Nike, Inc.: Cost of Capital

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Cost of capital concept:

Cost of Capital is another key aspect influencing Northpoint Company’s decision. The cost of capital, the minimum acceptable rate of return, is the return that investors could earn in opportunities of equal risk. The cost of capital links together many aspects of financial management because shareholder wealth is maximized through the process of arranging financing to minimize the cost of capital and choosing capital investments to maximize net present value by using the cost of capital as the required rate of return.

The weighted average cost of capital concept (WACC) is a calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. All sources of capital are included in calculating the WACC. A decrease in WACC denotes a decrease in valuation and an increase in risk.

WACC=Kd(1-t)*D/(D+E)+Ke*E/(D+E)

Kd= cost of debt

Ke= cost of equity

E = market value of the firm's equity

D = market value of the firm's debt

t = corporate tax rate

Case Analysis

Single or Multiple Cost of Capital?

Nike’s sources of revenue are as follows: 62% footwear, 30% apparel that complements its footwear, 3.6% equipment, and 4.5% non-Nike brands. We feel as if the use of single cost of capital would be a better solution instead of the multiple cost of capital that was used by Joanna Cohen because Nike’s business segments do not vary a large amount when evaluating risk.

2. Methodology for calculating the cost of capital: WACC

The calculations used by Joanna Cohen are not correct. She used the book value of equity to calculate the proportion.When using the WACC method, we can use the book value of debt as the market value because bonds are not quite active in the market. However, we have to use the market value of equity to calculate because it can accurately reflect Nike’s current value of equity.

Based on the available balance sheet, we re-calculate the proportion of the debt and the equity below:

Equity= Price of stock * numbers of shares outstanding:

42.09*273.3= $11,503.2 millions (based on EXHIBIT 1&4)

The proportion of the total liabilities: 1,296.6/(1,296.6+11,503.2)=10.13%

The proportion of the total shareholder’s equity: 11,503/(1,296.6+11,503.2)=89.87%

3. Cost of Debt

Cohen used the interest expense of the year divided by the average debt balance to calculate the cost of debt, which fully ignored the discounted cash flow of the cost of debt. We can calculate the current yield to maturity of the Nike’s bond to represent Nike’s current cost of debt.

Calculator solution:

PV= ($95.60)

FV= $100

PMT=$100* 6.75%= $6.75

Y=20

CPT I/Y=7.17%

After Tax Cost of Debt: Kd=YTM ( Yield to Maturity)* (1-tax rate)

=7.17%*(1-38%)

=4.44%

4. Cost of Equity

We use 3 methods to estimate the cost of equity. We use all dividend-discount model(DDM), earnings-capitalization ratio and capital-asset-pricing model(CAPM).

Dividend-discount model (DDM)

Calculation (based on EXHIBIT 4):

Based on the dividend discount model, P0 = D0 * (1+g) / (k – g), then we get the return rate (the cost of equity):

k = D0 * (1+g) / P0 + g

= 0.48 * (1 + 0.055) / 42.09 + 0.055

= 6.7%

Dividend-discount model fully considers the time value of consistent cash flow of an investment. For investors, it is very important because we have to consider the real purchasing power of money decreased due to inflation. However, without enough consideration of risk cost, DDM may underestimate the cost of equity. In addition, all of the data is based on historical record and with the predetermined growth rate, the result is not reliable considering of the future situations.

II. Earnings-capitalization ratio

Calculation (based on EXHIBIT 1&4)

According to the earnings capitalization model, we have cost of equity is 5.13％.

Cost of equity = E1 / P0

= $2.16 / 42.09

= 5.13%

Earnings-capitalization ratio is very easy to calculate and to get the necessary accounting data. However, it does not reflect the true value of an investment or the cost of the budgeting without any consideration of the risk and the growth of the firm.

III. Capital-asset-pricing model(CAPM)

Cohen took the average of Nike’s betas from 1996 to July 2001. But we used the β of Nike in 2001to calculate because we need to find a beta that is most representative to future beta. We don’t agree that Cohen used the average of Nike’s betas from 1996 to July 2001 to measure the future systematic risk. So we suggest using the most recent beta, 0.69.

Calculation (based on EXHIBIT 4):

E(Ri) = Rf +【E(Rm) - Rf】* βi

Because the government bond yield is 5.74%, Geometrical historical risk premium is 5.90%, and the β of Nike in 2001 is 0.69, then we get:

E(Ri)= 5.74%+5.90%* 0.69

= 9.81%

CAPM is a theory based on the whole market. It includes the effects between the market as the integrity and each individual stock. What’s more,