Nike, Inc. - Cost of Capital

Nike, Inc.: Cost of Capital

I. Introduction

        Kimi Ford is a portfolio manager at NorthPoint Large-Cap Fund. On July 5, 2001, Kimi Ford wrote an analysis about Nike, Inc., the footwear manufacturing company. Nike had experienced significant decline on the stock stock. Kimi Ford decided to buy some Nike’s shares because Ford believed Nike’s stock price was undervalued. NorthPoint Large-Cap Fund is a company that invested in the Fortune 500 companies such as General Motors, McDonald, 3M, ExxonMobil, and etc. Under Kimi Ford, NorthPoint Large-Cap Fund performed extremely well. For example, even though S&P 500 fell 10.1% in 2001, NorthPoint Large-Cap Fund was able to gain return as much as 20.7%.

        On June 28, 2001, Nike held an analysts’ meeting to discuss Nike’s strategy to boost revenue. Nike experienced losses in the net income as much as $220 million from 1997 to 2001. Nike planned to create mid-price shoes products which ranging from $70 to $90 a pair. In addition to that, Nike planned to push the apparel products with the Mindy Grossman in order to boost Nike’s revenue. Nike’s managements was also targeting Nike’s long-term revenue-growth and earnings-growth from 8% to 10% and above 15%.

        After the Nike’s management released the expected revenue-growth and earnings-growth, there were many opinions from the experts. According to Lehman Brothers, Nike’s share price was undervalue, then Lehman Brothers gave strong buy signal for the investors. On other hand, UBS Warburg and CSFB argued Nike’s management was too optimistic, thus gave Nike “hold” signal for the investors. Moreover, according to Kimi Ford, Nike’s share price was undervalued by 11.17% from the current share price of $42.09.

II. Problems

        Nike’s stock price was declining from 48% in 1997 to 42% in 2000. Kimi Ford is trying to decide whether to buy Nike’s stock or not. Before Kimi Ford buy Nike’s stock, she asked her new assistant Joanna Cohen to create Nike’s financial forecast. After Joanna Cohen created the DCF model for Nike, she found that Nike’s stock price was currently at $42.09 or 11.17% WACC. However, based on Joanna Cohen’s projection of WACC, she found out that Nike’s WACC is 8.4% which result in $63.50 of Nike’s stock price, showing that Nike’s current stock price was undervalued. However, when Cohen created the DCF model, she made several mistakes which will result in different stock price.

III. Recommendation/Solution

        Joanna Cohen needs to fix the WACC calculations. Cohen was using the CAPM model when calculating the WACC. The formula for WACC is Kd * (1-tax) * Wd + Ke * We. Cohen results when calculating the WACC was 8.4%. This result came from 2.7% * 27.0% + 10.5% * 73.0% = 8.4%. When Cohen was calculating the cost of debt, she was using the total interest expense and dividing it with the company’s average debt balance. In addition to that, when Cohen was calculating the cost of equity using the CAPM, she was using the average historical beta instead of the current beta available. Moreover, she was wrong when calculating the weight of equity which result wrong number in weight of debt. Joanna Cohen was only using the total shareholders’ equity instead of current price available * current shares outstanding which result in 27% and 73%. According to Joanna Cohen’s calculation, Nike’s stock price was undervalued at a discount rate at 11.17%. Nike’s stock price should be around $63.50. However, based on my calculation, Nike’s WACC should be 9.27% instead of 8.4% which result in Nike’s stock price around $58.46. Even though both of calculations show Nike’s stock price was undervalued, but Joanna Cohen’s calculation of WACC was not accurate.

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