Statement of Problem

In this case, main motivation is centered on what could be appropriate discount rate or WACC
for Nike and what is the stock price that can be achieved from firm valuation process. As the
previous estimate of Kimi Ford (portfolio manager in NorthPoint Group-a mutual fund) has
shown initially used cost of capital was 12% but sensitivity of estimated stock price is high with
respect to used cost of capital. Ambiguity here is not limited to this. Joanna Cohen (an assistant
in mutual fund) is also asked to calculate WACC with more detailed framework and her proposed
number which is 8.4% is also different. Thus, it is required to calculate WACC with realistic
assumptions and inputs to value Nike for decision of whether NorthPoint should invest or not in
Nike stock.
Key Facts from Case
NorthPoint mutual fund has a policy of including mature, financially stable within their
portfolios such as ExxonMobil, McDonalds, GM etc. This was one intention why mutual fund is
interested in investing Nike. Apart from this, Nike has experienced decreases in financial
indicators recently. For instance, their bottomline (net) margin was 8.5% in 1996 and decreased
to 6.2% in last 5 years. Trend in all margin data can be found in Table 1, and downward trend in
all types of margin values can be taken as a decline in efficiency of Nikes operations.
Furthermore, considerable decline in growth in nominal profit amounts and revenue growth
shows declining prospects of Nike (relevant data is in Table 2). As a strong response to this lower
profitability, Nike organized an analysts meeting and announce new strategies to potential
investors. A market expansion in midpriced segment, a push in apparel line and more effort on
cost control were all among those measures. This ambiguity was main reason behind different
valuation results of different analysts.
Analysis
The analysis conducted to reach WACC has several steps, each of which includes critical
assessment of Cohens analysis. To begin with, Cohen used ratio of interest expense on
outstanding debt balance. However, since Nike has corporate bonds previously issued, it will be
more accurate to use yield on it. Since interest expense is not a forward-looking measure, YTM
on bond which is market-determined is more comprehensive and accurate for future. Table 3
shows our calculation of cost of debt. In the case a previously issued bond of Nike was given. It
has 25 years of maturity with semiannual coupon payments at 6.75% and is currently traded at
$95.6. We also assumed a 2% of flotation cost. Tax rate is 38%. Hence we constructed the
payment scheme from Nikes perspective in the form of lower initial price (flotation costs
impact) and after tax coupon payments. We used Excel Solver to come up with YTM rate which
equates present values of payments of bonds to current price. The annual equivalent of that YTM
with simple compounding is around 9%. So our finding is somewhat different from 2.7% cost of
debt of Cohen.

Secondly, weights in the formula of WACC which are directly coming from capital structure of
firm should be focused. Basically, we do not agree with the weights used by Cohen as she has
employed the book values of debt and equity. However as Nike is a mature firm, the market
value of its equity might be far different from book value that includes the par value of stock that
was issued in the past. Table 4 shows our calculation. We include the same items given in the
case as sources of capital: current portion of LT debt, NP and LT debt. Its assumed that market
values of debt items are same as book values of debt items as there is no secondary market for
those items to be traded and priced separately. To find market value of Nikes equity we
multiplied shares outstanding and current share price. Resulting weights of debt and equity are
10.19% and 89.81% which we determine being same as target capital structure.
Cost of equity is another input for WACC calculation. There are two widely used methods to
come up with proper cost of equity. Firstly, CAPM model incorporates two types of
compensation an investor receives through holding security: time value compensation (through
risk free rate) and risk compensation (beta multiplied by excess market return). For risk
compensation, as nonsystematic risk can be diversified away through portfolio formation, only
risk considered is systematic risk which is something measured by beta (sensitivity of stock
return to macroeconomic fluctuations). Our calculation can be seen in Table 5. We mostly agree
with Cohen here except for equity risk premium. Normally, its wise to match the maturity of
Treasury bond (used for risk free rate) and life span of a project (whom we discount); but since
here its the company we are valuing and corporations are assumed to live forever, using the
yield on Treasury with longest maturity (20 years) is logical. For beta measure, we are bounded
with the provided data in the sense that only past 5 years beta figures has been provided to us
with respect to the stock of Nike. Hence we concluded that continuing with the average Beta
figure is valid. Lastly, our deviation point from Cohen is the fact that she used the geometric
mean for market risk premium but in the class notes it was given that using arithmetic average is
more effective method for processes that contain a focus or estimation involved for future. One
important assumption here is that past data is accepted to be independent draws from the same
distribution. If this is the case we know that expectation operator is an unbiased estimator of
actual population value (of some future phenomenon). Since the firm valuation is done through
the estimated cash flows we have used arithmetic average (7.5%). Resulting cost of equity is
11.74%.
Second method to come up with cost of equity is Gordons constant growth dividend discount
model. In Table 6, our DDM calculations are given. According to this model, investors required
rate of return is calculated from division of next dividend to current stock price, summed with
constant assumed dividend growth rate. Nikes distributed dividend has been same at $0.48 per
share for last 3 years. Furthermore, value line forecast of dividend growth is given as 5.5%
which we took as a proxy for constant growth rate. Cost of equity from this DDM method is
6.7% which is far lower than the figure we found in CAPM (almost 60% of that figure). DDM is
not feasible if firm of interest is not distributing dividend, luckily Nike has a certain dividend

policy. One criticism against it could be that its growth rate is less sticky and not responsive as
estimated growth rate of firm itself. But in this case, this is not so true. 5.5% assumed dividend
growth is not too much different from constant taken growth rate of revenues used in DCF
analysis for 10 years of investment horizon (there growth rate was 6%). Despite the fact that
Nike is a mature firm, its current investment and plan implementation process with measures that
we have discussed at the beginning (market extension, cost control) may prevent it to have
smooth dividend growth for future. With this consideration and very low cost of equity figure
obtained from DDM, we decided to use CAPM instead and determine cost of equity as 11.74%.
After deciding to use CAPM for cost of equity, respective calculation for WACC has been
conducted in Table 7. Resulting WACC figure is 11.46%.
Based on the resulting WACC of our analysis, we would not reach to the same conclusion as Ms.
Fords in terms of acquisition of Nike stocks. As seen on Table 8 of Appendix, our analysis
shows that current value of Nike shares is $ 38.87 and so it is overvalued at the current market
level. Thats why our recommendation would not be to buy the stock at this price level.
WACC is a benchmark for company managers to evaluate the economic feasibility of
opportunities and mergers. It is as a whole required return on the firm. It is the discount rate to
use for cash flows with risk that is similar to that of the overall firm. By taking a weighted
average, we can see how much interest the company has to pay for every dollar it finances.
WACC is used when valuing and selecting investments, assessing ROIC. In discounted cash flow
analysis, for instance, WACC is used as the discount rate applied to future cash flows for
deriving a business's net present value. It is also used for economic value added calculations.
Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum
rate of return at which a company produces value for its investors.
Cohens decision to use single cost of capital instead of multiple costs of capital can be assessed
from a couple of dimensions. First, if there is going to be a multiple costs of capital evaluation, it
has to be on footwear and apparel since they constitute 92% of the total revenues. Then it has to
be decided whether apparel business has enough diversion from footwear business in terms of
risks they face and in terms of the profile of those businesses. Even though it is stated in Ms.
Cohens analysis that those two are directly seen as sports-related products, we also learn from
the case that there are growth opportunities in apparel business. This shows there is a level of
distance between two segments and there is an opportunity to be exploited in a segment without
expanding that much in the other one. But again on the other hand, the apparel and footwear are
both related to sports involved activities and it can be argued that they are prone to the same type
of risks in the market. This brings us to the position that without further information, it is hard to
reach a decisive result on using single vs. multiple costs of risks.

APPENDIX
Table 1

Table 2

Table 3

Table 4

Table 5

Table 6

Table 7

Table 8