Nike, Inc: Cost of Capital

1. Why is it important to estimate a firms cost of capital? What does it represent? How is it
used?
The cost of capital is the cost of the company for financing their business either from debt or
equity. Furthermore, the cost of capital also represents the risk and return for investors, as a
riskier company will have higher borrowing costs than a safe one. In other words, the cost of
capital is the rate of return required by the investors in order to attract their funds to the firm as
compensation for their contributions of capital. The cost of capital is important due to it affects
both the firms long-term investment decisions and the wealth of the investors. Moreover, by
estimate a firms cost of capital, the investors have a benchmark to diversify their portfolio,
minimizing the risk, and maximizing profits.
2. How determines cost of capital? Is it set by managers or investors?
Cost of capital represent by WACC (Weighted Average Cost of Capital). Firstly, we measuring
the capital structure to get the proportion of debt, preferred stock, and/or equity that the
company uses when it raises new funds. Secondly, determine the required rate of return on each
security. Finally, calculate a weighted average after tax return on the debt and the return on the
equity.
The WACC is set by both the investors and by the managers. The investor will set the cost of
capital to estimate the return as a compensation for their contributions of capital. For the
company, the managers should estimate the cost of capital as well since when the managers
made financing decision it will affect the firms cost of debt whether the debt was funded from
bonds, bank loans, common stock, or preferred stock. This cost of debt and capital structure
will affect the WACC. Therefore, the manager will know the minimum return that a company
must earn on existing asset base to satisfy its creditors, owners, and other providers of capital.
3. What was your estimate of WACC? What mistakes did Joanna Cohen make in her
analysis? Or do you agree with Joanna Cohens WACC calculation? Why or why not?

(Calculation about WACC, YTM, PV Bonds, CAPM, and DDM is attached on excel)
No, I dont agree. Joanna Cohen uses a book value instead of a market value on notes payable
and equity. This value affect on WACC calculation due to different debt and equity ratio. She
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MBA5705 Business Finance Antonius Dyan Nugrahanto Aji / 26532441

also used a historical average beta, where she should have used the most recent beta as it is a
more accurate indicator of how a change in the market index correlates with a change in Nikes
value. Furthermore, Joanna also calculated the cost of debt calculated using total interest
expense and dividing it by average debt balance, whereas the cost of debt should have been
attained by calculating the Yield to Maturity on Nikes bonds.
4. Calculate your own WACC for Nike and be prepared to justify your assumptions?
Calculate the cost of equity using the CAPM and the DDM (see formula sheet)
CAPM
Cost of equity
9.81%
WACC
9.28%
(Calculation about CAPM and DDM is attached on excel)
CAPM:
Expected return = risk-free rate +

DDM
6.70%
6.48%

risk premium
= rf + (rm - rf)
= 5.74% + 0.69
(5.9%)
= 9.81%
CAPMs Assumption:
a. Risk free using 20-year current yield on U.S Treasuries since the live of long-term debt is 20
years.
b. Risk Premium using Geometric Mean.
c. Beta using current beta since it is a more accurate indicator of how a change in the market
index correlates with a change in Nikes value.
DDM:
1= 0 (1+ g)
0.48 (1+5.50 )

0.5064

r equity =

1
+g
P0

0.5064
+5.50
42.09

6.70

5. Describe the valuation of Nike and comment on it? What are some of the issues with using
WACC in the valuation? What would you recommend regarding an investment in Nike?
The enterprise value of Nike is $17,048.3 million and the equity value is $15,788.4 million. The
market value of the equity is 4.5 times than the book value. This means that it is worth it to
invest in Nike. Furthermore, the equity value per share of Nike based on a cost of capital of
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MBA5705 Business Finance Antonius Dyan Nugrahanto Aji / 26532441

9.28% is $58.15. Comparing with the current price which is $42.09, this price is undervalued.
(Calculation about Nike Value is attached on excel).
Using WACC can be problematic because of the assumptions and estimates. While estimating
the cost of equity, there are different methods can applied such as the dividend discount model,
the CAPM model, or even bond yield plus risk premium. In each model, the problem is that at
least one of the variables is an estimate. To add on to the complexity the complex structure of
cost of capital in a company can make it difficult to estimate the WACC. Furthermore, WACC
also has a problem when to estimate the cost of debt, for instance when the maturity of treasury
bonds and our bonds are different. We will have to estimate the rate.
In Nike, who its management has plans on improving the top-line growth and operating
performance to boost the revenue, indicates the sound future performance. Nike also focus on
developing the midrange athletic-shoe product will give entry to emerging markets and push it
apparel line to boost the revenue. Furthermore, Nike has also committed on cost saving by
expense control. Finally, the target of long-term revenue growth is 8% to 10% and the target of
earnings-growth is above 15%.
All above measure indicates the better performance from Nike. I would recommend a buy of
Nike as the current share price is undervalued with an equity value of $58.15 per share
compared to a market price of $42.09 per share.

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MBA5705 Business Finance Antonius Dyan Nugrahanto Aji / 26532441