Nike Wacc Case Study

Topics: Arithmetic mean, Weighted average cost of capital, Average Pages: 10 (2268 words) Published: January 10, 2012
Financial Management


1. What is the WACC and why is it important to estimate a firm’s cost of capital? Do you agree with Joanna Cohen’s WACC calculation? Why or why not? 2. If you do not agree with Cohen’s analysis, calculate your own WACC for Nike and justify your assumptions. 3. Calculate the costs of equity using CAPM, the dividend discount model, and the earnings capitalization ratio. What are the advantages and disadvantages of each method? 4. What should Kimi Ford recommend regarding an investment in Nike?


Case Overview
Nike, Inc. NorthPoint Group Investment Decision

 Current share price of USD 42.09  Declining market share for the period 1997-2000  Strategy for revitalizing the company under consideration  Plan to boost revenue and optimize costs  Highly experienced management team

 Mutual fund management firm  Emphasis on large-cap value stocks  Has been outperforming the market for the past 18 months  Kimi Ford – portfolio manager seeking to identify undervalued stocks, consistent with the fund’s investment strategy

 Stock valuation based on forecasting future cash flows over a ten year period  Discounting the UFCFF using a predetermined WACC value  Calculating the discount factor based on the CAPM approach  Considering sensitivity analysis


Understanding the WACC
 The Weighted Average Cost of Capital is the interest rate (minimal return) at which investor-supplied capital (equity and interest bearing loans) has been provided. Therefore, it is the weighted average minimum expectation, which shareholders and creditors require for their respective investments made with the company under consideration.  The WACC reflects both, the cost of equity and the cost of debt. Different sources of funds have different costs and therefore, depending on the capital structure of the organization, the weightings of debt and equity are calculated and assigned.  The WACC is calculated using the following equation: WACC = [E/(D+E)] x Ke + [D/(D+E)] x Kd (1-t)  The minimum required return on shareholders’ investment.  CAPM method has been widely used in calculating the cost of equity.  Ke = Rf + b.(Rm – Rf)  Risk level and volatility are calculated based on historical data. Cost of Equity Cost of Debt

 The interest rate at which a company can acquire new debt.  Any fixed rates on outstanding debt are not relevant, since the investors are concerned with what it will cost the company to generate cash from any future investments, which would occur at market rates rather than historical ones.  After tax cost of debt = (1-t)Kd, since interest is tax deductible.


Critique of Joanna’s Calculations
Calculating Ke
 Since Joanna’s FCF forecast reflects a ten year period, it could be argued that, for the sake of consistency, the yield of a risk free ten year security should be used instead.  An arithmetic mean estimation of the risk premium is generally accepted as an appropriate approach by the investment community.*  Since Nike is a multinational company, its revenue stream bears additional risk based on the specific allocations to various countries. This should reflect additional risk premium such as exchange rate risk, political risk etc. Such calculation goes beyond the scope of this case but it should not be ignored.  Beta has been calculated as a historic average but the included value YTD 06/30/01 should be excluded not only since it is not consistent in terms of period length, but the apparels business is seasonal with great portion of the revenues coming during the months of Dec. and Nov. Historic betas prior to 1996 should not be excluded.

Calculating Kd
 Cost of debt is not properly calculated since potential shareholders and creditors are not concerned with interest on outstanding debt, but rather the current market rate at which the company could borrow to finance its operations and potential expansion.  The technique used by Joanna is useful...
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