1.0 different methods for calculating the company’s costs of

1.0                                executive summary

 

In this report, we focus on Nike’s Inc. Cost of Capital and the importance of finance for the company as well as for future investors. In the case study stated the management of Nike Inc. has addresses issues both on top-line growth and operating performance. The company’s cost of capital is the most critical element in such decision and it is important to estimate precisely the weighted average cost of capital (WACC).

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This analysis, we assess the importance of Weighted Average Cost Of Capital (WACC) in decision making and show how the correct calculated WACC for Nike Inc. Therefore, there are three different methods for calculating the company’s costs of equity were used which is the first is by using a Capital Assets Pricing Model (CAPM), the second by using a Dividend Discount Model (DDM) and the third is by using an  Earning Capitalization Model (EPS/Price). Based on the calculation findings, therefore, we can conclude whether it is recommended to invest in Nike or not.

 

2.0                       problem statements

Kimi Ford, a portfolio manager at NorthPoint Group, began considering the possibility of purchasing Nike Shared for the NorthPoint Large-Cap Fund. One week earlier, the Nike analysts meeting disclosed that since 1997, revenue had plateaued for Nike while net income had fallen significantly. The new management plan was to address both top-line growth and operating performance by fiercely improving the mid-priced segment. However, before Kimi can make a decision regarding the share purchase these questions below should look over:

1.      What is the Weighted Average Cost Of Capital (WACC) for Nike?

2.      Do Nike shares correctly value at $42.09 per share?

3.      Is Joanna Cohen’s calculation correct and feasible?

4.      Is this a good investment for NorthPoint Group?

 

3.0       COST OF CAPITAL AND WEIGHTED AVERAGE COST OF CAPITAL                         (wACC)

3.1                   COST OF CAPITAL

Cost of capital is a more general concept and is simply what the firm pays to finance its operations without being specific about the composition of the capital structure (cost of debt and cost of equity). When companies borrow funds from outside lenders, the interest paid on these funds is called the cost of debt whereas the cost of equity is inferred by comparing the investment to other investments (comparable) with similar risk profiles. 

Some small business firms only use debt financing for their operations. Other small startups only use equity financing, particularly if they are funded by equity investors such as venture capitalists. As these small firms grow, it is likely that they will use a combination of debt and equity financing. Debt and equity make up the capital structure of the firm, along with other accounts on the right-hand side of the firm’s balance sheet such as preferred stock. As business firms grow, they may get financing from debt sources, common equity (retained earnings or new common stock) sources, and even preferred stock sources.

Calculation of Cost of Debt

The cost of debt for a business firm is usually cheaper than the cost of equity capital. This is due to interest expense on debt which is a tax-deductible expense for the business firm. This is why many small business firms, unless they have investors, use debt financing.

The smallest of business firms may use short-term debt only to purchase their assets. For example, they may just use supplier credit (accounts payable). They could also just use short-term business loans, either from a bank or some alternative source of financing.

Other businesses may use intermediate or long-term business loans or may even issue bonds to raise money for financing.

Calculation of Cost of Equity

Unlike cost of debt, which the company must pay in the form of predetermined interest, equity does not have a concrete price that the company needs to be paid back, but that doesn’t mean no cost of equity exists and it generally costs more than debt due to the tax advantage of interest payments.

Common shareholders expect to obtain a certain return on their equity investment in a company. The equity holders’ required rate of return is a cost from the company’s perspective because if the company does not deliver this expected return, shareholders will simply sell their shares, causing the price to drop. The cost of equity is basically what it costs the company to maintain a share price that is theoretically satisfactory to investors.

Importance of Cost of Capital

The cost of capital is very important in financial management and plays a crucial role in the following areas:

i)         Capital budgeting decisions: The cost of capital is used for discounting cash flows under Net Present Value method to measure investment proposals. So, it is very useful to choose a project which satisfies return on investment.

 

ii)       Capital structure decisions: An optimal capital is that structure at which the value of the firm is Value of the firm is maximum and cost of capital is the lowest. So, cost of capital is crucial in designing optimal capital structure.

 

iii)      Evaluation of final Performance: Cost of capital is used to evaluate the financial performance of top management. It involves the comparison of actual profit of the projects and taken projects overall cost.

 

iv)      Other financial decisions: Cost of capital is also useful in making such other financial decisions as dividend policy, capitalization of profits, making the rights issue, etc.

3.2                   WEIGHTED AVERAGE COST OF CAPITAL

Cost of capital is measured in terms of weighted average cost of capital, also known as WACC. WACC is the average interest rate a company must pay to finance its assets. As such, it is also the minimum average rate of return it must earn on its current assets to satisfy its shareholders or owners, its investors, and its creditors.

 

Weighted average cost of capital is based on the business firm’s capital structure and is composed of more than one source of financing for the business firm; for example, a firm may use both debt financing and equity financing.

 

WACC is derived from the sum of debt holders (cost of debt) and shareholders (cost of equity). In order to compute the weighted average cost of capital of a company; the individual cost of capital i.e. cost of debt and cost of equity is weighted by their proportions in the firm’s capital structure.

The following is the WACC formula:

WACC = RS x S / V + RB x (1-T) x B / V

 

 

RS is the return on equity (cost of equity)

RB is the interest rate (cost of debt)

T is the corporate tax rate

B is the value of debt

S is the value of equity

V is the Value of Firm or sum of the value of the firm’s debt and equity

 

Investors use WACC as a tool to decide whether to invest. The purpose of calculating WACC is to estimate the discount rate (minimum return required by investors) and it’s also can be used to calculate the intrinsic value of a company. Hence, in order to allow Kim Ford to make the purchase decision, Nike’s current share price value should be less than intrinsic value of a stock and the share price is undervalued.

Kimi Ford showed that Nike’s share was undervalued at a discount rate of 11.17% with the equity value is 42.09 which equal to the current share price. Any rate lower than 11.17% would make share price undervalued. Based on Joanna Cohen’s Analysis, Nike’s cost of capital read as 8.4% which less than 11.7%, it revealed that Nike’s share was undervalued and less than its intrinsic value, hence, Nike is worth to invest. The underlying logic is investor should invest something for less than it is currently worth. Therefore, it shown the importance of getting the WACC as accurate or relevant as possible.

4.0       Assessment of current Weighted Average Cost of Capital                          (WACC) calculation.

The following is an assessment of the assumptions and basis used by Joanna Cohen in the computation of the Weighted Average Cost of Capital (WACC) of Nike.

4.1                          single OR MULTIPLE cost of capital

Based on the characteristics of Nike it seems reasonable to adopt a single cost of capital approach despite the apparently many business segments. The reasons are summarized in the following.

Nike’s main business segment is footwear that contributes to the revenue with about 62%, with the second largest segment being apparel contributing with 30%. Products like sport balls, timepieces, eyewear, skates, bats, and other equipment designed for sport activities contributes with only about 3.5%, whereas non-Nike branded products contribute by merely 4.5%. Nike apparel and products together with non-Nike branded products do contribute significantly to the revenue. However, this is due to the following deficiencies not sufficient to consider them as cost of capital distinct from footwear:

Except for the non-Nike branded products, which only contribute little to the revenue, there are no significant differences in the risk rates for the different business segments.

Business activities such as marketing, distribution, customer service, quality and guarantee are common for the Nike branded products that are further displayed in stores having similar designs.

4.2                          COST OF debt

The WACC is used for discounting cash flow in the future. Hence, in such an assessment all components must be current and forward looking to describe a company’s future ability to raise capital. In her assessment Joanna Cohen used historical data in estimating the cost of debt. In doing so she made the mistake of not considering the future interest that Nike is obligated to pay on its new borrowings. Instead the cost of debt or borrowing should be estimated by maturity of bonds and also the credit rating of Nike.

4.3              COST OF equity

To estimate the cost of equity Joanna Cohen chose the CAPM (Capital Asset Pricing Model) to estimate the cost of equity, with:

·         Risk free rate as 20 year T-bond

·         An average of Nike’s historical Beta

·         A market risk premium (based on the geometric mean)EJ1 

The arithmetic mean for the market risk premium is actually higher than the geometric mean, but the latter is commonly used for valuation of investment options as it is an independent measure of the risk.

There are alternatives to the CAPM but they tend to be more subjective, are not necessarily valid for the present case. The chosen model is, despite its limitations, a useful device for understanding the risk return relationship as it provides a logical and quantitative approach for estimating risk.

4.4       Debt Equity Ratio

Since the objective is to assess a company’s ability to raise capital in the future it is important that the market value and not a historical book value is used as the basis for as the basis for debt and equity weights, i.e. consider current share price, average shares outstanding and debt.

 

5.0       revised assumptions and computation for wacc

The WACC of Nike can be computed as follows:-

WACC         = RS x S / V + RB x (1-T) x B / V

                      = 9.81% (0.899) + 7.16% (1-0.38) (0.101)

                      = 8.82% + 0.45%

                      = 9.27%

5.1                   KEY ASSUMPTIONS FOR WACC

Based on the analysis highlighted in Section 4, the following assumptions for the computation of WACC are proposed:-

5.1.1        Single Cost of Capital

All business segments of Nike had about the same risk.

5.1.2        Current Cost of Debt 

WACC is used for discounting all its future cash flows to determine the value of the entire firm. As such, the current cost of yield to maturity of the Nike’s bond (data provided in Exhibit 4) will be more relevant to estimate the future cost of debt instead of past interest rates (derived by past interest expense over average balance of debt)

Nike’s current cost of debt which is calculated from the current yield to maturity can be calculated as follows:-

Current bond price is 95.60

Coupon rate is 6.75%/2 = 3.375%

N=40 (2021-2001) years X 2

The discount rate is 7.16% per annum.

 

6.0               USING CURRENT MARKET RISK, BETA TO ESTIMATE COST OF  EQUITY

The average beta from 1996 to July 2001 used by Joanna which is 0.80 may not be representative to be the measure of the existing systematic risk for Nike. As such, the recent beta of 0.69 will more relevant in measuring the future beta of Nike.

Hence, the revised cost of equity for Nike will be:

RS = Rf + ?i x (RM – RF)

RS is expected return on Nike

RF is Bond with T 20 years maturity to represent risk free rate = 5.74%

?S is systematic risk of Nike = 0.69

RM – RF is geometric mean market risk premium = 5.9%

The new cost of equity for Nike, RS  = 5.74% + 0.69 (5.9%)

                                                                                                = 9.81%         

6.1       DEBT EQUITY RATIO

The estimation for the debt equity ratio computation should be based on current market value of Nike instead of net book value. The rationale for using market value 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 outstanding shares.

               = $ 42.90 x 273.3 million

                                                            = $ 11,503 million

Market value of debt = Book value of debt as at 31 May 2001

= $ 1,291 million

Equity (%)                                           = $ 11,503 million / ($11,503 million + $1,291 million)

= 89.9% or 0.899

Debt (%)                                             = 100.0 % – 89.9%

= 10.1% or 0.101

6.2                   CALCULATION OF COST OF EQUITY

6.1                   Capital Asset Pricing Model (CAPM)

In the case, Joanna Cohen uses the Capital Asset Pricing Model (CAPM) to calculate Nike Ink’s cost of equity.

The formula for Cost of Equity can be expressed as such:

KE – Rf + ? (RPm)

Whereby,

KE             = Cost of Equity

Rf              = Risk-free Rate

RPm = Market Risk Premium

?   = Beta Value of the Stock in Question

Joanna Cohen’s calculations is reflected as below:

10.5% = 5.74% + 0.8(5.9%)

Whereby her risk-free rate is derived from the current yield from the 20-year Treasury bonds, and the geometric mean of the historical risk premiums as market risk premium. Her beta value is derived from the average of historic betas, which is 0.80.

There is reason to believe that Joanna’s calculations might have overestimated Nike Inc’s cost of equity. As it is, Kimi Ford is looking into investing in Nike Inc’s shares at the current date, therefore using the year to date Beta value of 0.69 is more informed than using an average Beta value of historic Betas, as it is more representative of future Beta, which is more relevant information to potential investors.

Therefore using 0.69 as Beta value using the CAPM equation, the cost of equity of Nike Inc can be recalculated as such:

KE = 5.74% + 0.69(5.9%)

KE = 9.81%

Advantages of using CAPM to estimate cost of equity

1.         It considers only systematic risk, i.e risk that cannot be diversified away. This is truer to reality especially in firms with diversified portfolios that therein eliminates unsystematic risks.

2.         CAPM’s theoretically-derived relationship between systematic risk and required return has been frequently tested empirically, and all confirm the legitimacy of the theory.

3.         It takes into consideration a company’s level of systematic risk in relation to the overall stock market, which gives a clearer picture of a company’s cost of equity.

4.         It is applicable to companies that do not pay dividends, or have dividend growth rates that are difficult to estimate.

Disadvantages

1.         Betas are unstable through time, and the Beta value that is used in the CAPM is derived from historic data. This is especially disadvantageous if the model is used to evaluate future investment decisions.

2.         A true risk-free rate is unattainable in reality. Therefore the model’s calculation can only be indicative rather than conclusive when it comes to estimating cost of equity.

6.2                   Dividend Discount Model (DDM)

The Dividend Discount Model approach uses a formula to calculate the discount rate of a firm, which tells you the cost of equity capital. The formula is expressed as such:

Whereby

Rs        = Discount Rate

Div = Expected dividend to be received next year

P          = Price per share

g          = expected growth rate

 

We can therefore calculate Nike’s cost of equity as per below:

The advantage of the DDM approach is that it is fundamentally simple, and allows enough flexibility when estimating future dividend streams. Although inputs can be overly simplified, the value approximations can be fairly useful. The formula is also reversible, which makes it easy to make market assumptions for growth and expected return.

The disadvantages that come with this model are that it is not applicable to firms that don’t pay steady dividends, and does not explicitly account for risks in its estimations. There are also more measurement errors, in terms minor data entry or formula errors when making use of spreadsheets. If the evaluator is subjective with their inputs, it can also result in misspecified models and less than ideal results.

6.3                   Earnings Capitalization Ratio (ECM)

Another model that can be used to calculate the cost of equity is the Earnings Capitalization Ratio (ECM). The formula can be defined as such:

Whereby

KE        = Cost of Equity

E1        = Expected Earnings per share

P0        = Price per share

Therefore, using this approach, the cost of equity for Nike Inc would be

This method is simple, however it is the poorest method among the three, as it doesn’t accurately show the cost of equity of a company. It is only reasonably acceptable to estimate equity costs for companies that no longer expect to grow. However, in Nike Inc’s case, they expect to grow even further therefore it is not applicable to use this model to estimate the cost of equity.

 

7.0       RECOMMENDATION

Before we can suggest what should Kimi recommend to the NorthPoint Group regarding an investment in Nike, here is the finding.

From the calculation of the Weighted Average Cost Of Capital (WACC), we get $9.27 percent. Hence the present value of Nike will be $58.13 which is higher than Nike’s Current market which is at price of $42.09. Besides that, on Kimi Ford quick analysis she found that Nike was undervalued at discount rate below 11.7 percent. She used a discount rate of 12 percent to find share price of $32.27. Hence, it makes the share price of Nike Inc. is overvalued by $4.82 as Nike currently trading at $42.09. Therefore, this is not reflecting Nike’s true market value.

Furthermore, Nike company want to develop a more athletic shoe products in the mid-priced segment which can increase their sales, avenue, profits, share price as well as increase their dividend in the long term. Therefore, by using this finding we can suggest that Kimi recommend the NorthPoint Group to buy Nike Inc. shares at this time because it had potential that would be beneficial to fund.

 

 EJ1She used geometric mean, but the arithmetic mean is higher (ie indicates a higher risk). Could this suggest a higher cost of equity?

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