A case study on Nike Inc. has been uploaded. Please address the following issues

in brief based on the case-

a. Identify and explain the major flaws in Cohens estimate of cost of capital.

b. Now, after addressing the previous errors write a letter to Kimi Ford again with the

revised estimate of the cost of capital with proper justifications. In the end, recommend

Ford if Nike would be a worthy investment or not?

Nike, Inc.: Cost of Capital 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. Although the stock market had declined over the last 18 months, the NorthPoint Large-Cap Fund had performed extremely well. In 2000, the found 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. Only a week earlier, on June 28, 2001, Nike had held an analysts' meeting to disclose its fiscal-year 2001 results. The meeting, however, had another purpose: Nike management wanted to communicate a strategy for revitalizing the company. Since 1997, its revenues had plateaused 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. In addition, recent supply-chain issues and the adverse effect of a strong dollar had negatively affected revenue. 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 mid-priced segment 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, had performed extremely well. On the cost side, Nike would exert more effort on expense control Finally, company executives reiterated their long-term sevente-growth targets of 8% to 10% and earnings-growth targets of above 15%. 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. 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 Nike's fiscal year ended in May. 2 Douglas Robson, "Just Do...Something Nite's Insularity and Foot-Dragging Have It Running in Place," Basiesek 2 July 2001). Sneakers in this segment sold for $70 to $90 a pair. * Mindy Grossman joined Nike in September 2000. She was the fomer president and chief executive of Jones Apparel Group's Polo Jeans division Her forecast showed that, at a discount cate of 12%, Nike was overvalued at its cucrent share price of $42.09 Exhibit 2). She had done a quick sensitivity analysis, however, which 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 Cohen immediately gathered all the data she thought she might need (Exhibit 1 through Exhibit 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. Exhibit 1 Nike, Inc.: Cost of Capital Consolidated Income Statements 1995 Year Ended May 31 1996 1997 1998 1999 2000 2001 (in millions of dollars except per-share data) Revenues $4,760.8 $ 6,470.6 $ 9,186.5 $9,553.1 $ 8,776.9 $8.995.1 $ 9,488.8 Cost of goods sold 2.865.3 3,906.7 5,503.0 6,065.5 5,493.5 5,403.8 5,784.9 Gross profit 1,895.6 2,563.9 3,683.5 3,487.6 3,283.4 3,591.3 3,703.9 Selling and administrative 1,209.8 1,588.6 2,303.7 2,623.8 2,426.6 2,606.4 2,689.7 Operating income 685.8 975.3 1,379.8 863.8 856.8 984.9 1,014.2 Interest expense 24.2 39.5 52.3 60.0 44.1 45.0 58.7 Other expense, net 11.7 36.7 32.3 20.9 21.5 23.2 34.1 Restructuring charge, net 129.9 45.1 (2.5) Income before income taxes 649.9 899.1 1,295.2 663.0 746.1 919.2 921.4 Income taxes 250.2 345.9 499.4 253.4 294.7 340.1 331.7 Net income $ 399.7 $ 553.2 $ 795.8 $ 399.6 $ 451.4 $ 579.1 $ 589.7 1.57 $ 287.5 2.07 $ 279.8 2.16 273.3 (8.1) (0.8) 13.0 2.5 15.0 28.3 5.5 3.0 1.8 Diluted earnings per common share $ 1.36 $ 1.88 $ 2.68 $ 1.35 $ Average shares outstanding (diluted) 294.0 293.6 297.0 296.0 Growth (%) Revenue 35.9 42.0 4.0 Operating income 42.2 41.5 (37.4) Net income 38.4 43.9 (49.8) Margins (%) Gross margin 39.6 40.1 36.5 Operating margin 15.1 15.0 9.0 Net margin 8.7 4.2 Effective tax rate (%)* 38.5 38.6 38.8 *The U.S. statutory tax rate was 35%. The state tax varied yearly from 25% to 3.5% Sources of data: Company filing with the Securities and Exchange Commission (SEC), UBS Warburg 37.4 9.8 5.1 39.9 10.9 6.4 39.0 10.7 6.2 8.5 39.5 37.0 36.0 Exhibit 2 Nike, Inc.: Cost of Capital Discounted Cash Flow Analysis 2003 2004 2005 2006 2007 2008 2009 2010 2011 6.0 58.0 25.0 2002 Assumptions: Revome growth (9) 7.0 COGS/sales (%) 60.0 SG&A/sales) Tax rate() 35.0 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 6.5 60.0 27.5 38.0 38.0 11.5 6.0 59.0 25.5 59.5 27.0 38.0 38.0 6.5 59.5 26.5 38.0 38.0 11.3 6.0 59.0 26.0 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 11.3 38.0 38,0 115 38.0 11.5 38.0 11.5 Discounted Cash Flow (in millions of dollars except per-share data) Operating income 1.218.4 S 1,351.6 S 1,554.6 5 1.717.0 51.950.0 $ 2.135.9 $2,4102 $2,554.8 $ 2.790.1 2.957.5 Taxes 463.0 5136 590.8 652.3 741.0 811.7 9159 970.8 1,060.2 1.123.9 NOPAT 755.4 838.0 963.9 1,0645 1.209.0 1,324,3 1,4943 1,584.0 1.729.9 1.833.7 Capex, net of depreciation Change in NWC 3.8 (1749) (1863) (1984) (195.0) (206.7) (219.1) (232.3) (246.2) (261.0) Free cash flow 764.1 663.1 777.6 $66.2 1,014.0 1.117.6 1,2752 1,351.7 1,483.7 1,572.7 Terminal value 17,998.3 Total flows 764.1 663.1 777.6 866.2 1.014.0 1,117.6 1,2752 1,351.7 1,483.7 19,371.0 Present value of flows $ 682.3 $528.6 S 553.5 5 550.5 S 575.4 $ 566.2 $ 576.8 $ 545.9 5 535.0 56,301.2 Enterprise value $ 11,415.4 Less: current outstanding debt 1.296.6 Equity value 10.118.8 Current shares outstanding 271.3 Equity value per share $ 37-27 Current share price: 42.09 Serestry of equity value to discount rate: Discount rate Equity value 8.00% $ 75.80 8.50% 67.85 9.00% 61.25 9.50% 55.68 10.00% 50.92 10.50% 46.91 11.00% 43.22 11.17% 42.09 11.50% 40.07 12.00% 3727 Source Case writers analysis Eshibit 3 Nike, Inc.: Cost of Capital Consolidated Balance Sheets As of May 31, 2000 2001 (in millions of dollars) Assets Current assets: Cash and equivalents Accounts receivable Inventories Deferred income taxes Prepaid expenses Total current assets $ 254.3 1,569.4 1,446.0 111.5 215.2 3,596.4 $ 304.0 1,621.4 1,424.1 113.3 162.5 3,625.3 Property, plant and equipment, net 1,583.4 1,618.8 Identifiable intangible assets and goodwill, net 410.9 397.3 Deferred income taxes and other assets 266,2 178.2 Total assets $ 5,856.9 $5,819.6 Liabilities and shareholders' equity Current liabilities: Current portion of long-term debt $ 50.1 $ 5.4 Notes payable 924.2 855.3 Accounts payable 543.8 432.0 Accrued liabilities 621.9 472.1 Income taxes payable 21.9 Total current liabilities 2,140.0 1,786.7 Long-term debt 470.3 435.9 Deferred income taxes and other liabilities 110.3 102.2 Redeemable preferred stock 0.3 0.3 Shareholders' equity: Common stock, par 2.8 2.8 Capital in excess of stated value 369.0 459.4 Uneamed stock compensation (11.7) (9.9) Accumulated other comprehensive income (111.1) (152.1) Retained earings 2.887.0 3,194.3 Total shareholders' equity 3,136.0 3,494.5 Total liabilities and shareholders' equity $ 5,856.9 $ 5,819.6 Sowce of data: Company filing with the Securities and Exchange Commission (SEC). Exhibit 4 Nike, Inc.: Cost of Capital Capital-Market and Financial Information on or around July 5, 2001 Current Yields on U.S. Treasures Nike Share Price Performance Relative to S&P 500: Jamuary 2000 to July 5, 2001 13 3-month 6-month 1-year 5-year 10-year 20-year 3.59% 3.5996 3.59% 4.88% 5.39% 5.74% 1.2 1.1 1.0 forward hross Dr 10- 10 Mary-00 Lordbe Jul 00 Nov.00 May-01 0.9 Historical Equity Risk Premiums (1926-1999) 08 Geometric meam 5.90% Arithmetic mean 7.50% 0.7 06 Current Yield on Publicly Traded Nike Debt 05 Coupon 6.75% paid semi-ammually 04 Issued 07/15/96 Maturity 07/15/21 1 Current Price $ 95.60 Nike ... SRP 500 Nike Historic Betas 1996 0.98 1997 0.84 Nike share price on July 5, 2001: $42.09 1998 0.84 1999 0.63 Dividend History and Forecasts 2000 0.83 Paymt Dates 31-Mar 30-Jum 30-Sep 31-Dec Total YTD 6/30/01 0.69 1997 0.10 0.10 0.10 0.10 0.40 1998 0.12 0.12 0.12 0.12 0.48 Average 0.80 1999 0.12 0.12 0.12 0.12 0.48 2000 0.12 0.12 0.12 0.12 0.48 2001 0.12 0.12 Consensus EPS estimates: FY 2002 FY 2003 Value Line Forecast of Dividend Growth from '98-'00 to '04'06: $ 2.32 $ 2.67 5.50% Data have been modified for teaching purposes. Sources of data: Bloomberg Financial Services, Ibbotson Associates Yearbook 1999. Value Line Investment Survey, BES. Exhibit 5 Nike, Inc.: Cost of Capital Joanna Cohen's Analysis TO: Kimi Ford FROM: Joanna Cohen DATE: July 6, 2001 SUBJECT: Nike's cost of capital Based on the following assumptions, my estimate of Nike's cost of capital is 8.4%: Single or Multiple Costs of Capital? I. The first question 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 reveme. 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. 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 sports-related 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. Methodology for Calculating the Cost of Capital: WACC Since Nike is funded with both debt and equty, I used the weighted average cost of capital (WACC) method. Based on the latest available balance sheet, debt as a proportion of total capital makes up 27.0% and equity accounts for 73.0%: II. Exhibit 5 (continued) Book Values (in millions Capital Sources Debt Cucrent portion of long-term debt Notes payable Long-term debt $ 5.4 855.3 435.9 $ 1,296.6 $ 3,494.5 Equity 27.0% of total capital 73.0% of total capital III. Cost of Debt 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. The rate is lower than Treasury yields, but that is because Nike raised a portion of its finding needs through Japanese yen notes, which carry rates between 2.0% and 4.3%. After adjusting for tas, 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%. Cost of Equity 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. My estimate of Nike's cost of equity is 10.5%. I used the current yield on 20-year Treasury bonds as my sisk-free cate, 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. IV. Putting It All Together After entering all my assumptions into the WACC formula, my estimate of Nike's cost of capital is 8.4%. WACC = K (1 t) *D/D+E) +K XE/D+E) = 2.7% X 27.0% + 10.5% X 73.0% = 8.4%