportunity
· Mengembangkan produk sepatu di segmen harga menengah yang sedang bertumbuh.
· Mendorong pendapatan melalui segmen produk apparel.

3. Threats
· Harga saham yang terus menurun akan terus berkelanjutan.
Statement of the problem
Keputusan apakah yang akan dikeluarkan oleh Kimi Ford dalam investasi NorthPoint Large
Cap Fund di Nike, Inc.?
Alternative Course of Actions
1. Membuat keputusan untuk investasi di Nike, Inc. dengan menggunakan perhitungan
Weighted Average Cost of Capital yang dibuat oleh Joanna Cohen.
2. Menahan investasi yang akan dilakukan pada Nike, Inc.dengan mempertimbangkan
keadaan perusahaan yang sedang menurun.
Recommendation
Kami merekomendasikan alternatif pertama, dimana Kimi Ford harus mengeluarkan
investasi untuk Nike, Inc.
Case Analysis of Nike, Inc.: Cost of Capital
Apparently, the issue of Nike’s case is to control and check the calculation cost of capital
done by Joanna Cohen who is the assistant of a portfolio manager at NorthPoint Group. But I
am willing to tell you that it can be a complex case in which we can doubt about sensitivity
analysis done by Kimi Ford (portfolio manager) because her assumptions such as Revenue
Growth Rate, COGS / Sales, S &A / Sales, Current Assets / Sales, and Current Liability /
Sales have been adopted from previous income statements and balance sheets from 1995 to
2001. Perhaps, we can take new assumptions. Generally, the case issue is to examine if the
share price of Nike is undervalue or overvalue and the common stock of Nike Inc should be
added to the North Point Group’s Mutual Fund Portfolio or not.
Now, let me approve Kimi Ford’s analysis and tell you only the mistakes of Joanna Cohen.
What is the cost of capital?
The cost of capital is the rate of return that a firm must earn on the projects in which it invests
to maintain the market value of its stock. Cohen calculated a weighted average cost of capital
(WACC) of 8.4 percent by using the Capital Asset Pricing Model (CAPM) for Nike Inc. I do
not agree with Joanna Cohen because of below mentioned:
-In the field of Equity’s Cost:
 She should use current yields on US Treasuries 3 to 12 months at 3.59% because the yield
curve is upward sloping. Upward sloping yield curve means that North Point Group should
rely to short-term financing instead of long term financing. In fact, by short term financing,
the manager can use cheaper cost of equity. It means that North Point Group should sell the
purchased shares of Nike during the period of one year.
 In the case of value of equity, Cohen’s should use liquidation value in calculating value of
equity. Liquidation value per share is more realistic than book value because it is based on
the current market value of the firm’s assets by using of balance sheet data.

4. Market Value of Equity (E) Calculation:
E = Stock Price x Number of Shares Outstanding
= $42.09 X 271.5
= $11,427.44
This figure is should be used for market value of equity (E) rather than Joanna Cohen figure
($3,494.50).
-In the field of Debt’s Cost:
 In calculating value of debt, Cohen should have discounted the value of long-term debt that
appears on the balance sheet. It means she should also consider the future value of total long
term debt base on coupon rate.
To calculate total value of debt, the steps are as follows:
Market Value of Debt (D) Calculation:
I considered the total amount of Debt for all items which are included by a interest
rate as follows:
-Current portion of long -term debt
-Notes payable
-Long - term debt
-Redeemable preferred stock
D = Current LT + Notes Payable + LT Debt (discounted)
= $5.40 + $855.30 + $435.9 + 0.3
= $1296.9
Using these figures, we can now find the market value of Nike Inc., and the company’s
capital structure.
The Calculation of Weighs:
The weights of debt and equity are calculated using the market values of debt and equity as
follows:
Weight of Debt (WD)
D + E = 1296.9 + 11,427.44 = 12724.34
WD = D/ D+E
WD = $ 1296.9 /$12724.34
= 10.2%
Weight of Equity (WE)
WE = E/ D +E
WE = 11,427.44/ 12724.34
=89.8%

5. Cost of Debt
There are two types of interest rate for Nike, Inc. as follows:
1) For Notes payable, Current portion of long - term debt and Redeemable preferred stock,
all these debts should be cleared during the period of maximum 12 months. Therefore, I
calculated the interest rate in accordance with Exhibit 1(Income Statement) for 2001 year as
follows:
Interest rate = Interest payment / Operating income
Cost of Debt = Interest rate = (58.7 / 1014.2) * 100 = 5.78%
You can see this interest rate is approximately equal to 20 year yields on U.S Treasuries
(Exhibit 4).
2) For Long - term debt, Nike, Inc. had issued the Bonds in which the Cost of debt was
calculated by finding the yield to maturity on 20-year Nike Inc. debt with a 6.75% coupon
semi-annually. I assumed Nike Inc. to have a single cost of capital since its multiple business
segments (shoes, apparel, sports equipment, etc.) are not very different and would experience
similar risks and betas.
Before-Tax Cost of Debt
I used three (3) methods as follows:
-Method (1): Using Cost Quotations Based on Coupon Interest Rate and Yield to
Maturity (YTM)
Cost of Debt = 14.14%
-Method (2): Based on calculating the IRR
Cost of Debt = 14.15%
-Method (3): Approximating the Cost Based on the Value Bond and Coupon Rate
Cost of Debt = 14%
All of the calculations have been included in my spreadsheet.
As we can see, all three methods present us approximately the same amount of the cost of
debt. I have chosen 14.15% for the cost of debt.
It is important to find the relationship between the required return and the coupon interest
rate. When the required return is greater than the coupon interest rate, the bond value will be
less than its par value. We choose cost of debt as 14.15% because it is rational (coupon value
annually is 13.50%). When current value of bond is less than par, required return will be
more than coupon rate.
Weight Average of Cost of Debt:

6. As I mentioned, there are two types of debt and consequently we have two types of Cost of
Debt. I calculated the weight average for Cost of debt as follows:
Total debt type 1 = $5.40 + $855.30 + 0.3 = $861
Total debt type 2 = $435.9
Total debt = $1296.9
W (type 1) = (861 / 1296.9) * 100 = 66.4% , Cost of Debt (type 1) = 5.78%
W (type 2) = (435.9 / 1296.9) * 100 = 33.6% , Cost of debt (type 2) = 14.15%
Weight Average of Cost of Debt = (66.4% * 5.78) + (33.6% * 14.15) =
3.84 + 4.75 = 8.59%
Therefore, the Cost of Debt is equal 8.6%
After-Tax Cost of Debt
Cost of financing must be stated on an after-tax basis. Because interest on debt is tax
deductible, it reduces the firm’s taxable income.
ri =rd x (1 –T)
=8.6% x (1 – 38%)
=5.33%
Nike Case
Summary
We recommend a buy for Nike's stock on July 6, 2001. Our analysis consists of a
discounted cash flows model. We projected unlevered free cash flows over the next
10 years and discounted them according to our derivation of Nike's weighted
average cost of capital. Our analysis suggests the stock is significantly undervalued,
given our expectation it will deliver earnings in the future.

7. Below we have analyzed Joanna Cohen's WACC calculation and her projection of
cash flows. We then calculate our own WACC, discuss the results of our own model
for cash flow projections, and conclude with our valuation and notes regarding our
recommendation.
Evaluation of Joanna Cohen's WACC Calculation
Cohen's WACC calculation is decent, but has a few issues, and a number of errors,
as described below.
Weighting the capital structure. She weights the capital structure using the book
value of equity. Nike is a public company, and its market capitalization is a more
relevant metric for equity than the book value of equity.
Cost of debt. To calculate the cost of debt, Cohen simply divides the interest
expense by the average balance of the interest-bearing debt. This is an
approximation for the true cost of the debt, but is too inaccurate. The interest
expense line may include expenses not directly related to the debt of the company
(unlikely, but perhaps non-cash payment-in-kind expenses for the preferred stock, or
simply interest expense recognized under GAAP, but not necessarily indicative of
real costs of debt).
The cost of debt should include the current market yield on Nike's publicly traded
debt, as this is a more pertinent metric.
Furthermore, Cohen uses the 20 year yield on treasury bonds to approximate the
risk free rate. We feel that the 3-month yield on treasuries is appropriate.
Market premium. Cohen uses a market premium of 5.9%, which is surprisingly low.
She claims it is the market performance in excess of the treasury rate, but fails to
defend this assertion. Perhaps using the arithmetic mean is a better approximation
than the geometric mean for the market risk premium.
Decision to use only one WACC. She divided each division by revenue. In
deciding whether to use an overall WACC, or to assign a WACC to each division,
she should have weighted each division by cash flows, and not by revenue. It is
reasonable to ignore the other sports division, as it is such a small fraction, but
perhaps it would have been wise to calculate different WACC's for the footwear and
apparel divisions. However, her evaluation of risk related to each division is a

8. defensible one in using a single WACC for the entire company, and we view this as a
potential issue, but not as an error per se.
Cost of Japanese debt. The risk related to Japanese debt comes not only from
interest rate risk, but also more significantly from foreign currency exposure. This risk
has not been accounted for and is actually a more potent risk to the debt than
fluctuations in the yield to maturity.
Tax benefit of interest expense related to Japanese debt. Under U.S. tax law,
interest expense on non-dollar-denominated debt is not a tax-deductible expense,
and thus these notes should not be tax-effected (our analysis, however, remains
within the scope of this class and tax-effects the yield to maturity).
Evaluation of Joanna Cohen's Cash Flow Projections
Overall, her projections seem fairly sound. She keeps margins fairly consistent, with
only slight variations. Revenue growth projections are modest, and the firm seems
decent cash requirements. However, there are a few issues with her projections.
Revenue growth projections. Company executives indicated a long-term revenue
growth target of 8% to 10% and earnings growth targets of above 15%. Why has she
cut her projections? We do not consider her move unreasonable, but we are
interested to hear why she did this.
Capital expenditures and depreciation. She projects depreciation and capital
expenditures as equal in the future. It is unlikely, considering the projected growth
rates, that Nike could grow without increasing capital expenditures. Looking at their
historic financial statements, capital expenditures far outweighed depreciation and
amortization, and so Cohen has made the mistake of understating cash
requirements related to fixed costs. (See appendix 1 for our projection of capital
expenditures and depreciation.)
Positive cash requirement for net working capital. In her first year's projection,
she shows a cash inflow of $8.8 million related to working capital. Where does this
come from, and why does it occur? Historically, her working capital requirements
have been consistently negative, and since she projects the company to grow, we
expect the company to use cash in working capital.

9. Equity value calculation. The calculation of enterprise value to equity value only
removes total debt. It should remove net debt and preferred stock, and so has
understated equity value.
Shares outstanding. Her figure for shares outstanding does not match the diluted
share count on the income statement, nor does it match the common shares
outstanding (when net income is divided by common EPS).
Cash flow recognition method. She assumes an end-point method for recognizing
cash flows. While this is not uncommon, it is also probably not appropriate, as Nike
receives cash flows throughout each period, and thus should recognize the cash
flows using a mid-point method.
WACC Calculation
See appendix 4 for full details of our WACC calculation. We calculated the cost of
debt using the yield to maturity, considering an upcoming coupon payment is about
to be made. Our cost of equity followed the capital asset pricing model, and the two
costs were weighted by their levels within the capital structure, using market
valuations in weighting the equity value.
Recommendation
In the attached appendices, we calculated our own WACC and projected cash flows,
duplicating Cohen's analysis but with corrections as we saw fit (described above). In
the appendix, we projected future capital expenditures and depreciation, as we did
not agree with Cohen's assertion that capital expenditures will equal depreciation.
We then discount the new cash flows subject to new, but similar, criteria, and arrive
at an enterprise value. Finally, we calculate an equity value and produce a similar
sensitivity chart as shown before.
The model in the appendices employs methods that correct those used by Cohen.
We re-projected capital expenditures and depreciation to be more accurate (as
appendix 1 demonstrates) and tweaked the discounting methods, as described in the
above sections.
Our analysis, in appendix 3, shows equity prices per share at various discount rates.
Most values are above the current share price of $42.09. Our chosen discount rate
of 9.09% yields a share price of $61.44, or a current under-valuation of the stock of
$19.35 (46%) per share. The discount rate that yields no over- or under-valuation

10. (the current price per share) is 11.41% – significantly higher than our discount rate of
9.09%.
Since the date of the case, Nike's stock rose sharply in the following 9 months,
proceeded to drop back down to similar levels after 1 year, and continued to grow
significantly thereafter. However, in recent months (2008), it has come down. The
short run (after the case) validates our analysis somewhat, however, it is
extraordinarily difficult to identify a time period that represents the point at which we
agree whether a valuation was "correct" or 'incorrect" (and of course, it is also very
difficult to identify what constitutes a correct valuation in the first place).
Appendix - http://www.filedropper.com/appendix1to4
Executive summaryIn this report we focus on Nike's Inc. Cost of Capital and
its financialimportance for the company and future investors. The management of
NikeInc. addresses issues both on top-line growth and operating performance. The
company's cost of capital is a critical element in such decisions and it isimportant to
estimate precisely the weighted average cost of capital (WACC).In our analysis, we
examine why WACC is important in decision making andwe show how WACC for
Nike Inc. is calculated correctly. Also, we calculatethe company's cost of equity using
three different models: the Capital AssetPricing Model (CAPM), the Dividend
Discount Model (DDM) and the EarningsCapitalization Model (EPS/ Price), we
analyze their advantages anddisadvantages and finally we conclude whether or not
an investment in Nikeis recommended.Our analysis suggests that Nike
Inc.'s common stock should be added to theNorth Point Group's Mutual Fund
Portfolio.I. The Weighted Average Cost of Capital and its Importance for Nike
Inc. The Weighted Average Cost of Capital (WACC) is the average of the costs of a
company's sources of financing-debt and equity, each of which is weightedby its
respective use in the given situation. By taking a weighted average,we can see how
much interest the company has to pay for every marginaldollar it finances. A firm's
WACC is the overall required return on the firm asa whole and, as such, it is often
used internally by company directors todetermine the economic feasibility of
expansionary opportunities andmergers. Also, WACC is the appropriate discount
rate to use in stockvaluation.II. Calculation of Nike's WACC The calculating
methodology for Nike's Inc. WACC seems to be inconsistentwith the principles1 that
should be followed when estimating this measure. These are our points of
disagreement with the calculations in Exhibit 5:- Calculation of the cost of debt
by taking the total interest expense for theyear 2001 dividing it by the company's
average debt balance, which is notappropriate for the WACC estimation- Use as tax
rate the sum of state and statutory taxes instead of the firm'smarginal tax rate- Use
of the Book Value of equity rather than the market value which issuggested as it
gives more precise results- Calculation of the cost of equity using long time period
for risk free rate and
risk premiumIn order to make our justifications more comprehensive we need the
formulafor estimating WACC:WACC= Wd*Kd(1-T) + We*KeFirst, we reexamine the
cost of debt (Kd) which in this case is the yield tomaturity (YTM) on the bonds. The

11. YTM is a good estimate for the cost of debtif a company had issued debt in the past
and the bonds are publicly traded just as in Nike's case. Our calculations for Nike's
yield to maturity based onthe given data showed that Kd= 7.16%.c1 (See Appendix
for detailedcalculations) The second variable that should be noted is T or the tax
rate. In hercalculations, Joanna Cohen added the 3% state taxes to the 35%
statutorytax where in WACC calculation the marginal rate should be
used. Themarginal tax rate generally refers to the "federal income tax that is
leviedonto the additional dollar earned" and usually is about 40%. The weights of the
costs, Wd and We, are very important in calculatingWACC as they show the
company's capital structure. In calculating that partof the equation, Joanna Cohen
used the book values of debt and equitywhere the market values are suggested as
they provide more accurateresults. As book and market values of debt and equity
may differ a lot,market values of debt and equity give a closer estimation of the
capitalstructure2. We calculate the enterprise value (P0*#shares outstanding
=$11,427.4357m). For debt, the book value gives a close estimation for thecurrent
value, whereas the same doesn't hold for the value of equity. Thus,debt is equal to
$1,296.6m (current portion of L-T debt + notes payable + L- T debt). In finding the
weights, the previous explanation shows that equity is88.65% whereas debt is
11.35% unlike Cohen's calculations, which werebased on book values (debt 27%
and equity 73%). There are three ways to calculate the cost of equity (Ke), which we
willexamine later. In our calculations of WACC we use the Capital Asset
PricingModel (CAPM), as it is considered to be the most complete model
forestimating the cost of equity.CAPM Equation is: Ke=Krf+ β(Km-Krf)c2,where
Ke is the cost of equity, β is beta that measures the tendency of a stock to
move up and down with the market, Km is the required return of the market, Krf is
the risk free rate and (Km - Krf) is equal to the market riskpremium.For the Krf (risk
free rate), we used the current yield on 10yr bond (5.39) U.S.
treasuries, instead of the 20yr, as the 10yr matches the duration of cashflows for the
Nike's investment project (Exhibit 2) and because it is relativelyless exposed to
unexpected changes in inflation and the liquidity premiumwhen compared to the
longer 20 yr bond3. For the market risk premium, Km- Krf, we used the arithmetic
mean (7.5%). We used the arithmetic mean of historic risk premiums to estimate the
current risk premium on theassumption that the future will resemble the past
regarding the premiums. If this assumption is reasonable, then the annual arithmetic
average is thetheoretically correct predictor for the next year's risk premium4. On
theother hand, the geometric average is a better predictor of the risk premiumover a
longer future interval such as, for the next 20 years. For β weused the historic
average of the past 6 years (0.8). After we calculate thecost of equity with CAPM
(Ke= 11.39%), we plug our results in the givenformula of WACC and we get
WACC=10.59c3.III. Alternative Methods of Calculating the Cost of EquityAlthough,
CAPM approach is considered to be an accurate and preciseestimate of Ke, there
are two other models used by those analysts who donot have complete confidence
in CAPM. These approaches are the DividendDiscount Model (DDM), which
compares dividends forecasted for the nextperiod with the current share price for the
firm and then adds the growthrate of the firm and the Earnings Capitalization Model
(ECM), whichcompares forecasted earnings for the next period over the current
shareprice. Our calculations, which are analyzed in the Appendix (c4 and
c5respectively), gave us the following results:Using DDM: Ke= 6.7%Using ECM: Ke=
9.88%We can see that the three different methods of calculating the cost

12. of equityproduced widely varied estimates. In such situations the financial analyst
hasto use his/her judgement as to relative merits of each estimate and thenchoose
the estimate which seemed more reasonable under thecircumstances.Comparing
the already discussed methods, we found that the mainadvantage of CAPM
approach is that it takes into consideration a company'smarket risk as the most
relevant risk to stockholders, hence to determine theeffect of the new activities and
projects of the company on stock price. Thismethod can be applied to firms that do
not pay dividends as well as newfirms, by using betas for similar firms (e.g., other
firms in the industry).However, with CAPM all our projections are based on historical
data onto thefuture, because of the estimate of Beta we use. Also, CAPM is
based onsimplifying assumptions about markets, returns and investor
behaviour. The dividend discount model (DDM) is a simple model for valuing equity.
It is