Nike Case Study Essay
Nike Case Study
Kimi Ford, a portfolio manager at North Point Group, is looking into the profitability of investing in the stocks of Nike for her fund that she manages. She is supposed to base her decision the company’s data which was disclosed in the 2001 fiscal reports. While Nike management had addressed several issues that are causing the decrease in market sales and stock price, management presented plans to improve and perform better. Nike revenue has been at a plateau since 1997 yet net income and market share were falling. Supply chain issues and the strong dollar negatively affected revenue too. Plans are in place to address top line growth and operating performance. To boost revenue, the company would develop more athletic shoes in the mid priced segment which has been overlooked by Nike in recent years. They also planned to push their apparel line which under strong leadership had performed very well to control expenses. Revenue growth targets are around 8-10% and earnings targets are above 15%. Analyst reactions were mixed as some of them thought this was too aggressive.
Lehman Brothers recommended a strong buy while others expressed misgivings and recommended a hold. At this point, North Point Group decided to do their own analysis in order to decide if Nike shares should be purchased for the fund. The weighted average cost of capital (WACC) is the rate that a company is expected to pay its debt and equity holders to finance its assets. It is the minimum return that a company must earn on existing asset base to satisfy its owners, creditors, and other providers of capital or they will invest somewhere else. Companies raise money from many sources such as common and preferred equity, straight, convertible, and exchangeable debt, options, warrants, pension liabilities, executive stock options, governmental subsidies, and others. Different securities, which represent different sources of finance, are expected to generate different returns. WACC is calculated taking into account the relative weights of each component of the capital structure- equity and debt, and is used to see if the investment is worthwhile to take part in.
Management notices the cost of capital while making a financial decision. The concept is very relevant in the following managerial decisions and hence its importance:
(1) Capital Budgeting Decision. Cost of capital may be used as the tool for adopting an investment proposal. Naturally, the firm will choose the project which gives a satisfactory return on investment which would never be less than the cost of capital incurred for its financing. In the many methods of capital budgeting, the cost of capital is the main factor in deciding the project out of different proposals pending before the management. It determines the acceptability of all investment opportunities by measuring financial performance. (2) Designing the Corporate Financial Structure. The cost of capital is a significant factor in designing the firm’s capital structure. The cost of capital is influenced by changes in capital structure. Financial executives keep an eye on capital market fluctuations and try to achieve the economical and sound capital structure for the firm. They may try to substitute the various methods of finance in an attempt to minimize the cost of capital and to increase the market price and the earning per share.
(3) Deciding about the Method of Financing. Financial executives must have knowledge of fluctuations in the capital market and should analyze the rate of interest on loans and normal dividend rates in the market from time to time. Whenever company requires additional finance there are better choices of the source of finance which bears the minimum cost of capital. Although cost of capital is an important factor in such decisions, but equally important are the considerations of relating control and of avoiding risk. (4) Performance of Top Management. The cost of capital can be used to evaluate top executive financial performance. Evaluation of the financial performance will involve a comparison of actual profitability’s of the projects and along with the projected overall cost of capital and an appraisal of the actual cost incurred in raising the required funds. (5) Other Areas. The concept of cost of capital is also important in others areas of decision making, such as dividend decisions, working capital policy, and more.
One important question is if Joanna Cohen should use a single or multiple of capital for each of Nike’s footwear and apparel divisions? We agree with the use of single cost rather than multiple costs of capital. The reason of estimating WACC is to value the cash flows of the entire company that is provided by Kimi Ford. Plus, Nike business segments have a similar risk and thus a single cost is sufficient for this analysis.
Joanna Cohen’s cost of debt was incorrect. An important fact is the WACC is used for discounting future cash flows, thus all components of the cost must reflect the firm’s concurrent or future abilities in raising capital. Cohen wrongly used the historical data in estimating the cost of debt. She divided interest expense by the average balance of debt to get 4.3% of before tax cost of debt. It doesn’t reflect Nike’s current or future cost of debt.
The correct way to calculate the cost of debt is explained below. If the cost of debt is intended to be forward looking, it can be estimated by the yield to maturity of bond. The more appropriate cost of debt can be calculated with the data provided in Exhibit 4 of the case. Market data is correctly used rather than historical data.
The values above were put into Excel’s rate function. This came to a 7.16% annual cost of debt. The tax rate is 38%. The correct way to get the after
tax cost of debt is to take 7.16% * (1-38%) = 4.44%
The correctly calculated before tax cost of debt is 7.16%. This is significantly higher than Joanna’s incorrectly calculated cost of debt of 4.3%. Her incorrect calculation came from using historical rates rather than market rates.
Next, the cost of equity is calculated. It is a good idea to use the 20 year T-Bond rate to represent the risk free rate. The cost of equity and the WACC are used to discount cash flows in the long run, thus rate of return of a T-Bond with 20 years maturity at 5.74% is the longest rate that is available.
The geometric mean of market risk premium is 5.9%. This is more accurate than using arithmetic mean to represent market risk premium. By using arithmetic mean to represent true market risk premium, we have to have independently distributed market risk premium. It is often found that market risk premiums are negatively serial correlated.
Market average Beta of .69 is used because it is a good indicator of the average Beta’s and their fluctuations throughout the years.
Capital Asset Pricing Model (CAPM)
|Cost of Equity(KE) | |KE = |Rf + β(Rf – Rm) | |Rf = |5.74% |
= |9.81% | |Beta |= 0.69 |Average Nike Beta | |
Next, the weights of debt and equity need to be calculated. The market value of equity is $42.09 share price X 271.5 million shares = 11,427,000
Due to the lack of information of the market value of debt, book value of debt at 1296.6 million is used to calculate weights.
Calculations for market and debt weights:
11,427,000 / (11,427,000 + 1297) = 89.8% Equity Weight
1 – 89.8% = 10.2% debt weight
4.44% After Tax Cost of Debt X 10.2% Debt Weight + 9.81% Cost of Equity X 89.8% Equity Weight =
The CAPM method was used when calculating cost of equity for the WACC. Advantages and disadvantages of this method are explained below.
• It only considers systematic risk, reflecting a reality in which most investors have diversified portfolios from which unsystematic risk has been essentially eliminated.
• It generates a theoretically-derived relationship between required return and systematic risk which has been subject to constant empirical research and testing.
• It is generally seen as a superior method of calculating the cost of equity than the dividend growth model (DGM) in that it explicitly takes into account a company’s level of systematic risk relative to the stock market as a whole.
• It is clearly better than WACC in providing discount rates for use in investment appraisal.
• It is practically impossible to estimate betas for many projects.
• People sometimes focus on market risk rather than corporate risk, and this may be a mistake.
The Dividend Discount Method is another method of calculating cost of equity. The assumption made with this model is that the company pays a substantial dividend, but Nike Inc. does not pay dividends. Therefore, we rejected this model since it does not reflect the true cost of capital.
The method Compares dividends forecasted for the next period with the current share price for the firm and then adds the growth rate of the firm.
Equation: Ke= D1/ P0 + g
– G= the value line forecast of dividend growth, which equals 5.5%
– PO= current share price, which is $42.09.
– D1= DO (1+g), which equal .48 (1+.055)
• DO= from dividend history and forecast chart, which equals .48
Therefore, cost of equity = .564/42.09 + .055= 6.7%
• Allow great flexibility when estimating future dividend streams • Provide useful value approximations even when the inputs are simplified • Can be reversed so the current stock price is used to impute market assumptions for growth and expected return • Investors are able to suit their model to their expectations rather than force assumptions into the
model • Specifying the underlying assumptions allows for sensitivity testing and analyzing market reactions to ever changing circumstances Disadvantages
• Subjective inputs can result in wrongly specified models and bad results • Over-reliance on a valuation that is really just an estimate • Sensitivity is high to small changes in input assumptions • Flow-through of minor formula or data entry errors when using spreadsheets The Cost of Equity Method is the other method for forecasting cost of equity.
The final model used to compute the cost of capital was the earning capitalization model. The problem with this model is that it does not take into consideration the company’s growth. Therefore we chose to reject this calculation. The earnings capitalization model calculations were found this way:
• Stands for earnings capitalization model
• This model compares forecasted earnings for the next period over the current share price.
– Ke: E1/ P0
– E1= (1+g) * (E0/ # of shares outstanding)
• G= retention ratio * return on equity
• Retention ratio= retained earnings/ net income
• 3194.3/ 589.7= 5.42
• Return on equity= net income/ total shareholders’ equity
• 589.7/ 3494.5= 16.88%
• G= 5.42* 16.88%= .914
• EO= Net Income, which equals 589.7
• Share Outstanding= 271.5
– E1= ((1+.914) * 589.7)/ 271.5= 4.1572
– PO= Nike current share price, which is 42.09
• Therefore, cost of equity=
– 4.1572/ 42.09 = 9.88%
Strong representation of earnings
Brealey & Myers argue in Principles of Corporate Finance that this model is not good to use for growing firms but is appropriate for no-growth firms. Hence it is not appropriate for Nike Inc. since this company is still growing.
Analysis and Recommendation
Kimi ford used a WACC discount rate of 8.4% to find a share price of $63.50. Nike is currently trading at $42.09. This makes the share price undervalued by $21.41. However, her discount rate does not reflect true market value due to the mistakes in her methods we discussed earlier.
The discount rate we came up with from using the CAPM was 9.27%. This higher WACC results in a lower share price of around $55.60. Share price has decreased once Joanna’s calculation methods have been corrected, but Nike is still overvalued so we still recommend buying the stock. Share price is now undervalued by $12.97.
• Globally recognized #1 sports brand
• Strong marketing, research and development, and innovation
• Worldwide logo recognition, brand loyalty, and slogan “Just do it.”
• Most profits are solely from footwear
• Revenue has plateaued, expenses have increased
• Supply chain issues affecting financial health too
• Price sensitive retail industry
• There are plans in place to address top line growth and operating performance
• Plans to create more athletic footwear
• Also plans to push apparel line
• High revenue growth (8-10%) and earning (15%) targets
• Uncertainties in international trade
• The market is cut throat
• Growing competition from other companies can lead to decreased market share
• Net Income: 589,700,000
• Total Assets:5,819,600
• Common Equity
– Common Stock, Par: 2,800,000
– Capital in excess of stated value: 459,400,000
– Retained Earnings: 3,194,300,000
– Total: 3,656,500,000
• NI/Sales: 589,700,000/9,488,800,000 = 6.2%
• Sales/TA: 9,488,800,000/5,819,600,000 = 1.63
• TA/CE: 9,488,800,000/3,656,500,000 = 2.60
• Profit Margin * TA Turnover * Equity Multiplier
• 6.2% * 1.63 * 2.60 = 26.27% ROE. This Return on Equity is high, further stating the fact that Nike stock is good to buy.
Nike has strong financial health and its stock is a sound investment. It would make a valuable addition to any mutual fund.