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. Nikes 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 Nikes 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 Nikes weighted-average cost of capital. They also argued that Nike would be undervalued when utilizing different estimations fo WACC. As Nikes 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:
- What is the weighted-average cost of capital (WACC)? What does it represent? Why is it important to estimate a firms cost of capital?
- Complete the estimation of Nikes stock price using the information given in the spreadsheet Cash Flow Estimation and assuming the analysts 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 analysts estimate of WACC of 12%, your estimation of the stock price should be $37.27)
- You can calculate the cost of equity using CAPM or the dividend discount model. What are the advantages and disadvantages of each method?
- Calculate the costs of equity using CAPM and the dividend discount model. Estimate Nikes cost of debt. The information needed is given in the spreadsheet Cost of Capital in the Excel file.
- Calculate your WACC for Nike and clearly justify your assumptions.
- What should you recommend regarding an investment in Nike?
B43 X fc I . B C D E F G K 1 Income statement in 2001 2 Sales 9,488.8 3 Cost of goods sold 5,784.9 4. Gross profit 3,703.9 5 Selling and administrative 2,689.7 6 Operating income 1,014.2 7 Interest expense 58.7 8 Other expense 34.1 9 Income before income taxes 921.4 10 Income taxes (36%) 331.7 11 Net income 589.7 12 13 14 2002 2003 2004 2005 2006 2007 2008 2009 2010 15 Assumptions(Projections) 16 Rev growth % 7.00% 6.50% 6.50% 6.50% 6.00% 6.00% 6.00% 6.00% 6.00% 6.00% 17 COGS/Sales % 60.00% 60.00% 59.50% 59.50% 59.00% 59.00% 58.50% 58.50% 58.00% 58.00% 18 SG&A/sales % 28.00% 27.50% 27.00% 26.50% 26.00% 25.50% 25.00% 25.00% 25.00% 25.00% 19 Tax % 38.00% 38.00% 38.00% 38.00% 38.00% 38.00% 38.00% 38.00% 38.00% 38.00% 20 Terminal value growth rate 3.00% 21 Cost of capital 12% 22 23 24 Based on the income statement in 2001 and the above assumptions, complete the following projections to find firm value and equity price. 25 Discounted cash flow 26 Sales 10153.016 Cash Flow Estimation Cost of captial 2011 B43 for B D E F G H J L M 22 23 24 Based on the income statement in 2001 and the above assumptions, complete the following projections to find firm value and equity price. 25 Discounted cash flow 26 Sales 10153.016 27 Cost of goods sold 6091.8096 28 Gross profit 4061.2064 29 Selling and administrative 2842.84448 30 Operating income 1218.36192 31 Taxes 462.9775296 32 Net operating income after tax 755.3843904 33 change in Capex 34 Change in net working capital 8.8 -174.9 -186.3 -198.4 -195 -206.7 -219.1 -232.3 -246.2 -261 35 FCF 36 Terminal value Terminal value can be 37 Total cash flow 38 39 NPV 40 Book value of debt 1296.6 41 42 Shares outstanding 271.5 in millions 43 Equity value per share 44 45 Current share price $42.09 46 47 Cash Flow Estimation Cost of captial X A34 fx 20-year D E F G H B 0.12 C 0.12 2001 $2.32 $2.67 3.59% 3.59% 3.59% 4.88% 5.39% 5.74% A 22 23 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 48 49 50 51 52 53 54 55 COUPON 2.25 3.625 3.875 2.375 3.375 2.4 MATURITY (value (in mill 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 11/1/2046 210.58 114.297 3/27/2025 288.86 107.417 YTM 0.3 2.6 2.536 0.773 2.606 0.689 56 Cash Flow Estimation Cost of captial A34 fr 20-year B D E F 0.98 0.84 0.84 0.63 0.83 0.69 7.50% 5.90% 5.50% 1 Historical betas of Nike 2 1996 3 1997 4 1998 5 1999 6 2000 7 up to 2001 June 8 9 10 Hostorical markket risk premium 11 Arithmetic mean 12 Geometric mean 13 14 Dividend growth rate forecasted by Value line 15 16 17 Dividend history 18 1997 19 1998 20 1999 21 2000 22 2001 23 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 31-Mar 0.1 0.12 0.12 0.12 0.12 31-Dec 0.1 0.12 30-Jun 0.1 0.12 0.12 0.12 0.12 30-Sep 0.1 0.12 0.12 0.12 0.12 0.12 $2.32 $2.67 3.59% 3.59% 3.59% 4.88% 5.39% 5.74% 25 Cash Flow Estimation Cost of captial B43 X fc I . B C D E F G K 1 Income statement in 2001 2 Sales 9,488.8 3 Cost of goods sold 5,784.9 4. Gross profit 3,703.9 5 Selling and administrative 2,689.7 6 Operating income 1,014.2 7 Interest expense 58.7 8 Other expense 34.1 9 Income before income taxes 921.4 10 Income taxes (36%) 331.7 11 Net income 589.7 12 13 14 2002 2003 2004 2005 2006 2007 2008 2009 2010 15 Assumptions(Projections) 16 Rev growth % 7.00% 6.50% 6.50% 6.50% 6.00% 6.00% 6.00% 6.00% 6.00% 6.00% 17 COGS/Sales % 60.00% 60.00% 59.50% 59.50% 59.00% 59.00% 58.50% 58.50% 58.00% 58.00% 18 SG&A/sales % 28.00% 27.50% 27.00% 26.50% 26.00% 25.50% 25.00% 25.00% 25.00% 25.00% 19 Tax % 38.00% 38.00% 38.00% 38.00% 38.00% 38.00% 38.00% 38.00% 38.00% 38.00% 20 Terminal value growth rate 3.00% 21 Cost of capital 12% 22 23 24 Based on the income statement in 2001 and the above assumptions, complete the following projections to find firm value and equity price. 25 Discounted cash flow 26 Sales 10153.016 Cash Flow Estimation Cost of captial 2011 B43 for B D E F G H J L M 22 23 24 Based on the income statement in 2001 and the above assumptions, complete the following projections to find firm value and equity price. 25 Discounted cash flow 26 Sales 10153.016 27 Cost of goods sold 6091.8096 28 Gross profit 4061.2064 29 Selling and administrative 2842.84448 30 Operating income 1218.36192 31 Taxes 462.9775296 32 Net operating income after tax 755.3843904 33 change in Capex 34 Change in net working capital 8.8 -174.9 -186.3 -198.4 -195 -206.7 -219.1 -232.3 -246.2 -261 35 FCF 36 Terminal value Terminal value can be 37 Total cash flow 38 39 NPV 40 Book value of debt 1296.6 41 42 Shares outstanding 271.5 in millions 43 Equity value per share 44 45 Current share price $42.09 46 47 Cash Flow Estimation Cost of captial X A34 fx 20-year D E F G H B 0.12 C 0.12 2001 $2.32 $2.67 3.59% 3.59% 3.59% 4.88% 5.39% 5.74% A 22 23 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 48 49 50 51 52 53 54 55 COUPON 2.25 3.625 3.875 2.375 3.375 2.4 MATURITY (value (in mill 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 11/1/2046 210.58 114.297 3/27/2025 288.86 107.417 YTM 0.3 2.6 2.536 0.773 2.606 0.689 56 Cash Flow Estimation Cost of captial A34 fr 20-year B D E F 0.98 0.84 0.84 0.63 0.83 0.69 7.50% 5.90% 5.50% 1 Historical betas of Nike 2 1996 3 1997 4 1998 5 1999 6 2000 7 up to 2001 June 8 9 10 Hostorical markket risk premium 11 Arithmetic mean 12 Geometric mean 13 14 Dividend growth rate forecasted by Value line 15 16 17 Dividend history 18 1997 19 1998 20 1999 21 2000 22 2001 23 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 31-Mar 0.1 0.12 0.12 0.12 0.12 31-Dec 0.1 0.12 30-Jun 0.1 0.12 0.12 0.12 0.12 30-Sep 0.1 0.12 0.12 0.12 0.12 0.12 $2.32 $2.67 3.59% 3.59% 3.59% 4.88% 5.39% 5.74% 25 Cash Flow Estimation Cost of captial
