# Nike Inc Cost of Capital Case Solution

Solution Id Length Case Author Case Publisher
860 1360 Words (5 Pages) Robert F. Bruner, Jessica Chan Darden School of Business : UV0010
This solution includes: A Word File and An Excel File

Kimi Ford, a portfolio manager of mutual fund management firm, was considering buying Nike shares for the fund, the North Point Large-Cap Fund. After analyzing the financial position of the company, Kimi forecast showed that the current price of Nike share is overvalued at a discount rate of 12 percent. Moreover, Nike was undervalued at discount rates below 11.2 percent. In order to calculate the discount rate, Kimi requested her new assistant to calculate the weighted average cost of capital. On the basis of some assumptions, Kimi calculated the cost of capital which comes out to be 8.4%. The evaluation of Cohen’s cost of capital and her assumptions is done below. Moreover, on the basis of revised assumptions, more accurate cost of capital is calculated.

## Following questions are answered in this case study solution:

1. What is the WACC and why is it important to estimate a firm’s cost of capital? Do you agree with Joanna Cohen’s WACC calculation? Why or why not?

2. If you do not agree with Cohen’s analysis, calculate your own WACC for Nike and be prepared to justify your assumptions.

3. Calculate the costs of equity using CAPM, the dividend discount model, and the earnings capitalization ratio. What are the advantages and disadvantages of each method?

4. What should Kimi Ford recommend regarding an investment in Nike?

## Nike Inc Cost of Capital Case Analysis

#### 1. What is the WACC and why is it important to estimate a firm’s cost of capital? Do you agree with Joanna Cohen’s WACC calculation? Why or why not?

Weighted average cost of capital is the average future finance cost of funds that the company is expected to pay over the long run. In other words, it is a weighted average of the rate that the company needs to pay to its securities holders in order to finance is assets. From an investor’s point of view, WACC is very important as it helps the investor to decide whether to invest in a certain business or not. The decision rule is that if the expected rate of return is higher than the weighted average cost of capital then investor should go for the investment otherwise not. Moreover, WACC is also used in determining terminal value of the firm and the discount rate through which share price can be determined. If the share price is greater than the actual share price, stock is undervalued otherwise overvalued.

Cohen’s estimate of Nike’s cost of capital after inputting all her assumptions comes out to be 8.4%. Most assumptions of Cohen’s in calculating the cost of capital are agreeable; however, there are some assumptions which should be revised in order to obtain more accurate weighted average cost of capital. The major problem in Cohen’s calculation is that she used book value of equity and debt in determining the equity and debt portion of the company. The calculation of weighted average cost of capital using book value makes the analysis impractical. The other assumption that needs to be revised is the use of the arithmetic mean of beta while applying CAPM model. Beta is a measure of degree of movement of asset’s return in response to the market return. Asset beta coefficient is calculated by taking into account the historical returns of the assets. As the related historical evidences have been taken into account, there is no need to use average of Nike’s beta from 1996 to the present.

#### 2. If you do not agree with Cohen’s analysis, calculate your own WACC for Nike and be prepared to justify your assumptions.

Two assumptions have been mentioned above which are needed to be revised in order to calculate accurate weighted average cost of capital. Following are the assumptions that are being taken in order to calculate the WACC for Nike.

• Although Nike has multiple business segments, single cost of capital has been used.

• Market value of equity has been used for calculation.

• Even though it is more practical to use market value of debt, book value of debt is used due to lack of related information.

• The cost of debt is calculated using the price, maturity, period and coupon rate of publicly traded Nike debt.

• Cost of Equity is calculated using CAPM model.

• Current value of beta is used for calculating cost of equity using CAPM.

• Current yield on 20 years US Treasury bond is used as risk free rate of return.

• Geometric mean of historical equity risk premium is used in CAPM model.

Specific weighted average cost of capital is calculated for each business segments if these business segments had different enough risk from each other. Broadly, there are four major business segments of Nike business. Three out of four segments make the 95.6 percent of total revenue of the company, and they have same risks. Hence, it is impractical to calculate different WACC for fourth segment, which account for 4.5 percent of revenue. Moreover, marker value of the equity gives a true picture of company’s cost of capital. For instance, if the company’s want to raise its capital using equity share, how much it would receive per share it will issue. So market determines it more accurately then the book value of company’s share. A practical estimation of cost of debt is by using the cost on publicly traded Nike debt as this cost would be incurred by the company if it will go to raise capital through debt. CAPM model is the most accurate model for determining the cost of equity. It is suitable to use current beta for calculating the cost of equity through CAPM as beta’s calculation accounts for the historical return of the asset.

The WACC calculated using above assumptions is 9.26%. The tables given below shows the cost and proportion of equity and debt:

 Cost of Debt Annual Coupon Rate 13% Cost of Debt 7.07% Cost of Debt after tax 4.38%
 Cost of Equity Beta - Average 0.69 Risk Free Rate Rf 5.74% Market Premium 5.90% Cost of Equity 9.81%

 Debt 1296.6 Equity 11427 Total Debt and Equity 12724 % of Debt 10.19% % of Equity 89.81%

#### 3. Calculate the costs of equity using CAPM, the dividend discount model, and the earnings capitalization ratio. What are the advantages and disadvantages of each method?

##### Dividend Discount Model

Cost of equity can also be calculated using dividend discount model. In this approach, it is assumed that the company is paying substantial dividend to its shareholders. In this model, the next year dividend is divided by the current price per share to estimate the cost of equity. The coming year dividend is calculating by growing the current dividend at dividend growth rate.

Amount to Pay

## Calculate the Price

Approximately ~ 1 page(s)

## \$0

### Get More Out of This

Our essay writing services are the best in the world. If you are in search of a professional essay writer, place your order on our website.

### Get Help in 35+ Services ## Hi there !

We are here to help. Chat with us on WhatsApp for any queries. 