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 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

(please see pictures 1-2). Assuming the weighted-average cost of capital was 12%, Nikes enterprise price value would be $11,415.4 million. Given that the current debt outstanding was $1,296.6, 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 provided in the pictures.

5. I have provided you with the cash flows estimation in the Excel file (please see pictures). 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 Cost of goods sold Gross profit Selling and administrative Operating income Interest expense Other expense Income before income taxes Income taxes (36%) Net income 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 2002 2003 2004 2005 2006 2007 2008 7.00% 6.50% 60.00% 60.00% 28.00% 27.50% 38.00% 38.00% 3.00% 12% 6.50% 59.50% 27.00% 38.00% 6.50% 59.50% 26.50% 38.00% 6.00% 59.00% 26.00% 38.00% 6.00% 59.00% 25.50% 38.00% 6.00% 58.50% 25.00% 38.00% Assumptions Rev growth % COGS/Sales % SG&A/sales % Tax % Terminal value growth rate Cost of capital Discounted cash flow Sales Cost of goods sold Gross profit Selling and administrative Operating income Taxes Net operating income after tax change in Capex Change in net working capital FCF Terminal value Total cash flow NPV Book value of debt Enterprice value Shares Equity value per share Current share price 10153.016 10813 11515.8 12264.3 13000.192 13780. 2 14607 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 811.654 915.86 755.38439 838.005 963.873 1064.54 1209.0178 1324.28 1494.3 8.8 -174.9 -186.3 -198.4 764.18439 663.105 777.573 866.144 -195 -206.7 1014.0178 1117.58 -219.1 1275.2 1275.2 764.18439 663.105 777.573 866.144 1014.0178 1117.58 $11,415.51 1296.6 $10,118.91 in millions 271.5 in millions $37.27 $42.09 0.98 0.84 0.84 0.63 Historical betas of Nike 1996 1997 1998 1999 2000 up to 2001 June Hostorical markket risk premium Arithmetic mean Geometric mean Dividend growth rate forecasted by Value line Dividend history 0.83 0.69 1997 7.50% 5.90% 5.50% 31-Mar 0.1 0.12 0.12 0.12 0.12 30-Jun 0.1 0.12 0.12 0.12 0.12 1998 1999 30-Sep 0.1 0.12 0.12 0.12 31-Dec 0.1 0.12 0.12 2000 0.12 $2.32 $2.67 2001 Consensus EPS estimates FY 2002 FY 2003 Current Y=yields on U.S. Treasuries 3-month 6-month 1-year 5-year 10-year 20-year Current yield on Nike Debt Coupon Issued Maturity Curent price 3.59% 3.59% 3.59% 4.88% 5.39% 5.74% 6.75% 7/15/1996 7/15/2021 95.6 Income statement in 2001 Sales Cost of goods sold Gross profit Selling and administrative Operating income Interest expense Other expense Income before income taxes Income taxes (36%) Net income 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 2002 2003 2004 2005 2006 2007 2008 7.00% 6.50% 60.00% 60.00% 28.00% 27.50% 38.00% 38.00% 3.00% 12% 6.50% 59.50% 27.00% 38.00% 6.50% 59.50% 26.50% 38.00% 6.00% 59.00% 26.00% 38.00% 6.00% 59.00% 25.50% 38.00% 6.00% 58.50% 25.00% 38.00% Assumptions Rev growth % COGS/Sales % SG&A/sales % Tax % Terminal value growth rate Cost of capital Discounted cash flow Sales Cost of goods sold Gross profit Selling and administrative Operating income Taxes Net operating income after tax change in Capex Change in net working capital FCF Terminal value Total cash flow NPV Book value of debt Enterprice value Shares Equity value per share Current share price 10153.016 10813 11515.8 12264.3 13000.192 13780. 2 14607 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 811.654 915.86 755.38439 838.005 963.873 1064.54 1209.0178 1324.28 1494.3 8.8 -174.9 -186.3 -198.4 764.18439 663.105 777.573 866.144 -195 -206.7 1014.0178 1117.58 -219.1 1275.2 1275.2 764.18439 663.105 777.573 866.144 1014.0178 1117.58 $11,415.51 1296.6 $10,118.91 in millions 271.5 in millions $37.27 $42.09 0.98 0.84 0.84 0.63 Historical betas of Nike 1996 1997 1998 1999 2000 up to 2001 June Hostorical markket risk premium Arithmetic mean Geometric mean Dividend growth rate forecasted by Value line Dividend history 0.83 0.69 1997 7.50% 5.90% 5.50% 31-Mar 0.1 0.12 0.12 0.12 0.12 30-Jun 0.1 0.12 0.12 0.12 0.12 1998 1999 30-Sep 0.1 0.12 0.12 0.12 31-Dec 0.1 0.12 0.12 2000 0.12 $2.32 $2.67 2001 Consensus EPS estimates FY 2002 FY 2003 Current Y=yields on U.S. Treasuries 3-month 6-month 1-year 5-year 10-year 20-year Current yield on Nike Debt Coupon Issued Maturity Curent price 3.59% 3.59% 3.59% 4.88% 5.39% 5.74% 6.75% 7/15/1996 7/15/2021 95.6