Hello,

Based on the attached document, I need the following questions answered. Thank you!

Why is it important to estimate a firm?s cost of capital? What does this represent? Is it set by the managers of the firm or by the investors?What is the central issue in the case and why is this question important? Do you believe that Nike should have multiple CoCs and why or why not?What is your estimate of the WACC for Nike? Do you agree with Joanna Cohen?s estimate of WACC and why or why not ? what mistakes did she make? Your answer should examine her assumptions and calculations for debt, equity, and weights.Calculate the costs of equity using the CAPM, DDM, and Earnings Capitalization method. What are the advantages and disadvantages of each method? Which method would you choose for Nike and why?Based on the WACC that you arrive at, should Kimi Ford buy Nike and why or why not. UVA-F-1353 PY NIKE, INC.: COST OF CAPITAL CO On July 5, 2001, Kimi Ford, a portfolio manager at NorthPoint Group, a mutual-fund management firm, pored over analysts' write-ups of Nike, Inc., the athletic-shoe manufacturer. Nike's share price had declined significantly from the beginning of the year. Ford was considering buying some shares for the fund she managed, the NorthPoint Large-Cap Fund, which invested mostly in Fortune 500 companies, with an emphasis on value investing. Its top holdings included ExxonMobil, General Motors, McDonald's, 3M, and other large-cap, generally old-economy stocks. While the stock market had declined over the last 18 months, the NorthPoint Large-Cap Fund had performed extremely well. In 2000, the fund earned a return of 20.7%, even as the S&P 500 fell 10.1%. At the end of June 2001, the fund's year-to-date returns stood at 6.4% versus 7.3% for the S&P 500. NO T Only a week earlier, on June 28, 2001, Nike had held an analysts' meeting to disclose its fiscal-year 2001 results.1 The meeting, however, had another purpose: Nike management wanted to communicate a strategy for revitalizing the company. Since 1997, its revenues had plateaued at around $9 billion, while net income had fallen from almost $800 million to $580 million (see Exhibit 1). Nike's market share in U.S. athletic shoes had fallen from 48%, in 1997, to 42% in 2000.2 In addition, recent supply-chain issues and the adverse effect of a strong dollar had negatively affected revenue. DO At the meeting, management revealed plans to address both top-line growth and operating performance. To boost revenue, the company would develop more athletic-shoe products in the midpriced segment3a segment that Nike had overlooked in recent years. Nike also planned to push its apparel line, which, under the recent leadership of industry veteran Mindy Grossman,4 had performed extremely well. On the cost side, Nike would exert more effort 1 Nike's fiscal year ended in May. Douglas Robson, \"Just Do ... Something: Nike's Insularity and Foot-Dragging Have It Running in Place,\" BusinessWeek (2 July 2001). 3 Sneakers in this segment sold for $70 to $90 a pair. 4 Mindy Grossman joined Nike in September 2000. She was the former president and chief executive of Jones Apparel Group's Polo Jeans division. 2 This case was prepared from publicly available information by Jessica Chan, under the supervision of Robert F. Bruner and with the assistance of Sean D. Carr. The financial support of the Batten Institute is gratefully acknowledged. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright 2001 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden School Foundation. Rev. 10/05. -2- UVA-F-1353 on expense control. Finally, company executives reiterated their long-term revenue-growth targets of 8% to 10% and earnings-growth targets of above 15%. PY Analysts' reactions were mixed. Some thought the financial targets were too aggressive; others saw significant growth opportunities in apparel and in Nike's international businesses. CO Kimi Ford read all the analysts' reports that she could find about the June 28 meeting, but the reports gave her no clear guidance: a Lehman Brothers report recommended a strong buy, while UBS Warburg and CSFB analysts expressed misgivings about the company and recommended a hold. Ford decided instead to develop her own discounted cash flow forecast to come to a clearer conclusion. Her forecast showed that, at a discount rate of 12%, Nike was overvalued at its current share price of $42.09 (Exhibit 2). However, she had done a quick sensitivity analysis that revealed Nike was undervalued at discount rates below 11.17%. Because she was about to go into a meeting, she asked her new assistant, Joanna Cohen, to estimate Nike's cost of capital. DO NO T Cohen immediately gathered all the data she thought she might need (Exhibits 1 through 4) and began to work on her analysis. At the end of the day, Cohen submitted her cost-of-capital estimate and a memo (Exhibit 5) explaining her assumptions to Ford. -3- UVA-F-1353 Exhibit 1 NIKE, INC.: COST OF CAPITAL Year Ended May 31 1995 (in millions of dollars except per-share data) 1996 PY Consolidated Income Statements 1997 1998 2000 2001 Revenues Cost of goods sold Gross profit Selling and administrative Operating income Interest expense Other expense, net Restructuring charge, net Income before income taxes Income taxes Net income $ 4,760.8 2,865.3 1,895.6 1,209.8 685.8 24.2 11.7 649.9 250.2 $ 399.7 $ 6,470.6 3,906.7 2,563.9 1,588.6 975.3 39.5 36.7 899.1 345.9 $ 553.2 $ 9,186.5 5,503.0 3,683.5 2,303.7 1,379.8 52.3 32.3 1,295.2 499.4 $ 795.8 Diluted earnings per common share Average shares outstanding (diluted) $ $ 1.88 293.6 $ NO 1999 35.9 42.2 38.4 42.0 41.5 43.9 4.0 (37.4) (49.8) (8.1) (0.8) 13.0 2.5 15.0 28.3 5.5 3.0 1.8 39.6 15.1 8.5 40.1 15.0 8.7 36.5 9.0 4.2 37.4 9.8 5.1 39.9 10.9 6.4 39.0 10.7 6.2 38.5 38.6 38.8 39.5 37.0 36.0 DO Margins (%) Gross margin Operating margin Net margin Effective tax rate (%)* $ 8,776.9 5,493.5 3,283.4 2,426.6 856.8 44.1 21.5 45.1 746.1 294.7 $ 451.4 $ 8,995.1 $ 9,488.8 5,403.8 5,784.9 3,591.3 3,703.9 2,606.4 2,689.7 984.9 1,014.2 45.0 58.7 23.2 34.1 (2.5) 919.2 921.4 340.1 331.7 $ 579.1 $ 589.7 $ $ $ CO T Growth (%) Revenue Operating income Net income 1.36 294.0 $ 9,553.1 6,065.5 3,487.6 2,623.8 863.8 60.0 20.9 129.9 653.0 253.4 $ 399.6 2.68 297.0 1.35 296.0 *The U.S. statutory tax rate was 35%. The state tax varied yearly from 2.5% to 3.5%. Sources of data: Company filing with the Securities and Exchange Commission (SEC), UBS Warburg. 1.57 287.5 2.07 279.8 $ 2.16 273.3 -4- UVA-F-1353 Exhibit 2 NIKE, INC.: COST OF CAPITAL $ 11,415.4 1,296.6 10,118.8 271.5 37.27 2005 2006 2007 2008 2009 2010 2011 6.5 60.0 27.5 38.0 38.0 11.5 6.5 59.5 27.0 38.0 38.0 11.5 6.5 59.5 26.5 38.0 38.0 11.5 6.0 59.0 26.0 38.0 38.0 11.5 6.0 59.0 25.5 38.0 38.0 11.5 6.0 58.5 25.0 38.0 38.0 11.5 6.0 58.5 25.0 38.0 38.0 11.5 6.0 58.0 25.0 38.0 38.0 11.5 6.0 58.0 25.0 38.0 38.0 11.5 $ 1,351.6 $ 1,554.6 $ 1,717.0 $ 1,950.0 $ 2,135.9 $ 2,410.2 $ 2,554.8 $ 2,790.1 $ 2,957.5 513.6 590.8 652.5 741.0 811.7 915.9 970.8 1,060.2 1,123.9 838.0 963.9 1,064.5 1,209.0 1,324.3 1,494.3 1,584.0 1,729.9 1,833.7 (174.9) (186.3) (198.4) (195.0) (206.7) (219.1) (232.3) (246.2) (261.0) 663.1 777.6 866.2 1,014.0 1,117.6 1,275.2 1,351.7 1,483.7 1,572.7 17,998.3 663.1 777.6 866.2 1,014.0 1,117.6 1,275.2 1,351.7 1,483.7 19,571.0 $ 528.6 $ 553.5 $ 550.5 $ 575.4 $ 566.2 $ 576.8 $ 545.9 $ 535.0 $ 6,301.2 NO Enterprise value Less: current outstanding debt Equity value Current shares outstanding Equity value per share 2004 CO Discounted Cash Flow (in millions of dollars except per-share data) Operating income $ 1,218.4 Taxes 463.0 NOPAT 755.4 Capex, net of depreciation Change in NWC 8.8 Free cash flow 764.1 Terminal value Total flows 764.1 Present value of flows $ 682.3 2003 T 2002 Assumptions: Revenue growth (%) 7.0 COGS/sales (%) 60.0 SG&A/sales (%) 28.0 Tax rate (%) 38.0 Current assets/sales (%) 38.0 Current liabilities/sales (%) 11.5 Yearly depreciation and capex equal each other. Cost of capital (%) 12.00 Terminal growth rate (%) 3.00 $ $ Current share price: Sensitivity of equity value to discount rate: Equity value $ 75.80 67.85 61.25 55.68 50.92 46.81 43.22 42.09 40.07 37.27 DO Discount rate 8.00% 8.50% 9.00% 9.50% 10.00% 10.50% 11.00% 11.17% 11.50% 12.00% PY Discounted Cash Flow Analysis Source: Case writer's analysis. $ 42.09 -5- UVA-F-1353 Exhibit 3 NIKE, INC.: COST OF CAPITAL Consolidated Balance Sheets PY $ 254.3 1,569.4 1,446.0 111.5 215.2 3,596.4 CO (in millions of dollars) Assets Current assets: Cash and equivalents Accounts receivable Inventories Deferred income taxes Prepaid expenses Total current assets As of May 31, 2000 2001 T Property, plant and equipment, net 1,583.4 Identifiable intangible assets and goodwill, net 410.9 Deferred income taxes and other assets 266.2 Total assets $ 5,856.9 NO Liabilities and shareholders' equity Current liabilities: Current portion of long-term debt Notes payable Accounts payable Accrued liabilities Income taxes payable Total current liabilities DO Long-term debt Deferred income taxes and other liabilities Redeemable preferred stock Shareholders' equity: Common stock, par Capital in excess of stated value Unearned stock compensation Accumulated other comprehensive income Retained earnings Total shareholders' equity Total liabilities and shareholders' equity $ 50.1 924.2 543.8 621.9 2,140.0 470.3 110.3 0.3 2.8 369.0 (11.7) (111.1) 2,887.0 3,136.0 $ 5,856.9 $ 304.0 1,621.4 1,424.1 113.3 162.5 3,625.3 1,618.8 397.3 178.2 $ 5,819.6 $ 5.4 855.3 432.0 472.1 21.9 1,786.7 435.9 102.2 0.3 2.8 459.4 (9.9) (152.1) 3,194.3 3,494.5 $ 5,819.6 Source of data: Company filing with the Securities and Exchange Commission (SEC). -6- UVA-F-1353 Exhibit 4 NIKE, INC.: COST OF CAPITAL Current Yields on U.S. Treasuries Nike Share Price Performance Relative to S&P 500: January 2000 to July 5, 2001 3.59% 3.59% 3.59% 4.88% 5.39% 5.74% 1.3 1.2 1.1 CO 3-month 6-month 1-year 5-year 10-year 20-year PY Capital-Market and Financial Information on or around July 5, 2001 1.0 0.9 Historical Equity Risk Premiums (1926-1999) Geometric mean 5.90% Arithmetic mean 7.50% 0.8 0.7 0.6 Average 0.98 0.84 0.84 0.63 0.83 0.69 NO Nike Historic Betas 1996 1997 1998 1999 2000 YTD 6/30/01 0.80 Consensus EPS estimates: FY 2002 FY 2003 $ 2.32 $ 2.67 DO 0.5 Nike Jul-01 May-01 Mar-01 Jan-01 Nov-00 Sep-00 Jul-00 May-00 Mar-00 Jan-00 0.4 T Current Yield on Publicly Traded Nike Debt* Coupon 6.75% paid semi-annually Issued 07/15/96 Maturity 07/15/21 Current Price $ 95.60 S&P 500 Nike share price on July 5, 2001: $ 42.09 Dividend History and Forecasts Paymt Dates 31-Mar 30-Jun 1997 0.10 0.10 1998 0.12 0.12 1999 0.12 0.12 2000 0.12 0.12 2001 0.12 0.12 30-Sep 0.10 0.12 0.12 0.12 31-Dec 0.10 0.12 0.12 0.12 Total 0.40 0.48 0.48 0.48 Value Line Forecast of Dividend Growth from '98-'00 to '04-'06: 5.50% * Data have been modified for teaching purposes. Sources of data: Bloomberg Financial Services, Ibbotson Associates Yearbook 1999, Value Line Investment Survey, IBES. -7- UVA-F-1353 Exhibit 5 NIKE, INC.: COST OF CAPITAL Kimi Ford FROM: Joanna Cohen DATE: July 6, 2001 SUBJECT: Nike's cost of capital CO TO: PY Joanna Cohen's Analysis Based on the following assumptions, my estimate of Nike's cost of capital is 8.4%: I. Single or Multiple Costs of Capital? NO T The first question that I considered was whether to use single or multiple costs of capital, given that Nike has multiple business segments. Aside from footwear, which makes up 62% of its revenue, Nike also sells apparel (30% of revenue) that complements its footwear products. In addition, Nike sells sport balls, timepieces, eyewear, skates, bats, and other equipment designed for sports activities. Equipment products account for 3.6% of its revenue. Finally, Nike also sells some non-Nike-branded products such as Cole Haan dress and casual footwear, and ice skates, skate blades, hockey sticks, hockey jerseys, and other products under the Bauer trademark. Non-Nike brands accounted for 4.5% of revenue. DO I asked myself whether Nike's business segments had different enough risks from each other to warrant different costs of capital. Were their profiles really different? I concluded that it was only the Cole Haan line that was somewhat different; the rest were all sportsrelated businesses. Since Cole Haan makes up only a tiny fraction of revenues, however, I did not think that it was necessary to compute a separate cost of capital. As for the apparel and footwear lines, they are sold through the same marketing and distribution channels and are often marketed in other collections of similar designs. Since I believe they face the same risk factors, I decided to compute only one cost of capital for the whole company. II. Methodology for Calculating the Cost of Capital: WACC Since Nike is funded with both debt and equity, I used the WACC method (weightedaverage cost of capital). Based on the latest available balance sheet, debt as a proportion of total capital makes up 27.0% and equity accounts for 73.0%: -8- UVA-F-1353 Exhibit 5 (continued) Book Values (in millions) Debt Current portion of long-term debt Notes payable Long-term debt Equity 5.4 855.3 435.9 $ 1,296.6 $ 3,494.5 27.0% of total capital 73.0% of total capital CO III. Cost of Debt $ PY Capital Sources My estimate of Nike's cost of debt is 4.3%. I arrived at this estimate by taking total interest expense for the year 2001 and dividing it by the company's average debt balance.1 The rate is lower than Treasury yields, but that is because Nike raised a portion of its funding needs through Japanese yen notes, which carry rates between 2.0% and 4.3%. NO IV. Cost of Equity T After adjusting for tax, the cost of debt comes out to 2.7%. I used a tax rate of 38%, which I obtained by adding state taxes of 3% to the U.S. statutory tax rate. Historically, Nike's state taxes have ranged from 2.5% to 3.5%. I estimated the cost of equity using the capital-asset-pricing model (CAPM). Other methods, such as the dividend-discount model (DDM) and the earnings-capitalization ratio, can be used to estimate the cost of equity. In my opinion, however, the CAPM is the superior method. DO My estimate of Nike's cost of equity is 10.5%. I used the current yield on 20-year Treasury bonds as my risk-free rate, and the compound average premium of the market over Treasury bonds (5.9%) as my risk premium. For beta, I took the average of Nike's betas from 1996 to the present. Putting It All Together Inputting all my assumptions into the WACC formula, my estimate of Nike's cost of capital is 8.4%. WACC = Kd(1 t) D/(D + E) + Ke E/(D + E) = 2.7% 27.0% + 10.5% 73.0% = 8.4% 1 Debt balances as of May 31, 2000 and 2001, were $1,444.6 million and $1,296.6 million, respectively