Nike Analysis

I. Introduction

Kimi Ford, a portfolio manager at NorthPoint Group, was reviewing the financials of Nike Inc. to consider buying shares for the fund she managed, the NorthPoint Large-Cap Fund. A week before Kimi Ford began her research, Nike Inc. held an analysts' meeting to reveal their 2001 fiscal results and for management to communicate a strategy to revitalize the company. Nike's revenues since 1997 had ceased to grow from $9.0 billion, and net income had now fallen $220 million ($800MM - $580MM). In addition a study printed in Business Week revealed that Nike's market share in the U.S. athletic shoe industry had fallen from 48 percent in 1997 to 42 percent in 2000. In the meeting, management planned to raise revenues by developing more athletic-shoe products in the mid-priced range, sold at $70-$90. Nike also planned to push its apparel line and exert more expense control. During the meeting, Nike's executives expressed that the company would still continue with a long-term revenue growth target at 8-10 percent and earnings-growth targets above 15 percent.

Kimi Ford decided that it was necessary to develop her own discounted-cash-flow forecast in order to arrive at a proper investment decision for her mutual fund. Her forecast proved that at a 10 percent discount rate, that Nike's stock price was overvalued at $5.95 per share. In addition, a sensitivity analysis she created revealed that Nike stock was undervalued at discount rates less than 9.4 percent. Ford was not clear on a decision to buy Nike stock, so she asked Joanna Cohen to estimate Nike's weighted average cost of capital.

II. Cost of Capital Calculations

Cohen calculated a weighted average cost of capital (WACC) of 8.3 percent by using the capital asset pricing model (CAPM) for Nike Inc. The problem with Cohen's calculations is that she used the book value for both debt and equity. While the book value of debt is accepted as an estimate of market value, book value of equity should not be used when calculating cost of capital. The market value of equity is found by multiplying the stock price of Nike Inc. by the number of shares outstanding.

Market Value of Equity

E = Stock Price # Shares Outstanding

$42.09 271.5

E = $11,427.44

This figure is much different than the book value of equity that Joanna Cohen used ($3,494.50). In addition, for market value of debt, Cohen uses the book value, when in fact she should have discounted the value of long-term debt that appears on the balance sheet. The market value of debt is found by adding the current portion of long-term debt, notes payable, and long-term debt discounted at Nike's current coupon.

Market Value of Debt

D = Current LT Notes Payable LT Debt (discounted)

$5.40 $855.30 $416.72

D = $1,277.42

Using these figures, we can now find the market value of Nike Inc., and the company's capital structure.

Weight of Debt Weight of Equity

W = D /D+E W = E /D+E

W = $1,277.42 $12,704.86 W = $11,427.44 $12,704.86

10.05% 89.95%

The next issue at hand is finding the correct costs of debt and equity in order to find an accurate calculation of WACC. Cohen used the 20-year yield on U.S. Treasuries as the risk free rate, which we found to be the correct figure given that Nike Inc. debt was valued over 25 years. Because there is no other given yield that is comparable to a 25-year valuation period, our risk free rate used in calculations is 5.74 percent.

Just as important as choosing a risk free rate is choosing the appropriate market risk premium. There are two historical equity risk premiums given for a time period from 1926 to 1999: Geometric mean and arithmetic mean. The geometric mean is a better estimate for longer life valuation while the arithmetic mean is better for a one-year estimated expected return. Therefore, we chose to use the geometric mean to coincide with the choice to use the 20-year yield on U.S. Treasuries, which is 5.9 percent.

Next, we had to decide on a beta to use for Nike Inc. for use in the CAPM approach. The logical choice was to use the average (0.80) to account for the large fluctuations seen in Nike's historic betas. We felt that the YTD beta was a reflection of current business practices, but the goal of Nike Inc. was to look forward and gain back market share and increase revenues. Consequently,