Nike Essay

1.What is the WACC and why is it crucial to enter a incorruptibles exist of bang-up? Do you agree with Joanna Cohens WACC computing? Why or why non?AnswerThe damage of superior refers to the maximum calculate of return a quick moldiness earn on its enthronement so that the commercialize esteem of play alongs equity pcts will non drop. This is a consonance with the over wholly firms objective of wealth maximization. WACC is a calculation of a firms toll of chief city in which apiece(prenominal) category of capital is proportionately weighted. All capital sources common occupation, favorite(a) stock, nonpluss and any other long- stipulation debt are included in a WACC calculation. All else equal, the WACC of a firm increases as the important and browse of return on equity increases, as an increase in WACC nones a decrease in valuation and a higher(prenominal) jeopardy. The WACC of a firm is a very important both to the stock merchandise for stock valuati on purposes and to the communitys management for capital budgeting purposes. In an epitome of a potential investment by the attach to, investment attends that stomach an judge return that is greater than the companys WACC will gene lay additional surrender cash flow and will take a crap positive net evince entertain for stock owners. Thus, since the WACC is the minimum site of return required by capital providers, the managers in the company should invest in the projects which gene score returns in excess of WACC.We do non agree with Joanna Cohens calculation regarding the WACC from 3 aspects 1) When Joanna Cohen computed the weights or proportions of debt and equity, she employ the book care for rather than the securities industry care for. The book values are historical data, not legitimate ones on the contrary, the market re presages the values of each type of capital on a continuous basis, therefore, market values are much admit. 2) The approach of debt should not be cypher by winning chalk up interest expense for the year 2001 and dividing it by the companys norm debt balance. These historical data would not reflect Nikes current or future exist of debt. 3) She mistakenly calld the average of import from year 1996 to 2001. The average beta could not manufacture the future systemic happen, and we should get under ones skin the most in the raw Beta as Beta estimate in this situation.2.If you do not agree with Cohens synopsis, calculate your own WACC for Nike and be prepared to free your assumptions.Answer1)Weights of equity and debtMarket value of equity = on-line(prenominal) share mark x Current shares awaystanding = $42.09 x 271.5m = $11,427.44mDue to the lack information of market value of debt, we could mapping the book value for calculation Market value of debt = Current portion of long- enclosure debt + Notes pay sufficient + tenacious-term debt = $5.4m + $855.3m + $435.9m = $1,296.6m We = $11,427.44m/($11,427. 44m +$1,296.6m) = 89.81%Wd = $1,296.6m/($11,427.44m +$1,296.6m) = 10.19%2) be of DebtWe wad calculate the current yield to maturity of the Nikes chemical bond to represent Nikes current equal of debt. Po=$95.6 N=202=40 PAR=$100 PMT=$1006.75%/2=3.375By victimisation financial calculator r=3.58%(semiannual)So Rd=3.58% x 2 = 7.16%3) apostrophize of lawUse 20-year T-bond rate to represent risk-free rate, as the rate of return of a T-bond with 20 years maturity is the longest rate which is available right now. So Rf=5.74% Use a geometric mean of market risk premium 5.9% as Market run a risk Premium As we mentioned in Q1, the most recent of import will most relevant in this respect, so we will use B=0.69 Re=Rf+B(Market Risk Premium)=0.0574 + 0.690.059 = 9.81%4)WACCUse task rate = US statutory tax rate + state tax= 35% + 3% = 38%WACC=Wd x Rd x (1-T) + We x Re= 10.19% x 7.16% x (1- 38%) + 89.81% x 9.81% = 9.26%3.Calculate the costs of equity utilise CAPM, and the dividend discount toughie.What are the advantages and disadvantages of each model?Answer1) toll of Equity exploitation CAPMMarket Risk Free score (Rf)= 5.74% (20-year yield on US Treasuries) Beta (B) = .69 (most recent beta employ as most relevant beta to calculate Nikes valuation) Market Risk Premium = 5.9% (Geometric Mean used as Historic Equity Risk Premium) address of Equity use CAPM = Re = Rf + B(Market Risk Premium) Re = 9.81% = 5.74% + .69(5.9%)Advantages-CAPM includes systematic risk by incorporating Beta in the equal of Equity formula. victimisation the stocks Beta to calculate equity will provide a return rate found on how violent the stock is perceived by investors. The higher the risk, the higher the Beta will be and will result in a higher required rate of return on the investment. Systematic risk cant be diversified away, piece of music unsystematic risk can be diversified away by maintaining a diversified portfolio. -CAPM proves to be a better model than others such as the Dividend disregard personate, because the valuation behind CAPM is based on risk and rates of return while the Dividend Discount Model relies heavily on dividends and a growth rate.Disadvantages-When using CAPM, it can be difficult determining the estimate of Beta. Different investments may involve unlike risks and the Beta used in calculating CAPM should reflect the appropriate amount of risk relating to the specific investment. -The risk free rates used in calculating CAPM are continually changing as with the values of the investments in the market which make up the market risk premium. The continual changes in the market can have negative impacts on the valuation of CAPM. -Another disadvantage in using the CAPM in investment appraisal is that investment appraisal is premised on a long-term time horizon, whereas CAPM go ins a single- effect time horizon, i.e. a holding period of one year. While CAPM variables can be presumed constant in successive future periods, market rea lity often shows that this is not the case.2)Cost of Equity using the Dividend Discount ModelGrowth (g) = 5.5%Dividend (D0) = $.48Share wrong (P0) = $42.09Cost of Equity using Dividend Discount Model = Re = (D0 x (1+g)/P0) +g Re = 6.7% = (.48 x (1+5.5%)/42.09+5.5%Advantages-Using the Dividend Discount Model is very easy to calculate because the formula is not complicated. There are no real technical or difficult calculations involved with using this regularity. -The inputs that are used in the calculations of this model are market information and can be easily obtained. -The Dividend discount model attempts to put a valuation on shares, based on forecasts of the sums to be paid surface to investors. This should, in theory, provide a very solid basis to determine the shares true value in present terms.Disadvantages-The Dividend Discount Model relies heavily on the growth rate to calculate the rate of return. If growth slows or becomes temporarily negative, it can result in calcula tions which may not truly represent future expected returns. -This model is reason using dividends and cant be used in instances where a company is not paying dividends. This is also a disadvantage for any investment without a reasonably constant growing dividend stream. -The Dividend Discount Model is very sensitive to minor changes in input figures. If the growth rate changes by 1 % the cost of equity will also change by that rate. -The Dividend Discount Model does not explicitly consider the risks which the company faces.4.What should Kimi Ford recommend regarding an investment in Nike?AnswerIn order for Kimi Ford to make a decision regarding an investment in Nike, she must compare an accurately calculated WACC to the sensitivity of equityvalue to discount rate chart shown in Exhibit 2. The sensitivity chart in Exhibit 2 states that at a discount rate of 11.17%, Nikes current share price is fairly valued at $42.09. If a discount rate were to be calculated below 11.17% thus the Nike shares would be under-valued in the current market, but if their discount rate were higher than the 11.17% Nike share price would be considered over-valued when compared to the current share price. When we calculated Nikes discount rate, we determined that their appropriate WACC should be 9.26%. Since this WACC of 9.26% is below 11.17%, we believe that Nikes shares are currently under-valued in the market. We believe that Nikes equity value based on the WACC of 9.26% should fall somewhere between $55.68 and $61.25. Kiki Ford should recommend adding Nike shares to the NorthPoint large-capitalisation Fund based on our analysis.03/03/2011CASE OVERVIEWKimi Ford is a portfolio manager at a large interchangeable-fund management firm called, NorthPoint Group. Ford is considering the addition of Nike Inc. to the Large-Cap Fund at NorthPoint Group. Nikes share price has notably declined since the starting line of the year. Her decision whether or not to add Nike to the portfolio sho uld be made by looking at the 2001 monetary year end 10-K report.In 1997 Nikes revenues plateaued around $9 billion while net income had move from around $800 million to $580 million. Also, from 1997-2000 Nikes market share in U.S. athletic shoes fell from 48% to 42%. Supply-chain issues and the adverse effect of a strong dollar had negatively affected revenue in recent years. At the June 28, 2001 analyst conflict Nike planned to add both top-line growth and operating performance. genius goal was to develop more mispriced ($70-$90) athletic shoes and the other to push its apparel line. At this meeting a charge long-term revenue growth rate between 8%-10% was given and an earnings-growth target above 15%.After reviewing all the analysts reports active the June 28th meeting Fordstill did not have a clear picture of how to value Nike. Ford then performed her own sensitivity analysis which revealed Nike was undervalued at discount rates below 11.17%.WHAT IS THE WACC?A firm derive s its assets by either upbringing debt or equity or both. There are costs associated with raising capital and WACC is an average figure used to indicate the cost of financing a companys asset base. More formally, the weighted average cost of capital (WACC) is the rate that a company is expected to pay to debt holders and shareholders to finance its assets. Companies boost silver from a number of sources so the WACC is the minimum return that a company must earn on existing asset base to satisfy its creditors, owners, and other providers of capital.WACC is calculated taking into account the relative weights of each component of the capital structure which agency it is the proportional average of each category of capital within a firm. This rate, also called the discount rate, is used in evaluating whether a project is feasible or not in the net present value (NPV) analysis, or in assessing the value of an asset.WACC = Wdebt * Kdebt * (1-t) + Wequity * Kequity + Wpreferred * Kpre ferredK = component cost of capitalW = weight of each component as percent of total capitalt = marginal corporate tax rateWHY IS IT IMPORTANT TO ESTIMATE A FIRMS COST OF CAPITAL?The cost of capital is an important issue from the perspective of management while taking a financial decision. We can list some basic issues related to the importance of WACC and its interpretation by firms* The importance of the WACC is in its relation to the evaluation ofprojects. For a project to be feasible, not just profitable, it must generate a return higher than the cost of raising debt (Kd) and the cost of raising equity (Ke). WACC is affected not only by Re and Rd, but it also varies with capital structure. Since Rd is usually lower than Re, then the higher the debt level, the lower the WACC. This partly explains why firms usually prefer issuing debt first before they raise more equity. As part of their risk management processes, some companies add a risk gene to the WACC in order to include a ri sk cushion in their project evaluation.* The cost of capital is also important for the management while taking a decision about capital budgeting. Naturally, the project which gives a higher (satisfactory) return on investment compared to the cost of capital incurred for its financing would be elect by the management. Cost of capital is the key factor in deciding which project to undertake out of varied opportunities.* The cost of capital is significant in designing the firms capital structure. It will direct the management about adopting the most appropriate and economical capital structure for the firm which means the management may try to substitute the various methods of finance to minimize the cost of capital so as to increase the market price and the earning per share.* The cost of capital is also an important factor for taking a decision about the soundest method of financing for the company whenever the company requires additional finance. The management may try to catch th e source of finance which bears the minimum cost of capital.* The cost of capital can be used to evaluate the financial performance of the top management by comparing actual positivenesss of the projects and the projected overall cost of capital and an appraisal of the actual cost incurred in raising the required funds.DO WE AGREE WITH JOANNA COHENS WACC unhurriedness? WHY OR WHY NOT?We do not completely agree with Joanna Cohens calculation of WACC. There areseveral problems in her calculation* In Cohens calculation, she used the book value for the weights of each capital structure component (debt and equity). record book value of equity should not be used when calculating cost of capital. Instead she should have calculated the market value of equity. Also, she should have discounted the value of long-term debt that appears on the balance sheet to find the market value of debt (even if the book value of debt is accepted as an estimate of market value).* Also, she should have cons idered the preferred stock while calculating the weights of the components of capital structure (the redeemable preferred stock is relatively small in Nikes capital structure so it doesnt affect the weights).* Another problem with her calculation is about the cost of debt. Cohen used a cost of debt which is even lower than treasury yield. In common sense, a company, even it might be a large AAA firm, should be risky than US government. Cost of debt should be calculated by finding the yield to maturity on 20-year Nike Inc. debt with current coupon rate paid semi-annually instead of by taking total interest expense for 2001 and dividing it by the companys average debt balance.USING SINGLE OR MULTIPLE COSTS OF CAPITAL IS APPROPRIATE FOR NIKE INC.?Even Nike Inc. has duple business segments such as footwear, apparel, sports equipment and some non-Nike-branded products (which accounts for relatively small fraction of revenues), we assumed Nike Inc. to have a single cost of capital since its multiple business segments are not very different and would grow similar risks and betas.WHICH EQUITY RISK PREMIUM SHOULD BE USED TO DETERMINE THE COST OF CAPITAL?For the cost of capital, the geometric mean is a better alternative to the arithmetic mean. Furthermore, the geometric mean is a more conservativemeasure to use compared to the arithmetic mean. The average market risk premium has fluctuated by large amounts in neat time periods from 1926-1999. 1926-1929 axiom high market risk premiums however, the 1930s and 1970s saw very low market risk premiums. Therefore, we use the geometric mean since it is a better standard compared to arithmetic mean when the measured period is long-life and contains more fluctuations.VALUE OF EQUITY, VALUE OF DEBT AND WEIGHTINGS OF EACH portion Value(in millions $) WeightCurrent Portion of Long term Debt 5.40 0.04%Notes Payable 855.30 6.73%Long-Term Debt 416.72 3.28%Total Debt 1,277.42 10.05%Equity 11,427.44 89.95% defer 1. The weight of debt and equity in total capital of NikeCALCULATION OF THE COST OF EQUITY UNDER divergent METHODS AND ADVANTAGES AND DISADVANTAGES OF EACH METHOD1. Capital Asset Pricing Model (CAPM) beneath CAPM we can find the cost of equity asKe = Rf + Betai * Equity Risk PremiumThe first issue is to find an appropriate risk-free rate. We think the 20-year yields on treasures would be the one because NIKE is assumed to be operated for such long time, tally to the revitalizing strategy proposed by the management and the long-term debt issued.Next is to determine the beta. The historic betas has been generally decreasing, and we assume it is the market condition and managements purpose that make NIKE to be a defensive company. Furthermore, we find that the competitors such as K-Swiss and Lacrosse also have beta less than one.So rather than the average, we use the YTD beta into calculation. On the other hand, since the beta has been found to be on average closer to the mean value of 1, which is th e beta of an average-systematic-risk security, we calculate the adjusted beta, giving two-third weight to the YTD beta and one-third weight to 1.Regarding the risk premium, we use the geometric mean since it is a better measurement compared to arithmetic mean when the measured period is longer and contains more fluctuations.Combining the above information, we calculate the cost of equity as followsUsing YTD Beta = 5.74% + 0.69*5.9% = 9.81%Using Adjusted Beta = 5.74% + (2/3)*0.69 + (1/3)*1)*5.9% = 10.42%Advantages* It provides an economically grounded and relatively objective procedure * It concentrates on the systematic risk that investors cant avoid, rather than unsystematic risk that can be avoided through diversification * It is suitable for company that doesnt pay dividend* It is widely used.Disadvantages* The assumptions may not be realistic. For example, investors may not be all risk averse and rational that holds efficient portfolio * Investors may concern more than just mark et risk.2. Dividend Discount Model (DDM) chthonic DDM we can find the cost of equity asKe = (D1/P0) + gKe = (0.48*1.055/42.09) + 5.5% = 6.70%Here we assume NIKE will pay dividend at constant growth rate of 5.5% which forecasted by Value Line, so we use the Gordon growth model to derive required rate of return.Advantages* It is simple and widely used* Can be used to infer implied required rate of return* It is helpful to perform a sensitivity analysis on the inputsDisadvantages* It is not suitable for company that doesnt pay consistent dividends or the dividends are not tied to profitability * It is suitable for only matured company3. Earnings Capitalization Ratio (ECM)Under ECM we can find the cost of equity asKe = E1/P0Ke = 2.32/42.09 = 5.51%Advantage* SimpleDisadvantages* It assumes the earnings would be the same in the future, which may not be true * It doesnt take the growth of company into consideration.Cost of Equity CAPM Risk-free Rate 5.74% Equity Risk Premium 5.90% Year- to-Date Beta 0.69 Adjusted Beta 0.79 Cost of Equity with YTD Beta 9.81% Cost of Equity with Adjusted Beta 10.42% DDM Current Dividend 0.48 Growth Rate 5.50% Current caudex Price 42.09 Forecasted Dividend 0.5064 Cost of Equity 6.70% ECM Consensus Earnings Estimate 2.32 Current Stock Price 42.09 Cost of Equity 5.51% Build-up Method Risk-free Rate 5.74% Equity Risk Premium 5.90% Cost of Equity 11.64%Table 2. Cost of Equity under different methodsWHICH RATE AS RISK thaw RATE IS BEST FOR NOTES PAYABLE AND LONG-TERM DEBT?For long term debt, the 20-year yield on U.S. Treasuries is best as the risk free rate. Considering the long time horizon of Nike, a 20-year bond is property. And also, it is comparable to the current 25-year bond which Nike issued 5 years ago. Although Nikes current bond is 25 years, we could consider it as a 20-year bond issued this year, and use the current price to calculate the 20-year bond YTM.And for short term debt, because the note payable was a major portion in the debt structure, the 1-year treasuries would be preferred as risk free rate.COST OF DEBT CALCULATION FOR NIKEWe could not agree with Cohens analysis. Because Cohen used a cost of debtwhich is even lower than treasury yield. In common sense, a company, even it might be a large AAA firm, should be risky than US government.First, Cohens emphasis that last year, the effective cost of debt of Nike was less than treasury yield cod to its Japanese Yen notes. However, the rates of debt based on currency change are unstable and non-repeatable. We could conceivable consider that Nikes last years low cost of debt is a kind of merchandise by chance.Second, to calculate the cost of debt, market value of debt should be used rather than the book value used by Cohen. The market value of debt is compounded by the current portion of long-term debt, notes payable, and long- term debt discounted at Nikes current coupon.Therefore, we would like to recalculate the cost of debt. Cost of d ebt was calculated by using the current liquidated 20-year bond of Nike, Inc. with a 6.75% coupon semi-annually. Then we obtain a cost of long term debt before tax as 7.17%, and cost of short term debt before tax as 5.02%.As shown above in Table 1, short term debt took a significant portion in Nikes debt structure therefore, we use a weighted cost of debt to combine both long term and short term debt effects as in following equationHere is the weight of short-term debt, while is the weight of long-term debt. And both cost of short-term and long-term debt are after tax.Cost of Debt Long Term Debt Coupon Rate 6.75% Time to Maturity 40 Current Stock Price $95.60 Cost of Debt 7.17% After tax revenue Cost of Debt 4.44%Short Term Debt 20-year Yield 5.74% 1-year Yield 3.59% Risk Premium 1.43% taxation Rate 38.00% Cost of Debt 5.02% After Tax Cost of Debt 3.11%Final Weighted Cost of Debt After Tax 0.36%Table 2. Cost of debtWHAT IS OUR WACC CALCULATION FOR NIKE?Under different methods , we would obtain different cost of equity, then, definitely different WACCs which range from 5.31% to 10.83%. However, no matter which method we use, the stock price of Nike is undervalued currently.WACC Under CAPM with Adjusted Beta 9.73% Under CAPM with YTD Beta 9.18% Under DDM 6.39% Under ECM 5.31% Under Build-up Method 10.83%Table 4. Weighted Average Cost of CapitalAs shown in Table 5, the actual implied discount rate by current price is 11.17%, which is significantly beyond the range of WACCs we calculated and presented in Table 4. Therefore, in our analysis, Nikes price would be considered as undervalued.Discount Rate Equity Value8.00 % $ 75.808.50 % 67.859.00 % 61.259.50 % 55.6810.00 % 54.9210.50 % 46.8111.00 % 43.2211.17 % 42.0911.50 % 40.0712.00 % 37.27Table 5. Sensitivity test on WACCspassportThis graph shows the estimated value provided under different WACCs, and NIKE is currently trading at 42.09 with corresponding 11.17% WACC. So if the calculated WACC is below 11.17 %, the estimated value would be higher than the current price and NIKE is undervalued if the calculated WACC is beyond 11.17%, the estimated value would be lower than the current price and NIKE is overvalued.After adjusting the possible mistakes that Joanna made, the table shows the calculated WACC under each methodMethod WACCCAPM (Adjusted Beta) 9.73%CAPM (YTD Beta) 9.18%DDM 6.39%ECM 5.31%Build-up 10.83%We can see none of them is above 11.17%, indicating NIKE is currently undervalued and Ford should add NIKE to the NorthPoint Large-Cap Fund. However, it is important to keep monitoring the revitalizing strategy that the management offered, since the future market condition may have huge impact on this strategy and hence, predicted future economic income.NorthPoint Group is a mutual fund management firm who has the preference on investing in Fortune 500 companies, such as EXXONMobil, GM, McDonalds 3M and other large-cap. If we look back to a decade ago, the fund had performed extreme ly thoroughly compared to the market in general (we refer S&P500 to represent the market).Kimi Ford was the portfolio manager in NorthPoint Group, who was concern about whether or not to add Nike, Inc. shares into her fund. Since net income and market share had been fallen from 1997, a new strategy was proclaimed by the Nike management team during the meeting held in June, 2001First, highly priced products are no longer their only target, now they would develop the midpriced segment so that more customers will be able to afford it.Second, another way to boost the revenue is to focus on its apparel line, which they found out to be profitable. Finally, Nike needs to reduce its costs by exerting more effort on expense control. ships company executives were optimistic about the long-term revenue, expecting an 8% 10% growths and earnings growth above 15%.Analysts had different opinion about the company prospects Lehman Brothers suggested a strong buy while UBS and CSFB recommended a h old. Meanwhile, Ford precious to make her own forecast so she developed a discount cash flow to determine that, at a discount rate of 12%, Nike was overvalued at its current price $42.09 and undervalued if the discount rate was below 11.17%. She asked her assistant, Joanna Cohen, to calculate the companys cost of capital precisely.On the report, Joanna Cohen used WACC to calculate the cost of capital, where she adopted book values to obtain a proportion of 27% of debt and 73% of equity. For cost of debt, she took total interest expense divided by average debt balance which resulted lower than treasury yields. For cost of equity, she used 20-year Treasury bond as risk-free rate and 5.9% as market premium. Moreover, she divided each variant by revenue, deciding to use one overall WACC. At the end, she came to a conclusion that the cost of capital for Nike, Inc was 8.4%.