Analysis of Nike's Financial Health and Investment Recommendation

Executive Summary

This case analysis of Nike, Inc. conducted as part of the Corporate Finance course at Northern Illinois University delves into the financial metrics to assess the cost of debt, equity, and ultimately, the Weighted Average Cost of Capital (WACC). The analysis identifies critical flaws in the initial report prepared by Joanna, particularly in calculating the cost of debt and equity using historical data instead of current market values. The recommendation section provides a detailed approach using the Discounted Cash Flow (DCF) model to ascertain Nike's stock value, offering investment advice to North Point Group.

Cost of Debt

First issue would be on Joanna’s calculation of the weights of equity and debt using book values. Based on its nature and definition, book value refers to cost entered in a company’s record throughout an asset’s life. The report had an evident flaw by using historical data in estimating the cost of debt when it should have been present market value.

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The rationality behind this decision is that we want to determine the cost of the firm’s capital today. The company’s cost of debt is cannot be depicted using historical data. Joanna’s calculation of debt by using 2001’s interest expense and subsequently dividing it by the average balance of debt is incorrect.

To find the real cost of debt, she should have calculated for the yield to maturity, on 20-year debt, and semiannually paid coupon, of the company’s bonds, as to amount to the cost of debt.

The current price is $95.60, coupon Rate at 6.75%, payment at $3.375, par value at $100, and the number of years at 25 (from July 1996 issuance to July 2021 maturity); however, given that the report is in 2001, we can subtract 5 years from 25 and multiply the difference by 2 to annualize it. We will arrive at the pre-annualized cost of debt at 3.5837% which we will multiply by 2 to get 7.1674%, before-tax.

The cost of debt then must be computed after taxes. Joanna did well by using 38%, as the sum of the state and required tax rates of 35% and 3%. After these, multiplying 7.1674% with (1-38%) will give us the cost of debt at 4.444%.

Table 1: Cost of Debt and Equity Calculation

Table 2: Market Values and WACC

Discounted Cash Flow Model for Stock Valuation

1. Cash Flow Calculation: Projected Cash Flows for 10 Years.
2. Terminal Value Calculation: Using Growth Rate of 3%.
3. Discounting: Using WACC of 9.2641% to find present value of cash flows.
4. Stock Price Calculation: Equity Value / Current Outstanding Shares.

Cost of Equity

About equity, the flaw would be that of the beta. Joanna used the average historical betas to arrive at 0.8, which does not consider systematic risks, instead of the using the current beta of 0.69.

Using 5.74% as the risk-free rate (rf) and 5.90% as the market risk premium (rp) was commendable on Joanna’s report. The rf comes from the 20-year treasury bond rate, while the rp reflects geometric mean, not the arithmetic mean. Given all the required variables, we can most accurately solve for the cost of equity under the Capital Asset-Pricing approach, by adding the risk-free rate, 5.74%, to the product of the beta, 0.69, and market risk premium, 5.90% to arrive at 9.811%.

Indeed, the dividend discount model (DDM) is “unfit” for Nike’s cost of equity. Using DDM would be incorrect since it follows the assumptions of constant growth rates and that the company regularly pays dividend, contrary to Nike. Given the growth rate at 5.5%, we find the estimated value of next dividend by the product of the current dividend, 0.48, and 1 + 5.5%. Next, divide the previously calculated value of next dividend with the share price and add the quotient to the growth rate. Arriving at 6.70%, we can infer the using the DDM approach understates the cost of equity by approximately 2.1%. Consequently, this model cannot amount to the legitimate cost of capital.

Weights

When it comes the weights of debt and equity costs, Joanna mistakenly used the book value, instead of market value (MV). Although book value serves as an estimate of market value, the calculations for the cost of capital should use the market value. Using the value amounting to all shareholders’ equity, 3, 494, 500, 000 is a mistake. The current market value of equity can be computed by the product of the number of shares outstanding, 271.5 million, and current stock price, $42.09. On the other hand, debt’s MV is the sum of the long-term debt, notes payable, and current portion of the long-term debt. Subsequently, we arrive at the debt and equity’s market values at 1.296.6 million and 11,427.44 million, respectively. Upon computing for the weighted average cost of capital (WACC), we can infer that 10.1902% is multiplied to the cost of debt and 89.8098% is for the cost of equity.

WACC

As mentioned above, the WACC is computed by adding the products of the respective rates to their costs - 10.1902% to 4.444%, and 89.8098% to 9.811%. While Joanna erroneously arrived at 8.4%, the true WACC is 9.2641%. (the report understated by approximately 0.8%). The discrepancy can be traced to the issues calculating the cost of debt, equity, and weights.

Investment Recommendation

Using the discounted cash flow model, we can determine the true value of Nike’s stock price. First, layout the cash flows from 2002 to 2011. Next, compute for the terminal value given the weighted cost of average at 9.2641% and terminal value growth rate at 3%. Subsequently, discount the present values for 10 years. The sum of all these cash flows, 17096.81, amount to the enterprise value from which the current outstanding debt, 1296.6, would be subtracted to get the equity value of 15800.21. Finally, the quotient of the equity value per outstanding current share of 271.5 should give us the real share price of 58.20.

With the recent data that share price is undervalued at $42.08, Nike’s shares are a definite strong buy if North Point Group is to invest in the long run; however, short-term investment with Nike should be taken with extra caution. Although both long and short-term investing potential for profits, the latter poses more risk. Given the nature of industry the company is in, fluctuating trends in clothing and footwear manifest significance on business operations – shifting from profits to losses. Nevertheless, with the current state the share price is in, North Point should invest while it is undervalued and sell soon as other investors join and overestimates the stock.

Conclusion

The corrected financial analysis presents Nike as an undervalued investment opportunity, primarily for long-term investors. The company's strong fundamentals and the corrected WACC indicate potential for significant returns. North Point Group is advised to capitalize on the current undervaluation, keeping an eye on market trends for optimal exit timing.