You were a portfolio manager in a mutual fund firm. On July 10^th 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 is 8%-10% and for earnings growth is above 15%.

The analysts had estimated the free cash flows for Nike from year 2002 to 2011 (Spreadsheet1). Assuming the weighted-average cost of capital was12%, Nikes enterprise price value would be $11,415.4 million. Given that the current debt outstanding was $1,296.6 million, the estimated equity value of would be $10,118.8 million. Because the shares outstanding was 271.5 million, the equity value per share would be $37.27. The Nike stock price was $42.09 at the time, so Nike was overvalued and your firm should not investment in Nike stock.

However, your colleagues provided mixed opinions on Nikes weighted-average cost of capital. They also argue that Nike would be undervalued if the discount rate is below 11%. As the Nikes valuation is very sensitive to its cost of capital, the correct estimation is crucial in making 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)?
2. Why it is important to estimate a firms cost of capital?
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. Calculate your WACC for Nike and clearly justify your assumptions. The information necessary for you to find the WACC is given in the Excel file.
5. I have provided you with the cash flows estimation in the Excel file. Using the WACC you calculated to find your estimated equity value per share.

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

Income statement in 2001 Sales 9,488.8 Cost of goods sold Gross profit Selling and administrative 5,784.9 3,703.9 2,689.7 Operating income 1,014.2 Interest expense 58.7 Other expense 34.1 Income before income taxes 921.4 Income taxes (36%) 331.7 Net income 589.7 2002 2003 2004 2005 2006 2007 2008 Assumptions Rev growth % 7.00% 6.50% 6.50% 6.50% 6.00% 6.00% 6.00% COGS/Sales % 60.00% 60.00% 59.50% 59.50% 59.00% 59.00% 58.50% SG&A/sales % 28.00% 27.50% 27.00% 26.50% 26.00% 25.50% 25.00% Tax % 38.00% 38.00% 38.00% 38.00% 38.00% 38.00% 38.00% Terminal value growth rate Cost of capital 3.00% 12% Discounted cash flow Sales 10153.016 10813 11515.8 12264.3 13000.192 13780.2 14607 Cost of goods sold Gross profit Selling and administrative Operating income Taxes 6091.8096 6487.78 6851.9 7297.28 7670.1132 8130.32 8545.1 4061.2064 4325.18 4663.9 4967.05 5330.0786 5649.88 6061.91 2842.8445 2973.56 3109.27 3250.05 3380.0499 3513.95 3651.75 1218.3619 1351.62 1554.63 1717.01 1950.0288 2135.93 2410.16 462.97753 513.616 590.761 652.462 741.01093 811.654 915.86 Net operating income after tax change in Capex Change in net working capital 755.38439 838.005 963.873 1064.54 1209.0178 1324.28 1494.3 8.8 -174.9 -186.3 -198.4 -195 -206.7 -219.1 FCF 1275.2 764.18439 663.105 777.573 866.144 1014.0178 1117.58 Terminal value Total cash flow 1014.0178 1117.58 764.18439 663.105 777.573 866.144 1275.2 $11,415.51 NPV Book value of debt 1296.6 $10,118.91 in millions 271.5 in millions Enterprice value Shares Equity value per share Current share price $37.27 $42.09 Historical betas of Nike 1996 0.98 1997 0.84 1998 0.84 1999 0.63 2000 0.83 up to 2001 June 0.69 Hostorical markket risk premium Arithmetic mean 7.50% Geometric mean 5.90% Dividend growth rate forecasted by Value line 5.50% Dividend history 30-Sep 31-Dec 31-Mar 30-Jun 0.1 1997 0.1 0.1 0.1 1998 0.12 0.12 0.12 0.12 0.12 1999 0.12 0.12 0.12 0.12 2000 0.12 0.12 0.12 2001 0.12 0.12 Consensus EPS estimates $2.32 FY 2002 FY 2003 $2.67 Current Y=yields on U.S. Treasuries 3.59% 3-month 6-month 3.59% 3.59% 1-year 4.88% 5-year 10-year 5.39% 20-year 5.74% Current yield on Nike Debt 6.75% Coupon 7/15/1996 Issued 7/15/2021 Maturity Curent price 95.6 Income statement in 2001 Sales 9,488.8 Cost of goods sold Gross profit Selling and administrative 5,784.9 3,703.9 2,689.7 Operating income 1,014.2 Interest expense 58.7 Other expense 34.1 Income before income taxes 921.4 Income taxes (36%) 331.7 Net income 589.7 2002 2003 2004 2005 2006 2007 2008 Assumptions Rev growth % 7.00% 6.50% 6.50% 6.50% 6.00% 6.00% 6.00% COGS/Sales % 60.00% 60.00% 59.50% 59.50% 59.00% 59.00% 58.50% SG&A/sales % 28.00% 27.50% 27.00% 26.50% 26.00% 25.50% 25.00% Tax % 38.00% 38.00% 38.00% 38.00% 38.00% 38.00% 38.00% Terminal value growth rate Cost of capital 3.00% 12% Discounted cash flow Sales 10153.016 10813 11515.8 12264.3 13000.192 13780.2 14607 Cost of goods sold Gross profit Selling and administrative Operating income Taxes 6091.8096 6487.78 6851.9 7297.28 7670.1132 8130.32 8545.1 4061.2064 4325.18 4663.9 4967.05 5330.0786 5649.88 6061.91 2842.8445 2973.56 3109.27 3250.05 3380.0499 3513.95 3651.75 1218.3619 1351.62 1554.63 1717.01 1950.0288 2135.93 2410.16 462.97753 513.616 590.761 652.462 741.01093 811.654 915.86 Net operating income after tax change in Capex Change in net working capital 755.38439 838.005 963.873 1064.54 1209.0178 1324.28 1494.3 8.8 -174.9 -186.3 -198.4 -195 -206.7 -219.1 FCF 1275.2 764.18439 663.105 777.573 866.144 1014.0178 1117.58 Terminal value Total cash flow 1014.0178 1117.58 764.18439 663.105 777.573 866.144 1275.2 $11,415.51 NPV Book value of debt 1296.6 $10,118.91 in millions 271.5 in millions Enterprice value Shares Equity value per share Current share price $37.27 $42.09 Historical betas of Nike 1996 0.98 1997 0.84 1998 0.84 1999 0.63 2000 0.83 up to 2001 June 0.69 Hostorical markket risk premium Arithmetic mean 7.50% Geometric mean 5.90% Dividend growth rate forecasted by Value line 5.50% Dividend history 30-Sep 31-Dec 31-Mar 30-Jun 0.1 1997 0.1 0.1 0.1 1998 0.12 0.12 0.12 0.12 0.12 1999 0.12 0.12 0.12 0.12 2000 0.12 0.12 0.12 2001 0.12 0.12 Consensus EPS estimates $2.32 FY 2002 FY 2003 $2.67 Current Y=yields on U.S. Treasuries 3.59% 3-month 6-month 3.59% 3.59% 1-year 4.88% 5-year 10-year 5.39% 20-year 5.74% Current yield on Nike Debt 6.75% Coupon 7/15/1996 Issued 7/15/2021 Maturity Curent price 95.6