NIKE, Inc.

COST OF CAPITAL
DIAJUKAN UNTUK MEMENUHI TUNTUTAN MATA KULIAH

STRATEGIC MANAGEMENT

KELOMPOK V

RATU SIMBIAK, YOUSANIA

SAPTENNO, YORITA

NAJOAN, JONATHAN

PASCASARJANA
UNIVERSITAS KLABAT
EXECUTIVE SUMMARY:

Kimi Ford, a portfolio manager for the mutual-fund management firm of NorthPoint
Group, was reviewing the financials of Nike Inc. to consider buying shares for the NorthPoint
Large-Cap Fund that she managed, which invested money mostly in Fortune 500 companies.
Its top holdings include ExxonMobile, General Motors, McDonald’s, 3M and other large cap,
generally old-economy. A week prior, Nike Inc. held an analysts’ meeting to share their 2001
fiscal results and develop a strategy to revitalize the company. The stock market declined
over the last 18 months, NorthPoint large-cap fund 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.

Nike, Inc is the athletic-shoe manufacturer. Nike has multiple business segments.
Aside from footwear, which makes up 62 percent of revenue, Nike also sells apparel (30
percent of revenue) that complement its footwear products. In the addition, Nike sells sports
balls, timepieces, eyewear, skates, bats, and other equipment designed for sport activities.
Equipment products accounts for 3.6 percent of revenue. Finally, Nike also sells some non-
Nike branded products (4.5 percent of revenue) such as Cole-Haan dress and casual footwear,
ice skates, skate blades, hockey sticks, hockey jersey, and under products under the Bauer
trademark. Nike’s revenues since 1997 had rown (plateaued) from $9 billion, while net
income had fallen $220 million (from $800 to $580). Nike’s market share in the U.S athletic
shoe industry had fallen from 48 percent in 1997, to 42 percent in 2000. In addition supply-
chain issues and the effects of a strong dollar negatively affected revenues. In the meeting,
management is concerned about the top-line growth and operating performance. Management
planned to increase revenues by developing more athletic-shoe products in ranges varying
between $70-$90 (the mid-priced segment) a segment that Nike had overlooked in the recent
years; and to push their apparel line. The company has planned to exert more effort on the
expense control. Nike’s executives expressed that the company would still continue with a
long-term revenue growth target of 8-10 percent and earning-growth target above 15 percent.

Nike vision is To be the world leading innovator in athelete footwear, apperel, equipment and
accesories. And its mission TO BRING INSPIRATION AND INNOVATION TO EVERY
ATHLETE IN THE WORLD. Objective : Long term Revenues growth target of 8-10
percent, and earnings growth targets above 15%.

Statement of problem is Should Kimi Ford buy Nike’s stock price right time now or not?
INTRODUCTION

On july 5, 2001, Kimi Ford, a portfolio manager for the mutual-fund management firm of
NorthPoint Group, was reviewing the financials of Nike Inc. to consider buying shares for the
NorthPoint Large-Cap Fund that she managed, which invested money mostly in Fortune 500
companies. Its top holdings include ExxonMobile, General Motors, McDonald’s, 3M and
other large cap, generally old-economy. A week prior, Nike Inc. held an analysts’ meeting to
share their 2001 fiscal results and develop a strategy to revitalize the company. The stock
market declined over the last 18 months, NorthPoint large-cap fund 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.

Nike, Inc is the athletic-shoe manufacturer. Nike’s revenues since 1997 had grown
(plateaued) from $9 billion, while net income had fallen $220 million (from $800 to $580).
Nike’s market share in the U.S. athletic shoe industry had fallen from 48 percent in 1997, to
42 percent in 2000. In addition, supply-chain issues and the effects of a strong dollar
negatively affected revenues. In the meeting, management is concerned about the top-line
growth and operating performance. Management planned to increase revenues by developing
more athletic-shoe products in ranges varying between $70-$90 (the mid-priced segment) a
segment that Nike had overlooked in the recent years; and to push their apparel line. The
company has planned to exert more effort on the expense control. Nike’s executives
expressed that the company would still continue with a long-term revenue growth target of 8-
10 percent and earnings-growth target above 15 percent.

VISION & MISSION

Vision :
To be the world leading innovator in athelete footwear, apperel, equipment and accesories

Mission:
TO BRING INSPIRATION AND INNOVATION TO EVERY ATHLETE* IN THE
WORLD (*If You Have A Body, You Are An Athlete)

Objective : Long term Revenues growth target of 8-10 percent, and earnings growth targets
above 15%
SWOT ANALYSIS

Strength :
- Number one sports brand in the world
- Global brand
- Strong at R&D and innovation
- Strong sense of marketing campaign
- No factories that tie up cash in buildings and manufacturing
- It manufactures where ever it can produce the highest quality products for the lowest
price
- Sponsored top athletes - gained valuable coverage
- Consumers feel NIKE is a “fashion brand”

Weaknesses :
- Most of Nike profit margin comes from the shoe sector/ Low concern to other market
segment
- The retail sector is very price sensitive
- Questionable factory working conditions

Opportunities:
- Could develop sport wear, sunglasses, and jewelry
- Enter the mid-price segment
- Push the apparel line
- Growing sporting industry as health benefits are being recognized

Threats:
- Nike is exposed to the international nature of trade or International market kompetition
- Competitive market for sports shoes and garments
- The declining market share in U.S
- Consumer looking for the better deal
- Competitors are developing alternative brands to take away Nike’s market share

STATEMENT OF PROBLEM

Should Kimi Ford buy Nike’s stock price right time now or not?
ALTERNATIVE SOLUTION:

We use WACC Formula to determine the discount rate use in Discounted cash flow analysis :

“WACC = (E/V). KE + (D/V).KD . (1-T)”

Legend:

V = D + E = Total Capital
D: Amount of Debt
E: Equity
KD: Cost of Debt
KE: Equity
T: Tax rate

1) Use Joanne assumption for WsACC formula

First assumption is single or multiple cost of capital. Joanne concluded that only the
Cole-Haan line that was somewhat different; the rest were all sports-related
businesses. Joanne believe they face the same risk factors. So she decide, to compute
only one cost of capital for the whole company
Second assumption is that the weight of debt and the weight equity is based on the
latest available balance sheet.
Capital sources Book Values
Debt
Current portion of long-term debt $5.4
Notes payable 855.3
Long-term debt 435.9
Total debt 1296.6 27%

Equity 3494.5 73%

The next assumption is the cost of debt joanne estimate of Nike’s cost of debt is 4.3%.
she estimate the cost by taking total interest for the year 2001 and dividin it by the
company’s average debt balance. After adjusting for tax, the cost of debt comes out to
2.7% with used a tax rate of 38%.

The last assumption is cost of equity. Joanne estimate the cost of equity using capital
asset pricing model (CAPM). Because in her opinion CAPM is the superior method.
And the Nike cost of equity is 10.5% . she used curent yield on 20-year Treasury
bonds as risk-free rate, and the compound average premium of the market over
Treasury bonds as risk-premium. For beta i took the averae of Nike’s beta from 1996
to the present.

WACC = Kd(1-t) * D/(D+E) + Ke* E/(D+E)

= 2.7% * 27.0% + 10.5% * 73.0% = 8.4%
 Equity value per share at 8.4% is $69.32

2) Use our assumption for WACC formula

To calculate the cost of equity we can used Capital Asset Pricing Model (CAPM)

Calculate KE : Cost of Equity

Using CAPM (popular) for calculate Ke

KE = KRF + (KM – KRF) x Beta
Beta: is seen as an ‘index of responsiveness’ of changes in a security’s returns
relative to changes in returns on the market, in this case is sport utility industry)
(In Exhibit 4 of Nike Inc., given from 1996 is Average beta = 0.80, beta in 2001 is
0.69)
KRF: risk free rate
(KM - KRF) : Risk market premium
KM: Return on market.
Using KRF = Profitability rate of Government bonds (U.S. Treasury), in Exhibit 4 we
have U.S Treasury 20-year KRF= 5.74%
According to Joana Cohen, she got risk premium = 5.90% (in Exhibit 4:
geometric mean = 5.90%, arithmetic mean = 7.50%)

Because of arithmetic mean is better for one-year period estimated expected returns,
while geometric mean is better for long-term period valuation. So, for long life
valuation, we can find stable valuation (Jacquier et al., 2003). That’s the answer for
Joana Cohen choses geometric mean for her calculated.

Joanna Cohen calculated: KE = 5.74% + 5.90% x 0.80

= 10.46% ( rounding 10.5%)

Cohen uses average beta from 1996 to July 2001, 0.80 to be the measure of systematic
risk, but we need to find out a beta that is most representative to future beta. As such,
most recent beta is the best choice in this situation(Sharpe, 1995). So most recent beta
estimate is recent beta at 06 June 2001 is 0.69.

We have : KE = 5.74% + 5.90% x 0.69

= 9.81%

And then, the calculate for cost of debt: The cost of debt, if it is intent to
be forwarding looking, should be estimated by yield to maturity of bond or according
to credit rating.
 The more appropriate cost of debt can be calculated by using data provided in Exhibit
4. We can calculate the current yield to maturity of the Nike’s bond to represent
Nike’s current cost of debt.

PV= 95.60
n=40
FV=100
I = 3.375 % (semiannual) 6.75% (annual)

+ Bond issued in 07/15/96, its maturity is 07/15/21 => 25-year bond (or the bond was
issued 5 years ago, because now is year 2001). As result, we have n=2×(25-5)=40 (paid
semiannually)
r
1−(1+ )−40 100
2
95.6=3.375 + r
r/2 (1+ )40
2

→ r= 7.16%
→ Cost of debt (after tax) is: 7.16%(1-38%) = 4.44%
KD do Joanna Cohen calculated = 4.3%

For The weight of Debt and Equity:

The WACC is used for discounting cash flows in the future (Lloyd & Davi, 2007),
thus all components of cost must reflect firm’s concurrent or future abilities in raising
capital. But Joanna Cohen uses the historical data in estimating the cost of debt ->
She did a mistake here. She divided the interest expenses by the average balance of
debt to get 4.3% of before tax cost of debt. It may not reflect Nike’s current or future
cost of debt.

Cohen is wrong to use book values as the basis for debt and equity weights; the
market values should be used in calculating weights. The reasoning of using market
weights to estimate WACC is that it is how much it will cause the firm to raise capital
today. That cost is approximated by the market value of capital, not by the book value
of capital. Cost of capital based on market value not book value (Pratt & Grabowski,
2008).

For market value of equity = Current Share Price x Current Shares Outstanding
= $42.09 x 271.5m
= $11,427.44m.

Due to the lack of information of the market value of debt, book value of debt,
$1,296.6m, is used to calculate weights.
Thus, the market value weight for equity is
 We = [11,427.44 / (11,427.44+1,296.6)]
= 89.8%

So, the weight for debt is 10.2%.

Wd = 1 - 89.8% = 10.2%

WACC calculation is

WACC = Kd(1-t) * D/(D+E) + Ke* E/(D+E)

=10.2% x 4.44% + 89.8% x 9.81%

= 0.45% + 8.81%= 9.26%

Equity value per share at 9.26% is $58.24

CONCLUSION:

According to Kimi Ford’s quick sensitive analysis, Nike was undervalued at discount
rate below 11.17%.
Kimi Ford used a discount rate of 12 percent to find a share price of $37.27. This
makes Nike Inc. share price overvalued by $4.82 as Nike is currently trading at $42.09.
We already established that we found this discount rate to not reflect the true market value
and solved for a discount rate that would be more accurate. Furthermore, discounting cash
flows in Exhibit 2 with the calculated WACC is 9.26%, the present value of Nike is
$58.24 much higher than Nike’s current market price of $42.09.
We assumpt the terminal value growth rate is 3%
So Nike shares price is undervalued. Moreover, Nike also changed their business strategy
by more concentrate in mid-priced segment, which is Nike less concentrate for a long time
before. That’s mean their total of sales might increase, lead to avenue increase, lead to profit
increase, of course, Nike’s share prices and dividend will be increase in long-term.
Using this data, we found that NorthPoint Large-Cap Fund should buy Nike Inc.,
shares at this time because the stock is undervalued and because it had growth potential that
would be beneficial to the fund.
In conclusion, based on all data including history data, recently data and future data, it is
clearly that decision is Kimi Ford should buy Nike’s shares because it quite safe,
underestimate of market and growth dramatically compare with its history, other companies
in industry and other shares in S&P 500. Overall, Nike’s shares are very potential.