Kenkel, Kerins, Kruse, Seifert 1

I. Introduction
Kimi Ford, a portfolio manager at NorthPoint Group, was reviewing the financials of Nike Inc. to
consider u!ing shares for the fund she managed, the NorthPoint "arge#$ap Fund. % week efore Kimi
Ford egan her research, Nike Inc. held an anal!sts& meeting to reveal their '((1 fiscal results and for
management to communicate a strateg! to revitali)e the compan!. Nike&s revenues since 1**+ had ceased
to grow from ,*.( illion, and net income had now fallen ,''( million -,.((// # ,0.(//1. In addition
a stud! printed in 2usiness 3eek revealed that Nike&s market share in the 4.S. athletic shoe industr! had
fallen from 5. percent in 1**+ to 5' percent in '(((. In the meeting, management planned to raise
revenues ! developing more athletic#shoe products in the mid#priced range, sold at ,+(#,*(. Nike also
planned to push its apparel line and e6ert more e6pense control. 7uring the meeting, Nike&s e6ecutives
e6pressed that the compan! would still continue with a long#term revenue growth target at .#1( percent and
earnings#growth targets aove 10 percent.
Kimi Ford decided that it was necessar! to develop her own discounted#cash#flow forecast in
order to arrive at a proper investment decision for her mutual fund. 8er forecast proved that at a 1( percent
discount rate, that Nike&s stock price was overvalued at ,0.*0 per share. In addition, a sensitivit! anal!sis
she created revealed that Nike stock was undervalued at discount rates less than *.5 percent. Ford was not
clear on a decision to u! Nike stock, so she asked 9oanna $ohen to estimate Nike&s weighted average cost
of capital.
II. Cost of Capital Calculations
$ohen calculated a weighted average cost of capital -3%$$1 of ..: percent ! using the capital asset
pricing model -$%P/1 for Nike Inc. ;he prolem with $ohen&s calculations is that she used the ook
value for oth det and e<uit!. 3hile the ook value of det is accepted as an estimate of market value,
ook value of e<uit! should not e used when calculating cost of capital. ;he market value of e<uit! is
found ! multipl!ing the stock price of Nike Inc. ! the numer of shares outstanding.
Market Value of Equity
E = Stock Price # Shares Outstanding
,5'.(* '+1.0
E = ,11,5'+.55
;his figure is much different than the ook value of e<uit! that 9oanna $ohen used -,:,5*5.0(1. In
addition, for market value of det, $ohen uses the ook value, when in fact she should have discounted the
Kenkel, Kerins, Kruse, Seifert '
value of long#term det that appears on the alance sheet. ;he market value of det is found ! adding the
current portion of long#term det, notes pa!ale, and long#term det discounted at Nike&s current coupon.
Market Value of Debt
D = Current LT Notes Payable LT Debt (discounted)
,0.5( ,.00.:( ,51=.+'
D = ,1,'++.5'
4sing these figures, we can now find the market value of Nike Inc., and the compan!&s capital structure.
Weight of Debt Weight of Equity
3 > 7 ?7@A 3 > A ?7@A
3 > ,1,'++.5' ,1',+(5..= 3 > ,11,5'+.55 ,1',+(5..=
1(.(0B .*.*0B
;he ne6t issue at hand is finding the correct costs of det and e<uit! in order to find an accurate calculation
of 3%$$. $ohen used the '(#!ear !ield on 4.S. ;reasuries as the risk free rate, which we found to e the
correct figure given that Nike Inc. det was valued over '0 !ears. 2ecause there is no other given !ield
that is comparale to a '0#!ear valuation period, our risk free rate used in calculations is 0.+5 percent.
9ust as important as choosing a risk free rate is choosing the appropriate market risk premium.
;here are two historical e<uit! risk premiums given for a time period from 1*'= to 1***C Geometric mean
and arithmetic mean. ;he geometric mean is a etter estimate for longer life valuation while the arithmetic
mean is etter for a one#!ear estimated e6pected return. ;herefore, we chose to use the geometric mean to
coincide with the choice to use the '(#!ear !ield on 4.S. ;reasuries, which is 0.* percent.
Ne6t, we had to decide on a eta to use for Nike Inc. for use in the $%P/ approach. ;he logical
choice was to use the average -(..(1 to account for the large fluctuations seen in Nike&s historic etas. 3e
felt that the D;7 eta was a reflection of current usiness practices, ut the goal of Nike Inc. was to look
forward and gain ack market share and increase revenues. $onse<uentl!, we felt the average eta
reflected the historical usiness practices of Nike Inc. etter.
From here, we calculated the cost of det and e<uit!. $ost of det was calculated ! finding the
!ield to maturit! on '(#!ear Nike Inc. det with a =.+0B coupon semi#annuall! -See %ppendi6 %1. 3e
assumed Nike Inc. to have a single cost of capital since its multiple usiness segments -shoes, apparel,
sports e<uipment, etc.1 are not ver! different and would e6perience similar risks and etas. ;he cost of
e<uit! was calculated as followsC
Cost of Debt Cost of Equity
(d) = !T" on #$ !ear Nike %nc& 'ond K-e1 > $%P/ Ef 0.+5B#$ !ear !ield on (S Treasuries
+.01B Ef @ 2etaF-/EP1 /EP 0.*(B)eo*etric "ean
1(.5=B 2eta (..+,erage Nike 'eta
Kenkel, Kerins, Kruse, Seifert :
%t this point, we calculated the 3%$$ of Nike Inc. using the weights and costs of det and e<uit!. ;he
formula used isC 3%$$ > wdkd-1#;1 @ weke.
WACC
-+CC = -d.d(/0T) 1 -ee
3dFKd-1#;1 3eKe
(.5=.'B *.5(.:B
9.!"#$
;he weighted average cost of capital for Nike Inc. is *..+=0 percent. ;he ne6t model that we used to
calculate the cost of capital was the dividend discount model. ;he assumption made with this model is that
the compan! pa!s a sustantial dividend, ut Nike Inc. does not. ;herefore, we reGected this model ecause
it does not reflect the true cost of capital. ;he calculation is as followsC
DDM
DD" = 2Do(/1g)3Po4 1 g
H(.5.-1@.(001?5'.(*I @ .(00
=.+(B
;he final model used to compute the cost of capital was the earning capitali)ation model. ;he prolem
with this model is that it does not take into consideration the growth of the compan!. ;herefore we chose
to reGect this calculation. ;he earnings capitali)ation model calculations were found this wa!C
ECM
EC" = E/3Po
'1=?5'.(*
0.:1B
III. %eco&&endation
Kimi Ford used a discount rate of 1( percent to find a share price of ,:=.15. ;his makes Nike Inc.
share price overvalued ! ,0.*0 as Nike is currentl! trading at ,5'.(*. 3e alread! estalished that we
found this discount rate to not reflect the true market value and solved for a discount rate that would e
more accurate. 3e found the weighted average cost of capital ! using $%P/, finding a discount rate of
*..+=0 percent. ;his discount rate results in a share price of ,:=.5*, meaning that Nike Inc. is overvalued
! ,0.=( per share.
4sing this data, we found that Nike Inc. should not e added to the NorthPoint "arge#$ap Fund at
this time ecause the stock is overvalued. 3hat Kimi Ford can do is wait for a etter u! period when this
stock is trading closer to the proper value. She should keep a close e!e on the compan! ecause Nike Inc.
has growth potential that would e eneficial to the fund. %long with this fact, management has goals for
the near future that could provide a great deal of profit for Nike Inc. %ll of the plans laid out at the
Kenkel, Kerins, Kruse, Seifert 5
e6ecutive meeting displa! that the compan! is taking steps to move toward the future, making this a stock
that could e attractive at a later date.