AMAL MOBARAKI -441212274-
Questions:
1. There are some mistakes in Joanna Cohen’s WACC Calculation.
2. Is her calculation of Kd correct?
Hints: Use of historic cost of debt is inappropriate. Yield to maturity is the proper cost of debt input (annualized rate that
equates present value of future interest payments and principal amount to the bond’s price. Data from Exhibit 4)
2. Is her calculation of the cost of equity using CAPM correct?
Hint: It is inappropriate to use historic beta. Most recent beta value is more appropriate.
3. Calculate the cost of equity using DDM. Does it seem appropriate?
Hint: Value-Line estimate of g is appropriate. (Use growth rate of price in 2001 compared to 2000).
4. Calculate the cost of equity using the earning’s capitalization ratio. Does it seem appropriate?
5. What are the advantages and disadvantages of each method?
6. If you don’t agree with Cohen’s analysis, calculate your own WACC for NIKE.
Hint: To calculate weights, should you use book values of debt and equity or market values of the two?
7. Is the NIKE stock overvalued or undervalued? What should Kimi Ford recommend regarding an investment in NIKE?
1.What is the WACC and why is it important to estimate a firm’s cost of capital? Do you agree with
Joanna Cohen’s WACC calculation? Why or why not?
Answer:
The cost of capital refers to the maximum rate of return a firm must earn on its investment so that the
market value of company's equity shares will not drop. This is a consonance with the overall firm's
objective of wealth maximization. WACC is a calculation of a firm's cost of capital in which each
category of capital is proportionately weighted. All capital sources - common stock, preferred stock,
bonds and any other long-term debt - are included in a WACC calculation. All else equal, the WACC of
a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a
decrease in valuation and a higher risk. The WACC of a firm is a very important both to the stock
market for stock valuation purposes and to the company's management for capital budgeting
purposes. In an analysis of a potential investment by the company, investment projects that have an
expected return that is greater than the company's WACC will generate additional free cash flow and
will create positive net present value for stock owners. Thus, since the WACC is the minimum rate of
return required by capital providers, the managers in the company should invest in the projects which
generate returns in excess of WACC.
We do not agree with Joanna Cohen’s calculation regarding the WACC from 3 aspects: 1) When
Joanna Cohen computed the weights or proportions of debt and equity, she used the book value
rather than the market value. The book values are historical data, not current ones; on the contrary,
the market recalculates the values of each type of capital on a continuous basis, therefore, market
values are more appropriate. 2) The cost of debt should not be calculated by “taking total interest
expense for the year 2001 and dividing it by the company’s average debt balance. These historical
data would not reflect Nike’s current or future cost of debt. 3) She mistakenly used the average Beta
from year 1996 to 2001. The average Beta could not represent the future systemic risk, and we should
find the most recent Beta as Beta estimate in this situation.
2.If you do not agree with Cohen’s analysis, calculate your own WACC for Nike and be prepared to
justify your assumptions.
Answer:
1)Weights of equity and debt:
Market value of equity = Current share price x Current shares outstanding = $42.09 x 271.5m =
$11,427.44m
Due to the lack information of market value of debt, we could use the book value for calculation:
Market value of debt = Current portion of long-term debt + Notes payable + Long-term debt = $5.4m +
$855.3m + $435.9m = $1,296.6m We = $11,427.44m/($11,427.44m +$1,296.6m) = 89.81%
Wd = $1,296.6m/($11,427.44m +$1,296.6m) = 10.19%
2)Cost of Debt:
We can calculate the current yield to maturity of the Nike’s bond to represent Nike’s current cost of
debt. Po=$95.6 N=20x2=40 PAR=$100 PMT=$100x6.75%/2=3.375
By using financial calculator: r=3.58%(semiannual)
So Rd=3.58% x 2 = 7.16%
3)Cost of Equity:
Use 20-year T-bond rate to represent risk-free rate, as the rate of return of a T-bond with 20 years
maturity is the longest rate which is available right now. So Rf=5.74% Use a geometric mean of market
risk premium 5.9% as Market Risk Premium As we mentioned in Q1, the most recent beta will most
relevant in this respect, so we will use B=0.69 Re=Rf+B(Market Risk Premium)
=0.0574 + 0.69x0.059 = 9.81%
4)WACC:
Use tax rate = US statutory tax rate + state tax
= 35% + 3% = 38%
WACC=Wd x Rd x (1-T) + We x Re
= 10.19% x 7.16% x (1- 38%) + 89.81% x 9.81% = 9.26%
3.Calculate the costs of equity using CAPM, and the dividend discount model.
What are the advantages and disadvantages of each model?
Answer:
1)Cost of Equity using CAPM:
Market Risk Free Rate (Rf)= 5.74% (20-year yield on US Treasuries) Beta (B) = .69 (most recent beta
used as most relevant beta to calculate Nike’s valuation) Market Risk Premium = 5.9% (Geometric
Mean used as Historic Equity Risk Premium) Cost of Equity using CAPM = Re = Rf + B(Market Risk
Premium) Re = 9.81% = 5.74% + .69(5.9%)
Advantages:
-CAPM includes systematic risk by incorporating Beta in the Cost of Equity formula. Using the stock’s
Beta to calculate equity will provide a return rate based on how risky the stock is perceived by
investors. The higher the risk, the higher the Beta will be and will result in a higher required rate of
return on the investment. Systematic risk can’t be diversified away, while unsystematic risk can be
diversified away by maintaining a diversified portfolio. -CAPM proves to be a better model than others
such as the Dividend Discount Model, because the valuation behind CAPM is based on risk and rates
of return while the Dividend Discount Model relies heavily on dividends and a growth rate.
Disadvantages:
-When using CAPM, it can be difficult determining the estimate of Beta. Different investments may
involve different risks and the Beta used in calculating CAPM should reflect the appropriate amount of
risk relating to the specific investment. -The risk free rates used in calculating CAPM are continually
changing as with the values of the investments in the market which make up the market risk premium.
The constant changes in the market can have negative impacts on the valuation of CAPM. -Another
disadvantage in using the CAPM in investment appraisal is that investment appraisal is premised on a
long-term time horizon, whereas CAPM assumes a single-period time horizon, i.e. a holding period of
one year. While CAPM variables can be assumed constant in successive future periods, market
reality often shows that this is not the case.
2)Cost of Equity using the Dividend Discount Model:
Growth (g) = 5.5%
Dividend (D0) = $.48
Share Price (P0) = $42.09
Cost of Equity using Dividend Discount Model = Re = (D0 x (1+g)/P0) +g Re = 6.7% = (.48 x
(1+5.5%)/42.09+5.5%
Advantages:
-Using the Dividend Discount Model is very easy to calculate because the formula is not complicated.
There are no real technical or difficult calculations involved with using this method. -The inputs that are
used in the calculations of this model are market information and can be easily obtained. -The
Dividend discount model attempts to put a valuation on shares, based on forecasts of the sums to be
paid out to investors. This should, in theory, provide a very solid basis to determine the share’s true
value in present terms.
Disadvantages:
-The Dividend Discount Model relies heavily on the growth rate to calculate the rate of return. If growth
slows or becomes temporarily negative, it can result in calculations which may not truly represent
future expected returns. -This model is calculated using dividends and can’t be used in instances
where a company is not paying dividends. This is also a disadvantage for any investment without a
reasonably constant growing dividend stream. -The Dividend Discount Model is very sensitive to minor
changes in input figures. If the growth rate changes by 1 % the cost of equity will also change by that
rate. -The Dividend Discount Model does not explicitly consider the risks which the company faces.
4.What should Kimi Ford recommend regarding an investment in Nike?
Answer:
In order for Kimi Ford to make a decision regarding an investment in Nike, she must compare an
accurately calculated WACC to the sensitivity of equity value to discount rate chart shown in Exhibit
#2. The sensitivity chart in Exhibit #2 states that at a discount rate of 11.17%, Nike’s current share
price is fairly valued at $42.09. If a discount rate were to be calculated below 11.17% then the Nike
shares would be under-valued in the current market, but if their discount rate were higher than the
11.17% Nike share price would be considered over-valued when compared to the current share price.
When we calculated Nike’s discount rate, we determined that their appropriate WACC should be
9.26%. Since this WACC of 9.26% is below 11.17%, we believe that Nike’s shares are currently under-
valued in the market. We believe that Nike’s equity value based on the WACC of 9.26% should fall
somewhere between $55.68 and $61.25. Kiki Ford should recommend adding Nike shares to the
NorthPoint Large-Cap Fund based on our analysis.
03/03/2011
CASE OVERVIEW
Kimi Ford is a portfolio manager at a large mutual-fund management firm called, NorthPoint Group.
Ford is considering the addition of Nike Inc. to the Large-Cap Fund at NorthPoint Group. Nike’s share
price has notably declined since the beginning of the year. Her decision whether or not to add Nike to
the portfolio should be made by looking at the 2001 fiscal year end 10-K report.
In 1997 Nike’s revenues plateaued around $9 billion while net income had fallen from around $800
million to $580 million. Also, from 1997-2000 Nike’s market share in U.S. athletic shoes fell from 48%
to 42%. Supply-chain issues and the adverse effect of a strong dollar had negatively affected revenue
in recent years. At the June 28, 2001 analyst meeting Nike planned to add both top-line growth and
operating performance. One goal was to develop more mispriced ($70-$90) athletic shoes and the
other to push its apparel line. At this meeting a target long-term revenue growth rate between 8%-10%
was given and an earnings-growth target above 15%.
After reviewing all the analysts’ reports about the June 28th meeting Ford still did not have a clear
picture of how to value Nike. Ford then performed her own sensitivity analysis which revealed Nike
was undervalued at discount rates below 11.17%.
WHAT IS THE WACC?
A firm derives its assets by either raising debt or equity or both. There are costs associated with
raising capital and WACC is an average figure used to indicate the cost of financing a company’s
asset base. More formally, the weighted average cost of capital (WACC) is the rate that a company is
expected to pay to debt holders and shareholders to finance its assets. Companies raise money from
a number of sources so the WACC is the minimum return that a company must earn on existing asset
base to satisfy its creditors, owners, and other providers of capital.
WACC is calculated taking into account the relative weights of each component of the capital structure
which means it is the proportional average of each category of capital inside a firm. This rate, also
called the discount rate, is used in evaluating whether a project is feasible or not in the net present
value (NPV) analysis, or in assessing the value of an asset.
WACC = [Wdebt * Kdebt * (1-t)] + [Wequity * Kequity] + [Wpreferred * Kpreferred]
K = component cost of capital
W = weight of each component as percent of total capital
t = marginal corporate tax rate
WHY IS IT IMPORTANT TO ESTIMATE A FIRM’S COST OF CAPITAL?
The cost of capital is an important issue from the perspective of management while taking a financial
decision. We can list some basic issues related to the importance of WACC and its interpretation by
firms:
* The importance of the WACC is in its relation to the evaluation of
projects. For a project to be feasible, not just profitable, it must generate a return higher than the cost
of raising debt (Kd) and the cost of raising equity (Ke). WACC is affected not only by Re and Rd, but it
also varies with capital structure. Since Rd is usually lower than Re, then the higher the debt level, the
lower the WACC. This partly explains why firms usually prefer issuing debt first before they raise more
equity. As part of their risk management processes, some companies add a risk factor to the WACC in
order to include a risk cushion in their project evaluation.
* The cost of capital is also important for the management while taking a decision about capital
budgeting. Naturally, the project which gives a higher (satisfactory) return on investment compared to
the cost of capital incurred for its financing would be chosen by the management. Cost of capital is the
key factor in deciding which project to undertake out of different opportunities.
* The cost of capital is significant in designing the firm's capital structure. It will direct the management
about adopting the most appropriate and economical capital structure for the firm which means the
management may try to substitute the various methods of finance to minimize the cost of capital so as
to increase the market price and the earning per share.
* The cost of capital is also an important factor for taking a decision about the soundest method of
financing for the company whenever the company requires additional finance. The management may
try to catch the source of finance which bears the minimum cost of capital.
* The cost of capital can be used to evaluate the financial performance of the top management by
comparing actual profitability’s of the projects and the projected overall cost of capital and an appraisal
of the actual cost incurred in raising the required funds.
DO WE AGREE WITH JOANNA COHEN’S WACC CALCULATION? WHY OR WHY NOT?
We do not completely agree with Joanna Cohen’s calculation of WACC. There are several problems in
her calculation;
* In Cohen’s calculation, she used the book value for the weights of each capital structure component
(debt and equity). Book value of equity should not be used when calculating cost of capital. Instead
she should have calculated the market value of equity. Also, she should have discounted the value of
long-term debt that appears on the balance sheet to find the market value of debt (even if the book
value of debt is accepted as an estimate of market value).
* Also, she should have considered the preferred stock while calculating the weights of the
components of capital structure (the redeemable preferred stock is relatively small in Nike’s capital
structure so it doesn’t affect the weights).
* Another problem with her calculation is about the cost of debt. Cohen used a cost of debt which is
even lower than treasury yield. In common sense, a company, even it might be a large AAA firm,
should be risky than US government. Cost of debt should be calculated by finding the yield to maturity
on 20-year Nike Inc. debt with current coupon rate paid semi-annually instead of by taking total
interest expense for 2001 and dividing it by the company’s average debt balance.
USING SINGLE OR MULTIPLE COSTS OF CAPITAL IS APPROPRIATE FOR NIKE INC.?
Even Nike Inc. has multiple business segments such as footwear, apparel, sports equipment and
some non-Nike-branded products (which accounts for relatively small fraction of revenues), we
assumed Nike Inc. to have a single cost of capital since its multiple business segments are not very
different and would experience similar risks and betas.
WHICH EQUITY RISK PREMIUM SHOULD BE USED TO DETERMINE THE COST OF CAPITAL?
For the cost of capital, the geometric mean is a better alternative to the arithmetic mean. Furthermore,
the geometric mean is a more conservative measure to use compared to the arithmetic mean. The
average market risk premium has fluctuated by large amounts in short time periods from 1926-1999.
1926-1929 saw high market risk premiums; however, the 1930s and 1970s saw very low market risk
premiums. Therefore, we use the geometric mean since it is a better measurement compared to
arithmetic mean when the measured period is longer and contains more fluctuations.
VALUE OF EQUITY, VALUE OF DEBT AND WEIGHTINGS OF EACH COMPONENT
| Value(in millions $)| Weight|
Current Portion of Long term Debt| 5.40| 0.04%|
Notes Payable| 855.30| 6.73%|
Long-Term Debt| 416.72| 3.28%|
Total Debt| 1,277.42| 10.05%|
Equity| 11,427.44| 89.95%|
Table 1. The weight of debt and equity in total capital of Nike
CALCULATION OF THE COST OF EQUITY UNDER DIFFERENT METHODS AND ADVANTAGES
AND DISADVANTAGES OF EACH METHOD
1. Capital Asset Pricing Model (CAPM)
Under CAPM we can find the cost of equity as;
Ke = Rf + Betai * Equity Risk Premium
The first issue is to find an appropriate risk-free rate. We think the 20-year yields on treasures would
be the one because NIKE is assumed to be operated for such long time, according to the revitalizing
strategy proposed by the management and the long-term debt issued.
Next is to determine the beta. The historic betas has been generally decreasing, and we assume it is
the market condition and management`s purpose that make NIKE to be a defensive company.
Furthermore, we find that the competitors such as K-Swiss and Lacrosse also have beta less than
one. So rather than the average, we use the YTD beta into calculation. On the other hand, since the
beta has been found to be on average closer to the mean value of 1, which is the beta of an average-
systematic-risk security, we calculate the adjusted beta, giving two-third weight to the YTD beta and
one-third weight to 1.
Regarding the risk premium, we use the geometric mean since it is a better measurement compared to
arithmetic mean when the measured period is longer and contains more fluctuations.
Combining the above information, we calculate the cost of equity as follows:
Using YTD Beta => 5.74% + 0.69*5.9% = 9.81%
Using Adjusted Beta => 5.74% + [(2/3)*0.69 + (1/3)*1)]*5.9% = 10.42%
Advantages:
* It provides an economically grounded and relatively objective procedure * It concentrates on the
systematic risk that investors can`t avoid, rather than unsystematic risk that can be avoided through
diversification * It is suitable for company that doesn`t pay dividend
* It is widely used.
Disadvantages:
* The assumptions may not be realistic. For example, investors may not be all risk averse and rational
that holds efficient portfolio * Investors may concern more than just market risk.
2. Dividend Discount Model (DDM)
Under DDM we can find the cost of equity as;
Ke = (D1/P0) + g
Ke = (0.48*1.055/42.09) + 5.5% = 6.70%
Here we assume NIKE will pay dividend at constant growth rate of 5.5% which forecasted by Value
Line, so we use the Gordon growth model to derive required rate of return.
Advantages:
* It is simple and widely used
* Can be used to infer implied required rate of return
* It is helpful to perform a sensitivity analysis on the inputs
Disadvantages:
* It is not suitable for company that doesn`t pay consistent dividends or the dividends are not tied to
profitability * It is suitable for only matured company
3. Earnings Capitalization Ratio (ECM)
Under ECM we can find the cost of equity as;
Ke = E1/P0
Ke = 2.32/42.09 = 5.51%
Advantage:
* Simple
Disadvantages:
* It assumes the earnings would be the same in the future, which may not be true * It doesn`t take the
growth of company into consideration.
Cost of Equity| | |
CAPM| | |
| Risk-free Rate| 5.74%|
| Equity Risk Premium| 5.90%|
| Year-to-Date Beta| 0.69|
| Adjusted Beta| 0.79|
| Cost of Equity with YTD Beta| 9.81%|
| Cost of Equity with Adjusted Beta| 10.42%|
|||
DDM| | |
| Current Dividend| 0.48|
| Growth Rate| 5.50%|
| Current Stock Price| 42.09|
| Forecasted Dividend| 0.5064|
| Cost of Equity| 6.70%|
|||
ECM| | |
| Consensus Earnings Estimate| 2.32|
| Current Stock Price| 42.09|
| Cost of Equity| 5.51%|
|||
Build-up Method| | |
| Risk-free Rate| 5.74%|
| Equity Risk Premium| 5.90%|
| Cost of Equity| 11.64%|
Table 2. Cost of Equity under different methods
WHICH RATE AS RISK FREE RATE IS BEST FOR NOTES PAYABLE AND LONG-TERM DEBT?
For long term debt, the 20-year yield on U.S. Treasuries is best as the risk free rate. Considering the
long time horizon of Nike, a 20-year bond is property. And also, it is comparable to the current 25-year
bond which Nike issued 5 years ago. Although Nike’s current bond is 25 years, we could consider it as
a 20-year bond issued this year, and use the current price to calculate the 20-year bond YTM.
And for short term debt, because the note payable was a major portion in the debt structure, the 1-year
treasuries would be preferred as risk free rate.
COST OF DEBT CALCULATION FOR NIKE
We could not agree with Cohen’s analysis. Because Cohen used a cost of debt
which is even lower than treasury yield. In common sense, a company, even it might be a large AAA
firm, should be risky than US government.
First, Cohen’s emphasis that last year, the effective cost of debt of Nike was less than treasury yield
due to its Japanese Yen notes. However, the rates of debt based on currency change are unstable
and non-repeatable. We could reasonable consider that Nike’s last year’s low cost of debt is a kind of
arbitrage by chance.
Second, to calculate the cost of debt, market value of debt should be used rather than the book value
used by Cohen. The market value of debt is compounded by the current portion of long-term debt,
notes payable, and long- term debt discounted at Nike’s current coupon.
Therefore, we would like to recalculate the cost of debt. Cost of debt was calculated by using the
current liquidated 20-year bond of Nike, Inc. with a 6.75% coupon semi-annually. Then we obtain a
cost of long term debt before tax as 7.17%, and cost of short term debt before tax as 5.02%.
As shown above in Table 1, short term debt took a significant portion in Nike’s debt structure;
therefore, we use a weighted cost of debt to combine both long term and short term debt effects as in
following equation:
Here is the weight of short-term debt, while is the weight of long-term debt. And both cost of short-term
and long-term debt are after tax.
Cost of Debt| | |
Long Term Debt| | |
| Coupon Rate| 6.75%|
| Time to Maturity| 40|
| Current Stock Price| $95.60|
| Cost of Debt| 7.17%|
| After Tax Cost of Debt| 4.44%|
Short Term Debt| | |
| 20-year Yield| 5.74%|
| 1-year Yield| 3.59%|
| Risk Premium| 1.43%|
| Tax Rate| 38.00%|
| Cost of Debt| 5.02%|
| After Tax Cost of Debt| 3.11%|
Final Weighted Cost of Debt After Tax| 0.36%|
Table 2. Cost of debt
WHAT IS OUR WACC CALCULATION FOR NIKE?
Under different methods, we would obtain different cost of equity, then, definitely different WACCs
which range from 5.31% to 10.83%. However, no matter which method we use, the stock price of Nike
is undervalued currently.
WACC| | |
| Under CAPM with Adjusted Beta| 9.73%|
| Under CAPM with YTD Beta| 9.18%|
| Under DDM| 6.39%|
| Under ECM| 5.31%|
| Under Build-up Method| 10.83%|
Table 4. Weighted Average Cost of Capital
As shown in Table 5, the actual implied discount rate by current price is 11.17%, which is significantly
beyond the range of WACCs we calculated and presented in Table 4. Therefore, in our analysis,
Nike’s price would be considered as undervalued.
Discount Rate| Equity Value|
8.00 %| $ 75.80|
8.50 %| 67.85|
9.00 %| 61.25|
9.50 %| 55.68|
10.00 %| 54.92|
10.50 %| 46.81|
11.00 %| 43.22|
11.17 %| 42.09|
11.50 %| 40.07|
12.00 %| 37.27|
Table 5. Sensitivity test on WACCs
RECOMMENDATION
This graph shows the estimated value provided under different WACCs, and NIKE is currently trading
at 42.09 with corresponding 11.17% WACC. So if the calculated WACC is below 11.17%, the
estimated value would be higher than the current price and NIKE is undervalued; if the calculated
WACC is beyond 11.17%, the estimated value would be lower than the current price and NIKE is
overvalued.
After adjusting the possible mistakes that Joanna made, the table shows the calculated WACC under
each method:
Method| WACC|
CAPM (Adjusted Beta)| 9.73%|
CAPM (YTD Beta)| 9.18%|
DDM| 6.39%|
ECM| 5.31%|
Build-up| 10.83%|
We can see none of them is above 11.17%, indicating NIKE is currently undervalued and Ford should
add NIKE to the NorthPoint Large-Cap Fund. However, it is important to keep monitoring the
revitalizing strategy that the management offered, since the future market condition may have huge
impact on this strategy and hence, predicted future economic income.
NorthPoint Group is a mutual fund management firm who has the preference on investing in Fortune
500 companies, such as EXXONMobil, GM, McDonald’s 3M and other large-cap. If we look back to a
decade ago, the fund had performed extremely well compared to the market in general (we refer
S&P500 to represent the market).
Kimi Ford was the portfolio manager in NorthPoint Group, who was concerned about whether or not to
add Nike, Inc. shares into her fund. Since net income and market share had been fallen from 1997, a
new strategy was proclaimed by the Nike management team during the meeting held in June, 2001:
First, highly priced products are no longer their only target, now they would develop the midpriced
segment so that more customers will be able to afford it.
Second, another way to boost the revenue is to focus on its apparel line, which they found out to be
profitable. Finally, Nike needs to reduce its costs by exerting more effort on expense control. Company
executives were optimistic about the long-term revenue, expecting an 8%~ 10% growths and earnings
growth above 15%.
Analysts had different opinion about the company prospects; Lehman Brothers suggested a strong
buy while UBS and CSFB recommended a hold. Meanwhile, Ford wanted to make her own forecast so
she developed a discount cash flow to determine that, at a discount rate of 12%, Nike was overvalued
at its current price $42.09 and undervalued if the discount rate was below 11.17%. She asked her
assistant, Joanna Cohen, to calculate the company’s cost of capital precisely.
On the report, Joanna Cohen used WACC to calculate the cost of capital, where she adopted book
values to obtain a proportion of 27% of debt and 73% of equity. For cost of debt, she took total interest
expense divided by average debt balance which resulted lower than treasury yields. For cost of equity,
she used 20-year Treasury bond as risk-free rate and 5.9% as market premium. Moreover, she divided
each division by revenue, deciding to use one overall WACC. At the end, she came to a conclusion
that the cost of capital for Nike, Inc was 8.4%.
