Presented by: Neha Sethumadhavan

North Point Large Cap Fund weighing whether to buy Nikes stock. Nikes experienced decline in the share prices also fall in the net income and market share. Nike management wanted to communicate a strategy for revitalizing the company. They had revealed a plan to address both top-line growth and operating performance. They wanted to develop more athletic shoe products in the mid priced segments and also push its apparel line. Kimi Ford requested her assistant, Joana Cohen, to estimate cost of capital.

The cost of capital is the rate of return required by a capital provider in exchange for foregoing an investment in another project or business with similar risk. Thus, it is also known as an opportunity cost. By taking weighted average, we can see how much interest a company has to pay for every marginal dollar it finances. A firms WACC is the overall required return on the firm as whole and as such managers must invest only in projects that generate returns in excess of WACC.

The WACC is set by the investors or markets, not by managers. Therefore, we cannot observe the true WACC, we can only estimate it.

Its ok to use single cost instead of multiple costs of capital. The reason of estimating WACC is to value the cash flows for the entire firm, that is provided by Kimi Ford. Cole-Haan makes up only a tiny fraction of revenues. The risk factors faced by both footwear and apparel lines are the same and sold through same distribution and marketing channels. Hence, a single cost is sufficient for this analysis.

No, I do not agree with Joannas estimation of WACC. There are certain disagreements with the calculations: Calculation of debt is done using the historical data, by dividing the interest expenses for the year 2001 by the average balance of debt, which is not appropriate. Market value of equity should be used instead of the book value as it gives more precise results. The sum of state and statutory tax rates should be used rather than the marginal tax rates.

The more appropriate cost of debt can be calculated by using the current yield to maturity of the Nikes bond to represent Nikes current cost of debt. Ytm = C + (F-P)/n 0.60P + 0.40F P = 95.60 N = (period 2001-2021) => 20 * 2 = 40 C = 6.75/2 = 3.375 or 0.0375 F = 100 Kd = 3.58 % (semi annually) , 3.58 * 2 = 7.16 % (annually) After tax cost of debt = 7.16(1-0.38) = 4.44%

Joanna Cohen uses the CAPM Model to compute the cost of equity. The main inputs of CAPM are: Risk free rate (Rf): 20-year T-bond rate is used; 5.74% Market risk premium ([E(RM) Rf ]): Geometric mean is used; 5.9% Beta or the market risk (E): average beta from 1996 to July 2001 is taken i.e. 0.80, The most recent beta should be taken as it will give a more recent estimate ; 0.69

According to CAPM, the cost of equity is : rE = Rf + E [E(RM) Rf ] Joanna cost of equity : 10.5=5.74 + (5.9) * 0.80 Hence the estimated new Cost of equity : = 5.74% + (5.9)* 0.69 = 9.81%

As per E/P approach:

Diluted EPS = 2.32 Market price = 42.09 Cost of equity = E1/P0 = 2.32/ 42.09 = 0.055119 = 5.51 %

As Dividend Discount model:

D0 = 0.48 D1 = D0(1+g) = 0.48(1+ 0.055) = 0.506 P0 = 42.09 g =0.055 Cost of equity = D1/P0 + g = 0.506/ 42.09 = 0.01203 + 0.055 = 6.70 % Hence, there is a discrepancy.

Market Value Of Equity Market share = 42.09 Average shares = 273.3 (MS* AS)= 11503.197 Market Value Of Debt Current proportion of LTD = 5.4 Notes Payable = 855.3 Long term Debt = 435.9 Debt = 5.4 + 855.3 + 435.9 = 1296.6

Market value of debt : Market value of equity : Total

1296.6 11503.197 12799.797

10.1298 89.8701

After tax cost of capital : 4.44 CAPM : 9.81 WACC : 9.81 * 0.899 + 4.44 * 0.101 = 9.27 % At 9.27 %, the present value of equity is 58.13, which is more than 42.09 at 11.17%. The value seems undervalued, hence we can recommend to Invest in Nikes shares.