Estimating the cost of capital You were a portfolio manager in a mutual fund firm. On July 10th 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 Fike'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? I 000 Formatting Format Clipboard Font Alignment Number Table Styles Styles Cel X46 B D E F G H 9,488.8 5,784.9 3,703.9 2,689.7 1,014,2 58.7 34,1 921.4 331.7 589.7 1 Income statement in 2001 2 Sales 3 Cost of goods sold 4 Gross profit 5 Selling and administrative 6 Operating income 7 Interest expense 8 Other expense 9 Income before income taxes 10 Income taxes (36%) 11 Net income 12 13 14 15 Assumptions(Projections) 16 Rev growth % 17 COGS/Sales % 18 SG&A/sales % 19 Tax % 20 Terminal value growth rate 21 Cost of capital 22 Cash Flow Estimation 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 7.00% 6.50% 6.50% 6.50% 60.00% 60.00% 59.50% 59.50% 28.00% 27.50% 27.00% 26.50% 38.00% 38.00% 38.00% 38.00% 3.00% 12% 6.00% 6.00% 6.00% 6.00% 6.00% 6.00% 59.00% 59.00% 58.50% 58.50% 58.00% 58.00% 26.00% 25.50% 25.00% 25.00% 25.00% 25.00% 38.00% 38.00% 38.00% 38.00% 38.00% 38.00% Cost of captial Search for anything O Font $ - % -33 X46 Aliment Conditional Format Formatting Table Sys 5 B D A 25 Discounted cash flow 26 Sales 27 Cost of goods sold 28 Gross profit 29 Selling and administrative 30 Operating income 31 Taxes 32 Net operating income after tax 33 change in Capex 34 Change in net working capital 35 FCF 6 Terminal value 7 Total cash flow 10153.016 6091.8096 4061.2064 2842.84448 1218.36192 462.9775296 755.3843904 8.8 1749-186.3 198.4 -195-206.7219.1 -2323246.2 Terminal value can NPV Book value of debt 1296.5 Shares outstanding Equity value per share 271.5 in millions Current share price $42.09 Cash Flow Estimation Cost of captial O Search for anything TE Number f 20-year 1 Historical betas of Nike B 2 1996 0.98 3 1997 0.84 4 1998 0.84 5 1999 0.63 6 2000 0.83 7 up to 2001 June 0.69 8 9 10 Hostorical markket risk premium 11 Arithmetic mean 7.50% 12 Geometric mean 5.90% 13 14 Dividend growth rate forecasted by Value line 5.50% 15 16 17 Dividend history 31-Mar 18 1997 0.1 19 1998 0.12 20 1999 0.12 2000 0.12 21 22 2001 0.12 23 24 Consensus EPS estimates Cash Flow Estimation Cost of captial 30-Jun 0.1 0.12 0.12 0.12 0.12 30-Sep 0.1 0.12 0.125 0.12 31-Dec 0.1 0.12 0.12 0.12 + Alignment ble Numbes A34 fi Styles 20-year B C D G H $2.32 $2.67 3.59% 3.59% 3.59% 4.8896 5.39% 5.74% A 24 Consensus EPS estimates 25 FY 2002 26 FY 2003 27 28 Current yields on U.S. Treasuries 29. 3-month 30 6-month 31 1-year 32 5-year 33 10-year 34 20-year 35 36 37 Current Nike Debt 38 ISSUER 39 NIKE 40 NIKE 41 NIKE 42 NIKE 43 NIKE 44 NIKE 45 46 47 Cash Flow Estimation YTM 0.3 2.6 COUPON 2.25 3.625 3.875 2.375 3.375 2.4 MATURITY Kvalue (in milli MARKET PRICE 5/1/2023 212.56 104.536 5/1/2043 187.61 117.139 11/1/2045 241.33 124.383 11/1/2026 155.66 109.125 11/1/2016 210.567 114.297 3/27/2025 288.86 107.417 2.536 0.773 2.606 0.689 Cost of captial O TI Search for anything