Estimating the cost of capital

You were a portfolio manager in a mutual fund firm. On July 10^th in 2001, you were asked to evaluate Nike, Inc. Nike's stock price had declined recently, which may provide a good buying opportunity considering the investment focus at your firm is value investing.

In the last analysts meeting held a week ago, Nike posited that the firm would develop more athletic shoes in the mid-priced range to attract more customers.Further, they would exert more effort in controlling all costs.Their long-term targets for revenue growth and earnings growth were 8%-10% and above 15%, respectively.

The analysts completed the projections of the growth rates of revenue and costs, as shown in the spreadsheet "Cash Flow Estimation." The analyst estimation for Nike's weighted-average cost of capital was12%. Given that the current debt outstanding was $1,296.6 million and the number of shares outstanding was 271.5 million, the analyst estimated that the equity value per share should be $37.27.However, the Nike stock price was $42.09 at the time, so the analyst concluded that Nike was overvalued, and your firm should not invest in Nike stock.

However, your colleagues provided different opinions on the estimation of Nike's weighted-average cost of capital. They also argued that Nike would be undervalued when utilizing different estimations fo WACC. As Nike's valuation is very sensitive to its cost of capital, the correct estimation is crucial in making the right investment decision.

To prepare your report, you need to clearly answer the following questions:

1.What is the weighted-average cost of capital (WACC)? What does it represent? Why is it important to estimate a firm's cost of capital?

2.Complete the estimation of Nike's stock price using the information given in the spreadsheet "Cash Flow Estimation" and assuming the analyst's estimation of WACC was correct. The completed estimation should be presented in the area marked in yellow in the spreadsheet. (Note that if you use the analyst's estimate of WACC of 12%, your estimation of the stock price should be $37.27)

3.You can calculate the cost of equity using CAPM or the dividend discount model. What are the advantages and disadvantages of each method?

4.Calculate the costs of equity using CAPM and the dividend discount model. Estimate Nike's cost of debt. The information needed is given in the spreadsheet "Cost of Capital" in the Excel file.

5.Calculate your WACC for Nike and clearly justify your assumptions.

6.What should you recommend regarding an investment in Nike?