Nike Cost of Capital Analysis
October 22, 2010
In this case analysis Kimi Ford, a portfolio manager for a large cap value mutual fund, NorthPointGroup is considering adding shares of Nike, Inc., an athletic shoe manufacturer as a new position in her fund. On July 5, 2001, Nike's share price had declined significantly since the beginning of the year. Although the market in general had declined over the last 18 months as well, NorthPoint Large-Cap Fund had firmly out- performed the market. Kimi had read mixed reports from the analysts, and decided to do her own discounted cash flow forecast for Nike, in order to come to a clearer conclusion. Her forecast showed that at discount rates below 11.17% Nike was undervalued. She asked her assistant to calculate cost of capital, and her assistant's analysis of the weighted average cost of capital was given in a memo to Kimi. On a closer look at her assistant’s analysis, the numbers used for the analysis appear to be wrong based on several of her assumptions in the calculation. My analysis of the WACC numbers, and the risks and return for potentially purchasing Nike shares for the portfolio follow in the report below.
Firstly, her assistant Joanna, used the book value of the firm’s equity instead of the current market value of the Nike’s equity, which would give a more accurate cost of capital here. In my calculation ( See Exhibit 1), I have calculated the equity number using the firm’s current stock price multiplied by the number of shares outstanding. Secondly, she used the interest expense for the company’s debt to arrive at the cost of debt, which again is inaccurate. In my calculation for the WACC, I calculated the weight of debt, and used the YTM for the company’s outstanding debt to arrive at the cost of debt figure. (see Exhibit 2) I also disagreed with Joanna’s risk free rate.
The price of the 20 year US treasury (which she used) can have much more volatility than short term treasury rates. If the company factors in interest rate risk, it would make sense to have laddered maturities to hedge the risk should they have to liquidate the securities in an unfavorable interest rate environment. Therefore if this strategy is employed, I would average the yields on US Treasuries to get the risk free rate, and use the resulting figure of 4.46% for the risk free rate. Thirdly, she uses the geometric mean for the equity risk premium which is a longer term market average, versus the arithmetic mean which is shorter term in nature. As a portfolio manager, I would assume that should Kimi decide to buy Nike in the portfolio, it would not necessarily be a long term hold in the portfolio if trading profits/losses were advantageous to the portfolio, so I chose to use the shorter term arithmetic mean for my CAPM calculation (see Exhibit 3). By incorporating these numbers into the weighted average cost of capital equation (see Exhibit 4) the portfolio manager could use the resulting figure to make the determination of the advantages of purchasing Nike at its current share price of 42.09.
E= Stock price x number of shares outstanding ( in millions of US dollars)
= 42.09 x 273.3
Weight of equity= E/D+E
= 11,503.18/1,277.42 +11,503.18
= 90.00 or 90%
This gives us the market value of the firm’s equity, which is much different from Joanna’s figure of ( 3,494.50)
( in millions of US Dollars)...
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