Kimi Ford is a portfolio manager at NorthPoint Group, a mutual-fund management firm. In July 2001, Ford considered buying shares of Nike, Inc., the well-known athletic shoe manufacturer. It would be prudent of Ford to base her assessment on Nike’s financial reports for 2001. Around the same time, Nike held an analysts’ meeting to disclose those financial results. They also addressed ways to revitalize the company, since share price was beginning to decline and revenues had plateaued at around $9 billion. Although Nike projected a rosy future, many analysts had mixed reactions to the projections. Ford was right to come up with her own forecast, seeing as the reactions ranged from too aggressive to growth opportunities.
In order to completely analyze Nike and its possible place in the NorthPoint Large-Cap Fund, Ford needs to know Nike’s cost of capital. One of the most useful ways to measure the cost of capital is the weighted average cost of capital (WACC). Theoretically, the optimal capital structure in the mix of types of financing that produces the lowest WACC. WACC is calculated by multiplying the cost of each type of financing a company uses, be it debt or the many types of equity, by their respective weights. It is the rate of return that a company needs to earn in order to satisfy the returns they have to pay out to debtholders and stockholders. The respective weight of each type of financing is determined by their percentage of total capital. The WACC is extremely relevant to a company’s capital budgeting team and other capital finance department members. WACC is extremely useful in determining whether or not to accept a capital project. If a proposed capital project produces a rate of return higher than the company’s WACC, that project should be accepted. If the project’s rate of return is lower than the WACC, it should be rejected. As mentioned before, the optimal capital structure produces the lowest WACC. Thus, WACC is used to determine a company’s preferred capital structure. We do not completely agree with the WACC of 8.3% that Joanna Cohen, Ford’s assistant, came up with. While we agree with some of the measures and assumptions she came up with, we disagree with others, all of which will be discussed in depth below. As you will read in the determination of our WACC below, we feel the proper cost of capital for Nike is 10.47%. Using this new cost of capital we believe Nike would be a good addition to the large-cap fund because after discounting projected cash flows, we found the value of Nike’s stock price to be undervalued by $4.72.
Determination of WACC
I. Single or Multiple Costs of Capital?
We agree with Cohen’s stance that only one cost of capital should be used. She discussed that Nike had many products lines, ranging from footwear and athletic wear to some non-Nike branded products. However, we agree with her statement that “they face the same risk factors.” Therefore, the single WACC should be appropriate for the entire company.
II. Methodology for Calculating Cost of Capital: WACC
In this instance it is appropriate to use the weighted average cost of capital (WACC) method, because Nike is funded by both debt and equity. But, we do not agree with how Cohen determined the weights of debt and equity. Cohen uses the book values of both Nike’s debt and equity to determine the two weights of capital used in calculating WACC. Preferably, the relative market values of the debt and equity should be used to determine the weights. However, it is allowable practice to use the book value of debt as part of the weight calculation in cases where the market value is not readily ascertainable.
To calculate the value of Nike’s debt we need to add the current portion of long-term debt, notes payable, and discounted long-term debt. The current portion of long-term debt and notes payable can be found in the financial statements. The long term debt needs to be discounted,...